Corporate Governance

- Y.H. Malegam

Fourth Nani Palkhivala Memorial Lecture,
delivered at Rani Seethai Hall Chennai on January 10, 2004

1.1 I feel greatly honoured to have been invited to deliver this memorial lecture on "Corporate Governance". 1.2 Nani Palkhivala was a legend in his lifetime. He possessed in abundant measure all those qualities which are admirable in a human being – humility in success, courage in adversity, uncompromising adherence to principles, unquestioned intellectual honesty, pride in his country and above all a deep concern for his fellow-human beings. It is these qualities which inspired an entire generation. 1.3 It is reported that on one occasion when President Kennedy had convened in the White House a gathering of the most talented individuals in the country from various fields, he welcomed them with the statement that the occasion was the largest gathering of talent in the White House since the time that Thomas Jefferson dined alone. 1.4 Such a remark could well have been made about Nani Palkhivala. He combined within himself an extraordinary range of intellectual talents and his interests and scholarship extended well beyond his specialised field of jurisprudence. He has spoken and written knowledgeably on a variety of subjects including economics, history and religion. 1.5 In a way, it is appropriate that the subject of this talk is "corporate governance" because Nani exemplified in his life, the three fundamental principles of corporate governance, namely, accountability, transparency and equality of treatment for all stakeholders. 2.1 Corporate Governance became a buzzword in the corporate world with the publication in 1992 of the Cadbury Report. But it is important to appreciate that Cadbury did not invent corporate governance. He merely gave it a form and substance and more importantly a definition as "the system by which companies are directed and controlled." 2.2 The issue of corporate governance, in fact, arises from the fundamental basis on which public corporations are formed and operate, namely the seperation of ownership and control. This is essentially an agency problem. In this agency relationship, the shareholders are the risk-bearers while the managers are the decision-makers. The danger is that the managers can act opportunistically at the expense of shareholders' interests and corporate governance procedures and practices are primarily designed to prevent this abuse. 2.3 The problem becomes more complicated when control of an organization is concentrated in one or a group of few shareholders. In such a situation, the agency problem degenerates into an insider – outsider problem. The insiders are the controlling shareholders together with the management who is beholden to them while the outsiders are the non-controlling shareholders. In this situation, a conflict can arise if the insiders treat the outsiders not as partners but a mere providers of finance. 3.1 The need for corporate governance has therefore existed ever since the form of a joint stock company was devised many centuries ago. What has however brought the issue to the forefront in recent years is the emergence of significant changes in the economic environment, a few of which we may briefly examine. 3.2 The first of these is a growing dissatisfaction with financial statements and their ability to predict corporate failures. The appointment of the Cadbury Committee in the UK jointly by the Accounting Institutes, the London Stock Exchange and the body of financial journalists was primarily triggered by a series of spectacular and sudden collapses of several large publicly quoted companies. There was consequently a feeling that if something was not done, London would soon lose its pre-eminence as a financial center and the UK Accounting Institutes would suffer a considerable loss of prestige. 3.3.1 A second factor was the growing dissatisfaction with the role of independent directors on the boards of companies and the seemingly large remuneration paid to them. One journal in the U.S. described directors as stars on a Christmas Tree, purely decorative but otherwise ineffective. In September 1998, in a speech delivered at New York University, Arthur Levitt, the then Chairman of the SEC had some harsh things to say about corporate managements, auditors and the boards. This speech which he titled as "The Numbers Game" was reported by one financial journal as "Lies, Damned Lies and Managed Accounting". 3.3.2 He said that there was difficulty in holding the line on good accounting pratices when competitors "operate in the grey area between legitimacy and outright frauds…….. a grey area where the accounting is being perverted, where managers are cutting corners; and where earnings reports reflect the desires of management rather than the underlying financial performance of the company". 3.3.3 As a direct consequence of this speech, a Blue Ribbon Commission was appointed in October 1998 by the New York Stock Exchange and NASDAQ which published in early 1999 the Blue Ribbon Committee report. This report is largely the genesis of the role of the Audit Committees as we know it today. 3.4.1 A third factor was the emergence of the institutional investor. In the U.S., the first pension fund was established by General Motors in 1950 and by 1990, the funds available for investment by institutional investors had grown to over U.S. $ 3.5 trillion. Thereafter these funds have been growing at the rate of US$ 1 to 1.5 billion per year. In the UK., institutional investors account for over three – quarters of the value of the London Stock Market and the ten largest investors, alone account for almost a quarter of the total market capitalization. In India, also, after the liberalization in 1991, we have seen the emergence of the private sector mutual funds which today have well over Rs.100,000 crores of investible funds and the Foreign Institutional Investors who have portfolio investments of over US$ 25 billion. 3.4.2 There has therefore emerged a new class of investors who are knowledgeable, conscious of their rights and willing to enforce them. In the U.S., the largest of the institutional investors CALPERS has devised its own model of the Corporate Governance code and it ensures that companies in which it has substantial holdings enforce this code. Again in the US, it is the institutional investors who have been at the forefront in demanding good corporate performance and have been instrumental in removing the CEOs of large corporations when they have failed to perform. 3.4.3 There is one other aspect of the emergence of the institutional investor which we must note. When a company does not perform, a shareholder has three choices. He can exit, he can voice his concern or he can continue to show his loyalty to the company by continuing as a shareholder. The first of these choices is often not available to the institutional shareholder, often because the size of its holding is too large or because it is using index funds. Therefore, the institutional investor is often by compulsion a long-term investor who needs to voice his concern. 3.5 A fourth factor which needs to be recognized is the impact of economic growth. As a society becomes more prosperous, it becomes more knowledge based. There is therefore the emergence of a new breed of individual investors who are hungry for knowledge and who are concerned with ethical issues. 3.6.1 Finally, there is the competition between developing countries to acquire the largest slice of the international funds earmarked for emerging markets and the growing realization that these funds will only flow to those markets which are strongly regulated and which have an ethical base. 3.6.2 There is increasing evidence that institutional investors are putting corporate governance at the top of their agenda. An Investor Opinion Survey by Mckinsey in 2002 showed that institutional investors would pay a premium ranging from 12% in the UK to 38% in Russia for well-governed corporations. Equally interestingly, in June 2002, Moody's announced that it had incorporated corporate governance variables in its credit rating methodology. 4.1 This then was the background in which the various codes of corporate governance were devised all over the world. Apart from the Cadbury Report in the UK and the Blue Ribbon Report in the U.S., perhaps the most important code is the OECD code which covers the European Union. 4.2 In India, following upon the recommendations of the Kumaramangalam Birla Committee Report, SEBI required the Stock Exchanges to introduce in February 2000 in the Listing Agreements Clause 49 laying down a code of Corporate Governance which is currently in force. 4.3 The Codes devised in difference environments differ in detail but they are all focused on three fundamental issues, namely : (a) The composition of the Boards of Directors and the role of independent directors. (b) The composition and role of the Audit Committee and (c) The communications to the shareholders including a Management Analysis and Discussion statement. 4.4 The basic proposition is that the Board of Directors must direct and control the management and in turn must be answerable to the shareholders: The Board must therefore be independent of the management. Therefore a majority of the directors must be non-executive. Moreover, while a director may be non- executive, he would not necessarily be independent. It is therefore necessary that there should be a minimum number of directors who are independent – one third under clause 49 – and the number should be increased - half under clause 49 – when the same individual combines within himself the role of Chairman and CEO. 4.5 Recognition is also given to the fact that the Board can function more effectively if it has sub-committees to discharge its different functions. The most important of these is the Audit Committee. It is the primary instrument through which the Board controls the management and therefore it has wide responsibilities and it is constituted wholly of non-executive directors, a majority of whom are independent. 4.6 If the Board is to be answerable to the shareholders, then, there has to be greater transparency in the information which the Board provides to the shareholders. Therefore, the financial statements submitted to the shareholders have to be supplemented by other information which enhances shareholders' understanding of how the Company has functioned during the year. This includes a report on corporate governance and more importantly a Management Analysis and Discussion Statement which examines the major factors which contributed to the Company's financial performance during the year and provides better understanding on the same. 5.1 And then in late 2001, Enron erupted, quickly followed by equally damaging disclosures in other large U.S. corporations like Worldcom, Quest and others. These failures resulted in a significant erosion in public confidence in financial reporting and in October 2002, the International Federation of Accountants established a Task Force on "Rebuilding Confidence in Financial Reporting", which submitted its report in July 2003. This report makes interesting reading. 5.2 It shows that Enron was not the first case of reporting failure associated with governance and business failure. The 1980s and the 1990s are littered with other examples of such failures and these failures are not confined to the U.S. In the UK, there were Maxwell, BCCI, Polly Peck and Barings. In France, there was Credit Lyonnais, in Germany there was Metalgesellschaft and Shneider. In Australia there was AWA, in Canada there was Canadian Commercial Bank and in Japan there was Yamaichi. 5.3 Enron was not, as many believe, the event that initiated the changed perception of the reliability of financial reporting. It was merely the event that confirmed a trend that was developing and its sheer size gave it a greater visibility that woke up many persons to issues that had been significant for some time. 5.4 An added feature was a sense of public outrage that while the various stockholders like shareholders, employees, and pensioners lost large sums, those who ran the companies enriched themselves, even while their businesses collapsed. An article in the September 2002 issue of Fortune magazine points out that while between January 1999 and May 2002, the stock prices of 25 companies fell by 75% or more, the executives of those companies "walked away" with $ 23 billion. 5.5 Moreover, these failures have not stopped with Enron or Worldcom. In February 2003, the Dutch Company, Royal Ahold, the world's third largest retailer announced that its profits for 2001 and 2002 had been overstated by US$ 500 million, later increased to $ 800 million. On the day of the announcement the company's share price fell by 63% in a single day and declined to only 11% of its level in late 2001. Ahold is often referred to as Europe's Enron. 5.6 Similarly in March 2003, the SEC accused Healthsouth Corporation, one of the largest provider of healthcare services in the U.S. of overstating its earnings between 1999 and the second quarter of 2002 by atleast US $ 1.4 billion. Later this figure was increased to US$ 2.5 billion when two more years were added. 5.7 Currently, there are newspaper reports that there has been a massive misappropriation in Italy's good giant, Parmalet and the "hole in accounts could exceed 10 bn. Euro (US$ 12.7 bn.). 6.1 What went wrong? A number of possible causes have been identified which we may briefly consider. 6.2.1 An important cause was the pressure to perform, both external and internal. The external pressures arose mainly from the capital markets. Managements were expected to meet market expectations of short term performance indicators like earnings or revenue growth and financial ratios tied to debt covenants and other measures. A small shortfall in reported earnings, when compared to market expectations, could result in a significant drop in market capitalization and adversely affect ratings and access to capital markets and increase the cost of funds. Therefore, as Arthur Levitt put it "Too many CFOs are being judged today, not by how effectively they manage operations, but by how they manage the Street (referring of course to Wall Street !) 6.2.2 The internal pressures arose because of Board expectations but more significantly from the fact that a significant portion of the senior management's remuneration was linked to operating and financial targets which were often overly optimistic. There was, therefore, an increasing temptation to resort to "creative accounting" to replace through accounting jugglery what could not be achieved through operating results. 6.3 Another cause was the growing complexity and sophistication of business structures and transactions. Companies increasingly are resorting to complex financial instruments like derivatives or to structured financial transactions and intricate operating agreements and to organizations like special purpose vehicles (SPVs) to transfer assets and liabilities off-balance sheet while substantially retaining all the risks and rewards of ownership but without control. Enron provided a good example, when it set up over 800 SPVs in the Cayman Isles to hide its problem assets, losses and liabilities and to generate bogus revenues. 6.4 Partly the problem was one of pure greed or sheer incompetence. Worldcom is a good example. In June 2002, Worldcom announced that it intended to restate its financial results for 2001 and the first quarter of 2002, to correct an inflation of income of approximately US $ 3.8 billion. It was later alleged by SEC that beginning with July 2000, Worldcom had over successive quarters reclassified on-going operating expenses as capital expenditure to the tune of approximately US$ 9 billion. Moreover, Worldcom is not the only example of technology companies capitalizing development costs to create the impression of profits. In the mid 1990s QSP in the U.S. did this with a vengeance and eventually went bust. 6.5.1 While the major culprits identified were corporate managements, independent directors and auditors, other intermediaries were also indicated. 6.5.2 In a speech in February 2002 at a conference of the Federal Bar Council, Harry Pitt, the then Chairman of SEC, referring to Enron said that "Enron teaches us it is inappropriate for corporate lawyers to assist clients in finding ways to evade legal requirements or disserve the public interest even if those results can be achieved in a manner arguably within the literal letter of the law". 6.5.3 There has also been criticisms of the role of merchant bankers. In May 2003, the SEC announced that it had sued Merrill Lynch and four of its former senior executives for helping Enron commit securities fraud in the Enron case and Merrill Lynch had offered a settlement of US$ 80 million which SEC had accepted. 7. Enron and the disclosures which followed have given a new impetus to the concept of corporate governance. The lead in this matter was taken by the Sarbanes Oxley Act in the US and that model has been largely followed in other countries. In India, the Department of Company affairs appointed in August 2002, the Naresh Chandra Committee and in November 2002, SEBI appointed the N.R. Narayana Murthy Committee. The terms of reference of the two committees over- lapped in a number of areas of corporate governance. 8.1 The main areas highlighted in the Sarbanes Oxley Act and the reports of the two committees are as follows :- (a) Strengthening the definition of the independent director and expanding his responsibilities. (b) Widening the role and responsibilities of the Audit Committee. (c) Imposing direct responsibility on the CEO and CFO for the fairness, completeness and truthfulness of the financial statements. (d) Giving greater importance to the responsibility of the Board and the Audit Committee for the adequacy of risk management procedures. (e) Imposing an obligation on companies to have a code of conduct and "whistle blowing" procedures. (f) Strengthening the independence of auditors. (g) Improving oversight of the subsidiary companies (h) Increasing scrutiny of related party transactions Some of these may be examined. 8.2.1 There is a growing realization that the agency problem requires that there must exist a system of checks and balances between the management, the board, the majority shareholders and the minority shareholders. An essential feature of this system is the existence of independent directors. It is very difficult to define an independent director because intendance is largely a state of mind. The Birla Committee definition, which is part of the present clause 49 says that a director is independent if he does not have a material pecuniary relationship or transactions with the company which, in the opinion of the Board, affect his independence. This definition is now sought to be widened by covering relationships of the company with relatives of directors, promoters and top management and excluding former employees of the company, prior partners or employees of audit firms and of attorneys and consultants who have significant relationship with the company and persons holding 2% or more of the capital. 8.2.2 But directors have to be independent not merely in form but also in substance. In this connection, it is necessary to recognize that independence can be impaired in various ways e.g. (a) the role of the Chairman and Managing Director. A study of the corporate scandals of the recent past has shown that strong CEOs have exerted a dominant influence over boards, making it difficult for independent directors to play a central role in the oversight function. There is therefore a strong case for the role of Chairman and Managing Director to be exercised by separate individuals and not by a single individual. In the U.K., over 90% of listed companies have effected this separation. (b) the influence of the dominant shareholders represented on the board. This is clearly visible in the case of multinational companies, PSU's and family controlled companies. (c) the knowledge, competence and maturity of the independent director. A director may be independent but he will not be effective if his contribution is not appreciated by other board members. 8.2.3 Of all committees of the board, the Audit Committee is the pivotal committee. It represents the bridge between the internal and external auditors and the board and is most effective when it is composed of independent directors who are financially literate and who meet and interact without the presence of management. The responsibilities of the Audit Committee have been greatly expanded. It is required to review all financial data before it is published and has responsibility to ensure compliance with risk management and code of conduct and to review the financial statements of subsidiaries and related party transactions. In discharging these and the other functions, the Audit Committee will have to maintain the right balance between control and interference. It cannot afford to adopt an adversarial role with the management as that may conflict with the other basic objective of corporate governance, namely, the enhancement of shareholder value. 8.2.4 The events of the last few years have also shown that there were few irregularities which were not within the knowledge of the CEO and CFO. It therefore became necessary to ensure that the primary responsibility for the preparation of the financial statements and for the disclosures of irregularities are cast on these individuals. 8.2.5 While initially corporate governance concentrated on the need for internal control, it is now increasingly recognized that internal control is only one aspect of risk management. The emphasis has therefore shifted to the identification of the risks to which the organization is exposed, the manner in which those risks are addressed and the monitoring of the risk control mechanism. 8.2.6 Experience has also shown that a major challenge for corporations and their leaders is to create a corporate culture that promotes ethical conduct on the part of the organization and its employees. There are three aspects of this challenge which need to be addressed : (a) Firstly, there is the need to create "tone at the top". Ethical conduct has to be demonstrated by the Board, the CEO and the top management. (b) Secondly, there has to be a well formulated Code of Conduct which must be communicated and which must be understood by all employees. (c) Finally, there must be adequate "whistle blowing" procedures. Most of the financial scandals which have surfaced have been detected only because of the information given by employees who have been troubled by unethical conduct. Therefore there is a need for a mechanism by which unethical or illegal conduct or abuse of the prescribed code of conduct is communicated to senior management or if the senior management is involved, to the Audit Committee; that the existence of this mechanism is known within the organisation; and, most importantly, that there is provision for non-victimisation of the informer. 8.2.7 To strengthen the independence of the auditor, a number of provisions have been suggested. These cover the prohibition on the auditor rendering services which compromise his independence and the mandatory rotation of the audit partner. There was also a suggestion of rotation of audit firms. This has been rejected by the Naresh Chandra Committee and in the US the issue was referred by the Senate to the U.S. General Accounting Office (GOA) for examination. After a study made between November 2002 and November 2003, covering a survey of 1,171 companies, extensive interviews with public accounting firms, audit committee chairman and other stakeholders and regulators and identification of all restatements of Fortune 1000 companies between 1st January 2001 and 31st August 2003, the GOA has reported that the cost of rotation would exceed the benefits, that there is a risk that audit independence and ultimately audit quality will be adversely affected, that selection and support costs of companies would increase and their choice of auditors would get restricted. 8.2.8 A study of major corporate frauds and failures in recent times has highlighted the fact that powerful CEOs have formed subsidiaries which they have controlled through boards which consisted only of the company's officers and the operations of these companies have been kept wholly outside the scrutiny of the main board. It is therefore being provided that there should be some minimum mechanism whereby the operations of the subsidiaries are subjected to scrutiny by the main board. These include review of financial statements, presence of independent directors and placement of minutes of the boards of the subsidiaries before the main board. 8.2.9 There are also proposals for a better oversight by the Audit Committee of transactions with related parties. Transactions in the normal course of business, in summary form, and transactions which are not in the ordinary course of business, individually, have to be placed before the Audit Committee. In addition, all transactions, whether with related parties or not, which are not on an arm's length basis have to be placed before the Committee with a justification for the transaction 9.1 It has sometimes been suggested that the Anglo-American model of corporate governance is not suitable to Indian conditions because most Indian companies are family owned. It is interesting to note that over 85% of businesses in the European Union and USA are family-run-in Italy the figure is as high as 99%. (Source : Nancy Upton and William Petty "Venture Capital Investment in Family Business" Venture Capital, 2000) 40% of the US S&P 500 are family-run firms (Source : University of Notre Dame and IMF Institute : Family Business magazine). 9.2 Infact, family-run corporations are exposed to certain challenges which can be addressed by corporate governance. The biggest challenge is succession as it nurtures an "insider – only culture". In the UK, only one in six family-run firms survive to the third generation and only one in eight to the fourth generation. (Source : Family Business Review, 2001). Other challenges are accessing capital and diversifying wealth. In consequence, family-run businesses invest for more of their own funds in the business than they should. Good corporate governance helps in over-coming these challenges. 10.1 It is also a mistake to consider that corporate governance is an issue which concerns only the company and its shareholders or perhaps its other internal stakeholders like employees. 10.2 The corporate form of organization has been the spearhead which has made it possible to attract capital, organize labour, fund the development of technology and establish efficient manufacturing and distribution systems which have significantly improved the quality of life for most persons. Sustaining confidence and trust in the system is, therefore, a matter of enormous public concern. 10.3 Trust is an essential ingredient of any functioning financial market. Good corporate governance therefore needs to be involved with norms, processes and behavioural patterns. It needs to provide the necessary assurance that investors and other stakeholders can rely upon the information that is provided by the corporation. It also provides other direct benefits to the corporation. It improves strategic thinking, rationalizes the management and monitoring of risk, limits the liability of the directors and top management and has a long-term beneficial reputational effect both within and outside the organization. 10.4 Good corporate enterprises recognize that they have an obligation to society and seek to discharge the obligation in a variety of ways. This includes protection of the environment, support of social causes and setting an example through ethical conduct Quite apart from the benefits to society, the reputation of an ethical organization provides benefits to the organization itself through a more acceptable market image, ability to attract talent and pride amongst its employees. 11.1 It is also necessary to recognize that it is not sufficient to articulate and lay down a code of corporate governance if a mechanism for its enforcement is also not created The vigour with which the state has moved in the post-Enron era in the U.S. provides a good example which needs to be emulated. 11.2 In the U.S. swift action has been taken and punishment meted out to all those who have been involved in financial misdemeanours. For example :- (a) A penalty of US$ 1.5 billion was sought to be imposed on Worldcom and it has been settled for US$ 500 million. This is in addition to civil actions taken against four senior officers. (b) Suits have been filed against the former CEO of Enron seeking disgorgement of all ill-gotten gains including compensation, civil money penalties and debarment from acting as director or officer of a publicly held company. (c) The Sarbanes – Oxley Act provide for significant protection for "whistle blowers". This includes job protection, a requirement that publicly traded corporations and their auditors and attorneys engage in ethical behaviour, obligation on corporate attorneys to make specified disclosures and the possibility of criminal action against erring officers. 12.1 Finally it is necessary to recognize that the code of corporate governance is only one of several measures including accounting standards, disclosure norms, take- over code, restrictions on insiders trading etc. which SEBI as the regulator has taken to "ring fence" the operations of corporations to ensure orderly market conditions. 12.2 The systemic risk arising from individual corporate failures cannot be under- estimated. This has been well illustrated in the recent past. The Asian Crisis in 1997 originated in Thailand and Indonesia but the contagion soon spread to other countries in the region. Though it had many other causes like high level of debts, corrupt lending policies, non-market criteria for credit allocation, inadequate monitoring etc., many believe its rigours would have been less severe if there had been confidence in corporate governance and financial transparency of the corporations. 12.3 Similarly Enron did not merely destroy a corporation. It destroyed Arthur Anderson, a blue-chip accounting firm of 85 years standing with 85,000 professional staff spread all over the world and its ramifications were felt in financial markets and in regulatory changes throughout the globe. 13. In the final analysis, corporate governance is not a mere matter of structures and procedures. It has to be a way of life. In a sense, the issues it addresses in the corporate world are not different from the issues which society addresses in a functioning democracy, that those to whom the assets of the corporation are entrusted for management, are accountable for those assets and for the manner in which they manage them and an assurance that no part of the assets have been diverted for personal gain; that there is adequate transparency in the manner in which these managers communicate this accounting to the shareholders and that this accounting is subjected to adequate scrutiny and the shareholder is entitled to rely upon the truthfulness of this accounting; and finally that the rights of every individual shareholder are protected and there is no oppression of the minority by the majority. In a wider sense and in a different context, these are the very causes which Nani Palkhivala so vigorously defended throughout his life.