The role of corporate governance in coping with financial crisis, corporate scandals and failures

Corporate greed & corruption witnessed in the Rs. 1.76 lacs crore 2G scam, which involved many large businesses last year only got bigger this year with a host of other cases grabbing the limelight. Be it the much bigger Rs.1.86 lacs coal scam, charges of bending rules by DLF, Reebok or allegations of spending money in lobbying first by Walmart and then by another dozen MNCs in India….the list kept getting bigger.

The term ‘governance’ has been derived from the word ‘gubernare’ which means to “rule or steer”. Though originally meant to be a normative framework for exercise of power and acceptance of accountability thereof in the running of kingdoms, regions and towns. However, over the years it has found significant relevance in the corporate world. This is particularly so in the context of the growing number and size of the corporations, the widening base of their shareholders, increasing linkages with the physical environment and overall impact on the society’s wellbeing. Governance has assumed greater limelight with a series of corporate failings, both in the public and private sectors, following which the markets, the investors and the society at large, have begun to lose faith in the infallibility of these large systems.

The last two decades of corporate literature has made a significant contribution on corporate governance  which started from Sir Adrian Cadbury Committee’s Report and continued in Hampel Committee’s Report, King’s Committee Report, Greenbury Committee’s Report, the Combined Code of the London Stock Exchange ,the OECD ‘Code on Corporate Governance’, the Blue Ribbon’s Committee Report, the CII guidelines in India and SEBI appointed KM Birla Committee’s recommendations. All this literature emanated due to identification of some specific problem areas of corporate management practices all around the world and attempts from various corners to solve these problems.

The Enron debacle of 2001 involving the hand-in-glove relationship between the auditor and the corporate client, the scam involving the fall of corporate giants in the US (like WorldCom,Qwest,Global Crossing, Xerox) and the consequent enactment of the stringent Sarbanes-Oxley Act in the US were some important factors which led to the Indian Government to wake up and Naresh Chandra Committee was appointed in 2002 to examine and recommend drastic amendments to the law involving the auditor-client-relationship and the role of independent directors.  In 2002, Securities and Exchange Board of India (SEBI) analysed the statistics of compliance with Clause 49 of the listed Companies and within a gap of few months in 2003 constituted the Narayan Murthy Committee.

Thus, applying the concept of governance in the corporate world, what we get is the term , “Corporate Governance.”

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 behaviour. It will take more than just leadership by the corporate sector to restore public confidence in our capital market and  ensure their on-going vitality. To address this challenge the buzzword is “CORPORATE GOVERNANCE”

EVOLUTION: 

Corporate Governance Systems have evolved over centuries often in response to corporate failures and systemic crisis. Historically each crisis or major corporate failure, often a result of incompetence, fraud and abuse, has given new elements of an improved system of corporate governance. Through a process of continuous change developed countries have established a complex mosaic of laws, regulations and institutions and implementation capacity in the government and the private sector.

Hence “Corporate Governance is about promoting corporate fairness, transparency and accountability.” –James D. Wolfensohn (Ninth President World Bank)

ACCOUNTABILITY

In governance accountability is answerability, blameworthiness, liability and the expectation of account-giving.

Political Accountability: is the accountability of the government, civil servants and politicians to the public and to the legislative bodies such as:

OBJECTIVES SOUGHT TO BE ACHIEVED

Sheridan and Kendall believe that good corporate governance consists of a system of structuring ,operating and controlling a Company to reduce frauds, and scandals and achieve the following objectives:

a. To fulfill the long-term strategic goals of the owners, consisting of building shareholder value or establishing a dominant market share.

b. To Consider and care for the interest of the employees (past present and future) including planning future needs, recruitment, training and working environment, severance and retirement procedures.

c. To maintain good relations with customers and suppliers in matters such as quality of service, considerate ordering and account settlement procedures.

d. To take account of needs of the environment and local community ,in terms of the physical effects of the company’s operation on the surrounding area and the economic and cultural interaction with the local population also better worded as “CSR=Corporate Social Responsibility” 

e. To maintain proper compliance with all the applicable legal and regulatory requirements under which the company is carrying out its activities . It may be mentioned here that in 1992, the Cadbury Committee on the financial aspects of corporate governance considered the concept of corporate governance and defined it as “the system whose aim is to align as nearly as possible the interests of individuals, corporations and society.” The Board of directors is responsible for the governance of the companies. Moreover the shareholders’ role in governance is to appoint the directors and the auditors to satisfy themselves that an appropriate governance structure is in place.

BOARD EFFECTIVNESS

The contribution of directors on the Boards of companies is critical for ensuring appropriate directions with regard to leadership, vision strategy, policies, monitoring, supervisions, accountability to shareholders and other stakeholders and to achieve greater levels of performance on a sustained basis as well as adherence to the best practices of corporate governance.

To enable better and more focused attention on the affairs of corporation, the board delegates particular matters to committees of the board set up for the purpose. Committees allow the board to handle greater number of issues with greater efficiency and prepare the groundwork for decision-making. Board Committees like Audit Committee, Remuneration Committee, Shareholders Grievance Committee, Ethics Committee and Corporate Governance Committee have an important role in the corporate governance process of any organization. Empowered Board are a major factor in improving the corporate governance standards thereby reducing frauds, scams and corporate failures. The empowered Boards get their powers from factors such as:

· Size of the Board

· Composition of the Board

· Proper delineation of the responsibilities between the board and management

· Board chairman, whether executive or non-executive

· Board dynamics

· Information to the Board

A board with right number of directors consisting more of independent directors with proper description of duties between the board and the management, an assertive and dynamic chairman, members’ willingness to go an extra mile in forging good dynamics etc. would be more powerful than the board which lack the above characteristics and which is CEO controlled one. Of all the factors that effect the board’s empowerment, information is considered to be crucial. An informed board is more powerful than an uninformed board.

Audit Committee –A tool of corporate governance framework

A system of good corporate governance promotes relationships of accountability between the principal actors of sound financial reporting –the board, the management and the auditor. It holds the management accountable to the board and the board accountable to the shareholders. The audit committee’s role flows directly from the board’s oversight function. It acts as a catalyst for effective financial reporting.

A proper and well functioning system exists therefore when the three main groups responsible for financial reporting –the board, the internal auditor and the outside auditors –form the three-legged stool that supports responsible financial disclosure and active and participatory oversight. The audit committee has an important role to play in this process, since the audit committee is a sub-group of the full board and hence the monitor of the process.

Majority of members of the Audit committee are independent directors and at least one member is required to be financially literate. One very important provision is that of CEO/CFO certification i.e. the CEO (MD) and the CFO (chief financial officer) shall certify to the board, the correctness of the financial statements of the Company.

The Audit committee has the power to investigate any activity within its terms of reference, seek information from any employee and obtain outside legal or other professional advice.

To summarise the role of Audit Committee, it may be stated thus:

a. Oversight of Company’s financial reporting process

b. Recommending the appointment and removal of external auditor, fixation of audit fee

c. Reviewing with management the annual financial statements before submission to the boards

d. Reviewing with the management, external and internal auditors, the adequacy of internal control systems

e. Discussion with internal auditors and any significant findings and follow-up thereon.

f. Reviewing the company’s financial and risk management policies

Hence the constitution of strong Audit Committees, as part of good corporate governance, would go a long way in reducing corporate failures.

TRANSPARENCY & DISCLOSURES (Part of Good Corporate Governance) as a way to mitigate the irregularities and fraud.

Going back as far as 1600s, financial reporting scandals have been the most visible and far reaching examples of hidden information and outright fraud. In the twentieth century financial reporting scandals were a key component of financial collapses ranging from the Great Depression, to the Asian Currency crisis, to the stock market meltdown at the turn of the millennium. Along the way plenty of executives made the journey from business media star to inmate, and thousand of employees lost their jobs due to massive greed and fraud at the top.

Globalisation has increased the competition in which the corporate world operates, therefore it has become increasingly important for the management to make the corporate business transparent and institutionally sound. A Company has an adopted set of practices for achieving its objectives through legal, regulatory and institutional environment. Further the Company intends to make business practices more and more transparent, and accountable to the stakeholders. It can be said that the relationship with the stakeholders’ create a social contract whereby the company is morally obliged to take account of the interest of these groups.

Increasing transparency will be key to the future success of corporate governance. Only with transparency will it be possible to deter frauds, embezzlement and financial scandals, and foster efficiency in the allocation of investments across corporations and countries.

ROLE OF DISCLOSURE IN FACILITATING AND ENHANCING CORPORATE GOVERNANCE

Disclosure to the shareholders and to the market has long been a key mechanism in corporation and capital market law. Disclosure is an issue that is highly regulated under the Securities Laws of many countries. However, in many instances corporates momentarily disclose beyond what is mandated by law.

One of the major responsibilities of the board of directors is to ensure that the shareholders and other stakeholders are provided with high-quality disclosures on the financial and operating results of the entity that the board of directors have been entrusted with. Almost all corporate governance codes around the world, including the OECD and ICGN principles, the CACG Guidelines and the Cadbury report, specially require the Board of directors to provide shareholders with information on the financial and operating results of a company to enable them to properly understand the nature of its business, its current state of affairs and how it is being developed for the future.

The United Nations conference on Trade and Development (UNCTAD) gives Guidance on good practices in corporate governance disclosure.

Financial Disclosure: The basic responsibility of the Board is to review the financial statements, approve them and then submit them to the shareholders. When the duties of the Board in this area are clearly disclosed, shareholders and other stakeholders could find it useful in providing an additional level of comfort regarding the fact that the financial statements accurately represent the situation of the company. It is upon the board of directors to ascertain that all subsidiaries and affiliated entities, including special-purpose ones, which are subject to consolidation as per the financial reporting standards applicable to the entity, have been properly consolidated and presented.Enterprises should fully disclose significant transactions with related parties.Most national financial reporting standards and IFRS, require extensive disclosure on this matter. The cardinal principle of financial reporting is that the view presented should be true and fair.

1. Non-Financial Disclosures  

Non-financial disclosures includes

a) Company objectives- There are two general categories of company objectives, the first is commercial objectives  such as increasing productivity or identifying  a sector focus, the second is much more fundamental and relates to governance objectives which concentrates on sustainability.

b) Ownership and shareholding rights: Disclosure should be made of the control structure and of how shareholders or other members of the organization can exercise their control rights through voting or other means.

c) Changes in Control and Transactions involving significant assets : Rules and procedures governing the acquisition  of corporate control in the capital markets and extraordinary transactions such as mergers and sales of substantial portions of corporate assets should be disclosed.

d) Governance structures and Policies: The composition of the board should be disclosed ,in particular the balance of executives and non-executive directors and whether any of the non-executives have any affiliations with the company.

e) Members of the Board and key Executives: There should be sufficient disclosure about the board members to assure shareholders and stakeholders that members can effectively fulfil their responsibilities. Conflicts of interests affecting members of the board should, if they are not avoidable, at least be disclosed.

f) Material issues regarding stakeholders and environmental and social stewardship

The board should disclose whether there is mechanism protecting the rights of other stakeholders in a business. The role of employees in corporate governance should be disclosed. The board should disclose its policy and performance in connection with environment and social responsibility and the impact of this policy and performance on the firm’s sustainability.

g) Material foreseeable risk factors

The board should give appropriate disclosures and assurance regarding its risk management objectives, systems and activities.  

h) Independence and External Auditors: The board should disclose that it has confidence that the external auditors are independent and their competency and integrity have not been compromised in any way.The process for the appointment of and interaction with external auditors should  be disclosed. 

i) Internal audit function: Enterprises should disclose the scope of work and responsibilities of the internal audit function and the highest level within the leadership of the enterprise to which the internal audit function reports. 

2. General Meetings 

Disclosure should be made of the process for holding and voting at annual general meetings and extraordinary general meetings as well as all other information necessary for shareholders to participate effectively in such meetings. 

3. Timing and means of Disclosure

All material issues relating to corporate governance of the enterprise should be disclosed in a timely fashion. Traditional channels of communication with stakeholders such as annual reports, should be supported by other channels of communication taking into account the complexity and globalisation of financial markets and the impact of technology.

It may be summed up thus– Without greater transparency in corporate governance, new laws and governance codes will do little to build investors confidence in the long run.

There is no magic formula that makes some corporations thrive while others fade away. History proves however that those corporations that continually hide the truth merely postpone the inevitable. Transparency may not lead to immediate success, but lack of transparency can surely lead to a swift failure. Today after many scandals and financial crises, the transparency in corporate governance is the debate du jour.

RISK GOVERNANCE

Risk governance, a part of the corporate governace framework ensures protection from frauds, scams and corporate scandals and failures.A lack of effective risk governance is found at the top of list of governance failures that led to the crisis (OECD 2009,UBS 2008,Walker 2009). Risk governance is generally defined as board and management oversight of risk and the attendant configuration of internal risk identification, measurement, management and reporting systems.

Global events since 2008 financial crisis have underscored the importance of companies taking an integrated enterprise-wide prospective of their risk exposure. There is heighten concern and focus on risk govenance and it has become clear that company should have a sound of risk management and internal controls to identify, assess, manage and mitigate risk.

The boards have to get information relating to:

· Risk management system operating in the Companies and its effectiveness

· Sources of risk

· Types of risk

· Risk factors

· Devices used to identify ,monitor and control varios risks

· Risk Insurance measures taken

The N.R.Narayanan murthy’s Committee on Corporate Governnace has recognised the importance of board’s role in isk management and has made it mandatory on the part of management to keep the Board informed on the risk management framework adopted by the Company.

Conclusion:

The Company’s corporate governance structure, systems and processes are based on two core principles:

i. Management must have executive freedom to drive the enterprise forward without undue restraints and

ii. This freedom of management should be exercised within a framework of effective accountability

From the core principles of corporate governance emerge the cornerstones of the company’s governance philosophy, namely trusteeship, transparency, empowerment and accountability control and ethical corporate citizenship. The company believes that the practice of each of these creates the right corporate culture that fulfils the true purpose of corporate governance.

To conclude, one can confidently state that good corporate governance can increase a company’s valuation and boost its bottom line. In the face of ever increasing global competition, enterprises need to be competitive if they are to survive. Corporate governance provides a cutting edge and has a substantial role to play in coping with financial crisis, corporate scandals and failures.

The process of constant improvement of corporate governance practices should remain an on-going process and not be undertaken only as an aftermath of some scam. As we can rightly sum up “prevention is better than cure”.

By: Suhita Mukhopadhyay

Company Secretary