CORPORATE GOVERNANCE IN INDIA Recent Developments in Governance Practice in Indian Corporates By Dr. Bandi Ram Prasad1 Consultant, Economics & Financial Markets +91 98201 59618
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Introduction Stock markets in the emerging markets and in particular India, experienced exceptional growth in the recent years. In terms of market capitalization India has already crossed $one trillion mark which it will soon catch up to that level in regard to value of share trading as well. Indian companies are showing robust growth in earnings and expansion enabling them to pursue global acquisitions. Foreign institutional investment in Indian markets is on a continuous surge, with the portfolio investment flows showing a dramatic rise from about $1 bn in the early 1990s to $18 bn in 2007. India now accounts for a major chunk of such flows to emerging markets. The sustained growth of investor interest in Indian markets could be attributed mainly to aspects such as prospects for higher domestic economic growth, surge in corporate profits and performance, rigour and quality of regulation in the financial markets and an extensive and effective intermediation process. Better practices in governance standards have been a major incentive for the corporates to expand the scope of their operations and enhance the quality of 1 The paper draws inputs from a report on the subject prepared by the author for a national institution. The author, a consultant in banking and securities markets was formerly with Bombay Stock Exchange as Chief Knowledge Officer and Indian Banks’ Association as Chief Economist and is currently a senior consultant with the Economic Analysis Group of the Dun and Bradstreet Information Services India Pvt. Ltd.
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performance that equipped them to engage intensely with the global and domestic financial markets in pursuit of further growth, diversification and value realization. Rapid growth of financial markets set a strong background for good governance. As financial markets expanded on the back of growing domestic and global investment, governance standards became a key determinant for investing in corporates. Well governed companies found it easier and cost effective to access public equity markets for resource mobilization that helped them expand the scope and significance of the business. Global IPO issuance was $246 bn in 2006 and $255bn in 2007. 14 of the top 20 issues in 2007 belonged to the BRIC (Brazil, Russia, India and China) markets that raised over $106bn compared to $90bn in 2006. China alone raised $57 bn in 2006 and $55 bn in 2007. In India, companies raised about $8 bn in each of the last two years from the public equity markets. It is not only issuance of fresh capital that received a big boost, but equally remarkable was the growth of secondary markets for securities leading to record levels of market capitalization. During the ten year period 1996-2006, market capitalization in the North America rose from $8.9 trillion to $23 trillion, in Europe/Middle East/Africa from $5.1trillion to $16.2 trillion and in the Asia Pacific $ 5 trillion to $11.8 trillion. Huge levels of capital flows to the equity markets in several emerging markets led to rapid rise in investments made in companies from emerging markets. The flow of net foreign direct investment (FDI) into developing countries increased from $170bn in 1998 to $325 bn in 2006 and net portfolio equity flows increased from $6bn to $94 bn during the same period. Net portfolio equity flows to China between the year 2000 and 2006 rose from $6.9 bn to $32 bn and in India from $2.3 bn to $8.7 bn. In the first ten months of 2007 alone, foreign institutional investment flows into India peaked to about $18bn making it one of the most favored destination for global portfolio flows. Global capital flows speeded up on the back of growing institutional investment. Institutional investors have been the major source of capital markets growth in the recent period. During the period 1995 and 2005, the
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assets under management of the institutional investors doubled from $21trn to $53 trn. The shift of home bias of the institutional investors into emerging markets stepped up the resource flows to the developing countries.
For
instance in the United States, in 1994, pension funds invested 41 percent of their portfolio in domestic equity and 7 percent in international equities, where as by 2005 that share rose to 48 percent in domestic equities and 15 percent in international equities. The portfolio allocation to bond markets during the same period reduced from 42 percent to 32 percent. Emerging markets received sizeable portion of the investments. In the US the dedicated Emerging Market mutual funds rose from about $27 bn in 2000 to $ 230 bn in 2006. In India too, the merger and acquisition activity increased substantially. Where as, the foreign acquisitions in India rose from $2.9 bn in 2005 to $28 bn in 2007, Indian acquisitions abroad rose from $1.5 bn to $18.1bn during this period. In addition to technology companies such as Infosys, Wipro and TCS, major Indian corporates who conducted sizeable cross border mergers by acquiring foreign target companies included; Tata, Suzlon, Bharat Forge, Ranbaxy, Hindalco, United Breweries etc. In the first three quarters of the year 2007, Indian companies announced 150 foreign acquisitions with a total value of $18.1 bn, a four fold increase of the total value in 2005. A survey of 340 of the world’s largest manufacturers, by the Paris based Capgemini Consulting revealed that India could challenge China as the leading manufacturing center of the world in the next three to five years. This paper presents a short outline of the progress made in India in regard to corporate governance in terms of policy and direction, processes and practices. The paper is organized in the following manner 1. Global View 2. Definitions of Corporate Governance 3. Evolution of Corporate Governance 4. Review of Literature 5. Assessment on Corporate Governance in India 6. Concepts and Principles in Corporate Governance in India 7. Corporate Governance Practice in India
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8. Recent Trends in Corporate Governance in India 9. Emerging Challenges 10. Looking Ahead 1. Global View A recent assessment (September 2007)2 on the implementation standards of corporate governance on a sample of about 1600 companies worldwide, Ethical Investment Research Services (EIRIS), a UK based leading global provider of independent research into the social, environmental and governance (ESG) performance of companies that tracks performance of about 3000 companies across the world, has brought out some interesting insights. These include; • 62% of the companies studied have boards containing more than a third
of
independent
directors.
However
the
proportion
of
independent directors varies greatly between countries. Over 90% of companies in North America, UK, Switzerland, the Netherlands, Norway, Finland and Australia have more than a third of independent directors, compared with less than 10% in Germany, Austria and Japan • Disclosure of directors’ remuneration is consistently high, with 96% of all companies disclosing this information. • In half of the countries studied, over 90% of companies separate the roles of chair and chief executive. However rates of separation are lower in the US (30%), Japan (54%) and France (56%). • These differences are driven by the fact that companies largely adhere to their relevant national Corporate Governance guidelines •
However
corporate
governance
practices
are
converging.
Governance codes are being revised to improve the levels of
2
The EIRIS Foundation is a UK based charity that supports ethical investment
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transparency and independence, and the proportion of companies adopting western models of board structure is increasing. • Significant improvements was evident in respect of gender empowerment and representation in the boards as also corporate social responsibility and environment. • Increasingly, companies view equal opportunities less as a way to avoid criticism or lawsuits, but more as a means to build reputation and gain competitive advantage by accessing a broader skill set. • Around 90% of companies in North America (94%), Europe (88%) and Australia/New Zealand (87%) have basic or advanced equal opportunities policies. Conversely, just over 50% of Japanese and less than 25% of companies in Asia ex-Japan meet these standards. The pattern is slightly different for equal opportunities management systems. The criterion includes disclosure of staff demographics in relation to women and ethnic minorities as well as the presence of flexible working policies. Europe and Australia/New Zealand both perform well, with around 80% and 70% respectively, demonstrating at least basic systems. Performance amongst Japanese companies is also strong at 60%, whereas it is weaker amongst US companies at 25%. In the US, companies are less inclined to disclose this information, possibly due to fear of litigation. •
Worldwide,
only
8.1%
of
board
members
are
women.
Representation of women on the board continues to be lowest in Japan at less than 1% and remains generally low in Mediterranean countries. These low levels are driven by a mixture of cultural factors including a history of fewer women in formal employment combined with weak legislative encouragement. • The highest rate of 33% is seen in Norway where the government has enforced a quota for a minimum of 40% board members to be women by the end of 2007. The number of women on the board is
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set to increase Spain as the Spanish government has recently established a quota similar to that imposed in Norway. •
The developments as discussed above lead to and envisage greater thrust on the quality of governance.
•
Corporate governance is catching up fast as a major instrument of corporate reform in several countries
•
Good governance emerged as a major incentive for corporate growth and in pursuing global business aspirations
•
Good companies are going beyond the mandatory requirements in adopting best practices in governance
•
Greater interaction and sharing of knowledge is gaining ground across countries in setting effective governance frameworks
•
Disclosure and transparency are emerging as the key determinants of good governance
•
As the financial markets grow and the developing countries corporations increasingly explore global financial markets for resources and business, harmonization of the corporate governance increases and intensified
2. Definition and Recent Evidence Corporate governance has been defined by scholars and market practioners as per the perspective with which they were analyzing the subject.
The practioner’s
point of view that was powerfully conveyed was that of N.R. Narayana Murthy, Chairman, Committee on Corporate Governance, Securities and Exchange Board of India, 2003 and he himself a highly successful and globally acclaimed entrepreneur who built Infosys on the premise and foundations of a strong corporate governance “The term “corporate governance”, is susceptible both to broad and narrow definitions. In fact, many of the codes do not even attempt to articulate what is encompassed by the term. The important point is that corporate governance is a concept, rather than an individual instrument. It includes debate on the appropriate management and control structures of a company. Further, it includes the rules relating to the power relations between owners, the Board of Directors,
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management and, last but not least, the stakeholders such as employees, suppliers, customers and the public at large:”. From a policy perspective and from who chaired the first ever influential and widely discussed report on the subject, Adrian Cadbury, the author of the Cadbury Report, said “In its broadest sense, corporate governance is concerned with holding the balance between the economic and social goals and between individual and communal goals. The governance framework is there to encourage the efficient use of resources and equally to require accountability for the stewardship of those resources. The aim is to align as nearly as possible the interest of the individuals, of corporations and of society. The incentives to corporations and those who own and manage them to adopt internationally accepted governance standards is that these standards will assist them to achieve their aims and to attract investment. The incentive for their adoption by states is that these standards will strengthen their economies and encourage business probity”. From a regulatory point of view Arthur Levitt, former chairman of the Securities and Exchange Commission, United States emphasized the importance of the corporate governance as “If a country does not have a reputation for strong corporate governance practices, capital will flow elsewhere. If investors are not confident with the level of disclosure, capital will flow elsewhere. If a country opts for a lax accounting and reporting standards, capital will flow elsewhere. All enterprises in that country- regardless of how steadfast a particular company’s practices may be-suffer the consequences. Markets exist by the grace of investors. And it is today’s more empowered investors that will determine which companies and markets will stand the test of time and endure the weight of greater competition. It serves us well to remember that no market has a divine right to investors’ capital”. Organization of Economic Cooperation and Development (OECD) which spearheaded the design and development of corporate governance principles and guidelines, from a global perspective defined it as” Corporate governance involves a set of relationships between a company’s management, its board, its shareholders, and other stakeholders. Corporate governance also provides the structure through which the objectives of the company are set and the means of attaining those objectives and monitoring performance are determined”
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An institutional point of view presented by Ira Millstein, who worked on drafting the OECD corporate governance guidelines as also the co-chairman of the NYSENASDAQ constituted Blue Ribbon Committee3 (1998) that looked into important aspects of the audit committees, defined “ Corporate governance refers to that blend of law, regulation and appropriate voluntary private sector practices which enables the corporation to attract financial and human capital, perform efficiently and thereby perpetuate itself by generating long term economic value for its stakeholders, while respecting the interests of stakeholders and society as a whole”. From an academic perspective based on extensive surveys and studies on the subject, Shleifer and Vishny (1997) define corporate governance as the ways in which suppliers of finance to corporations assure themselves of getting a return on their investments; Zingales (1998) views governance systems as the complex set of constraints that shape the ex post bargaining over the quasi-rents generated by the firm; Gillan and Stakes (1998) define corporate governance as the system of laws, rules, and factors that control operations at a company. To sum up, the important message of the need for a good corporate governance is well articulated by M. Damodaran, Chairman, Securities and Exchange Board of India, who spearheaded introduction of most significant reforms in the Indian stock markets, including the October 2007 guidelines on the Participatory Notes (PNs) observed “There are those who will tell you that business and ethics cannot stand together. In the short run, it might appear that company pay a price for adhering to values while their competitors get ahead in a shorter time frame, but in the long run people would learn to distinguish, stakeholders learn to ask the right questions and distinguish between the grain and chaff. Those that don’t subscribe to values will fall by the way side; those that subscribe to values will last the course and will set benchmarks”.
3 Report and Recommendations of the Blue Ribbon Committee on Improving the Effectiveness of the Corporate Audit Committees. NYSE and NASDAQ, 1998.
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3. Evolution of Corporate Governance The roots of the recent developments in the corporate governance could be traced to Treadway Commission (1985), United States which found that inadequate internal controls lead to financial failures, which later led to the Commission defining objectives of the internal controls which are; (a) effectiveness and efficiency of operations (b) reliability of financial reporting and (c) compliance with laws and regulations and (d) safeguarding of assets. The evolution of the corporate governance guidelines in the global context and from the perspective of progress made in India is given in the chart below. Table 1: Recent Evolution of the Corporate Governance Cadbury Report, United Kingdom 1995
The objective of the Cadbury committee was to investigate how large public companies should adopt corporate governance guidelines with a focus on the procedures of financial report production and the role of the accounting profession. Issues included the role of the board of directors, standards of financial reporting, accountability of the auditors and directors pay.
Greenbury Report, United Kingdom, 1995
The report dealt with the remuneration of executives and non-executives board members and recommended the setting up of a remuneration committee in each public company to determine remuneration packages for the board members. It also provided suggestions on the disclosure of remuneration and the setting up of remuneration policy and service contracts and compensation. Four major issues were discussed with practical guidelines offered; (a) the role of directors (b) directors compensation (c) the role of shareholders (d) accountability and audit. The first of the voluntarily evolved codes in India.
Hampel Report, United Kingdom, 1998 CII Voluntary Code of Corporate Governance,1998 Kumara Mangalam Birla Committee, India, 1999
Sarbanes-Oxley Act, 2002
The mandatory recommendations of the Kumar Mangalam committee include the constitution of Audit Committee and Remuneration Committee in all listed companies, appointment of one or more independent directors in them, recognition of the leadership role of the Chairman of a company, enforcement of Accounting Standards, the obligation to make more disclosures in annual financial reports, effective use of the power and influence of institutional shareholders, and so on. The Committee also recommended a few provisions, which are non- mandatory. A major initiative of corporate compliance, the SarbanesOxley Act of 2002, is also known as the Public Company Accounting Reform and Investor Protection Act of 2002 is a US federal law that has main features such as ; establishment of the Public Company Accounting Oversight Board (PCAOB), auditors independence, corporate
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Higgs Report, 2003 Smith Report, 2003 Narayana Murthy Committee, 2002
Naresh Chandra Committee,2003 OECD Principles,2004
Clause 49 of the Listing Agreement, 2005
responsibility, enhanced financial disclosures, analyst conflict of interest, commission resources and authority, corporate and criminal fraud accountability, while collar crime penalty enhancement, corporate tax returns and corporate fraud accountability. On non-executive directors. On Audit Committees. The key mandatory recommendations focus on strengthening the responsibilities of audit committees; improving the quality of financial disclosures, including those pertaining to related party transactions and proceeds from initial public offerings; 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; the position of nominee directors; and stock holder approval and improved disclosures relating to compensation paid to non-executive directors. Non-mandatory recommendations include moving to a regime where corporate financial statements are not qualified; instituting a system of training of board members; and the evaluation of performance of board members. The auditor-company relationship, Auditing the auditors Independent directors: Role, remuneration and training. The OECD Principles cover five aspects of governance (a) the rights of shareholders (b) the equitable treatment of shareholders (c) the role of stakeholders (d) disclosure and transparency (e) the responsibilities of the board. A major compliance directive that came into force from the quarter ended June 2005, it has major aspects of compliance by listed companies that include; definition of independent directors; Non-Executive Director’s compensation and disclosures, other provisions as to Board and Committees, Code of Conduct, Composition of Audit Committee, Meeting of Audit Committee, Subsidiary Companies, Disclosures pertaining to (a) basis of related transactions (b) accounting treatment (c) risk management (d) proceeds from public/rights/preferential issues (e) remuneration of directors and management discussion and analysis, CEO/CFO Certification, report on corporate governance, auditors certificate on compliance etc.
The current structure of the corporate governance in India as evolved in the recent years is as below. Table 2 : Major features of the Corporate Governance in India Legal Framework Voting Rights Firm Capital Structure Shareholder Meetings
Companies Act, 1956 and Clause 49 of the Listing Agreement of Stock Exchanges All shareholders have the right to vote. Proxy voting allowed. Companies allowed to issue shares with multiple voting rights or dividends Requires board/shareholder approval to change capital structure. A merger needs 75% of the shareholder vote It is required to hold AGM every year. Allows
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Board Structure
Board Meetings
Election of Directors Board Committees Disclosure
Accounting
Audit Committees
Related Party Transactions Whistle Blower Policy Submissions
shareholders controlling 10% of voting rights or paid up capital to call a special or Extra Ordinary General Meeting One third of the board should be non executive and a majority of these independent. In case where the Chairman of the board is an executive, 50 % of the board be comprised of independent directors The Board should meet at least four times a year. 33% of the board members or two members, whichever is greater, be present. All fees and compensation paid to the non-executive directors require prior approval of the shareholders in the AGM The directors of the Board be approved and appointed by the company in the Annual General Meeting. Every board is required to have a shareholder grievance committee and an audit committee. Remuneration committee is non-mandatory Every company to have a compliance officer responsible for setting policies, procedures and monitoring adherence. SEBI has established an insider trading committee to monitor the same. Companies required to disclose information through annual reports/websites etc.,Management Discussion Analysis, a part of the Annual Report Shareholders to appoint an independent auditor, certified by Institute of Chartered Accountants of India. Accounting standards comply with International Accounting Standards (IAS) and International Financial Reporting Standards (IFRS). Companies conduct comprehensive audits annually. Audit Committee to have a minimum of three members, of which two-thirds be independent directors and at least one members should have accounting/finance background. Audit Committee also reviewed internal control systems Clause 49 required listed companies to disclose material significant related party transactions to shareholders. Right of access to all employees. Direct access to audit committee without informing the superiors. Quarterly Compliance Report within 15 days from the end of the quarter. (Format revised) Annual Compliance by the separate section in the Annual report. Compliance Certificate from the auditors of the company.
Sources: Stock Exchanges, Institute of International Finance.
4. Review of Literature Early discussion on the governance rose from an analysis by Berle and Means4 (1932) following the Great Crash in the US in 1929, which traced the problem of 4
Berle A.A. and Means G.C.., The Modern Corporation and the Private Property, New York: MacMillan, 1932
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governance due to the separation of ownership and control. The authors recommended stake holder value over the share holder value as essential for good governance, a premise on which formal securities regulation began in the US with the setting up of the Securities and Exchange Commission (1933). This debate led the governance being associated with the agency problem {Coase, 1937)5, (Jensen and Meckling6, 1976), (Fama and Jensen7,1983) in which the essence is the separation of ownership and control.
Agency problem refers to the difficulties
financiers have in assuring that their funds are not expropriated or wasted on unattractive projects(Shliefer and Vishny8,1997) Early work in the corporate law development in the 18th and 19th centuries in Britain, Continental Europe and Russia had focused more on addressing to the problems of managerial theft rather than that of shirking or even empire building. Shleifer and Vishny cite studies on vast mangerialist literature that explains how managers use their effective control rights to pursue projects that benefit them rather than investors which are described as private benefits of control {Grossman and Hart9,1982)} Managers can expropriate shareholders by entrenching themselves and staying in the job even if they are no longer competent or qualified to run the firm. Poor managers who resist being replaced might be the costliest manifestation of the agency problem (Jensen and Ruback10, 1983) Agency theory considered the firm as a nexus of contracts; associating the firm and the entire group of resource contributors (the team of productive inputs) and analyzing the relationship between the principle (shareholders) and the agent (managers), the conceptual framework which is found relevant even today. This perspective led to a wide range of studies relating to the board of directors, share holders meetings, remuneration system for managers, the legal and accounting regulations and takeover etc. With the enormous growth of financial markets, the interest on corporate governance flows beyond the finance and extends to law, economic, politics, sociology and management science.
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Coase, Ronald (1937), The Nature of the Firm, Economica, 4, 386-405 Jensen, Micheal and William Meckling (1976), Theory of the Firm, Managerial Behaviour, Agency Costs, and Ownership Structure, Journal of Financial Economics, 3, 305-60 7 Fama, Eugene and Micheal Jensen (1983b), Separation of Ownership and Control, Journal of Law and Economcs, XXVI, 301-25 8 Shleifer, A.,and R.Vishny, 1997, A Survey of Corporate Governance, Journal of Finance, 52, 737-775 9 Grossman, Sanford., and Oliver D. Hart, 1982, Corporate Financial Structure and Managerial Incentives, in John J. McCall, ed.: The Economics of Information and Uncertainty (University of Chicago Press, Chicago, IL 10 Jensen, Michael and Richard Ruback,1983; The Market for Corporate Control: The Scientific Evidence, Journal of Financial Economics, 11, 5-50 6
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Historical developments that impact the overall scope of the corporate governance in different countries is discussed by Randall K. Morck, Lloyd Steir11 (2005) who observed that financial disasters tainted French confidence in financial securities early on, and set corporate governance in that country on a different parity from that of Britain, where a similar trauma was overcome and forgotten. Similarly historical trends such as imperial monopoly in China that was evident in the late 19th century, large scale trading networks belonging to particular communities and ethnic and sectarian groups in India, family and bank controlled pyramidal groups in Germany, Zeibatsu and Keiratsu in Japan and Chaebols in Korea etc., have influenced the process of growth of corporate governance in the respective countries. Certain features that are common to all countries that contributed to the varying types and pace of the corporate governance norms include; Accidents of history, ideas, families,business groups, trust, law, origins, evolution, transplants, large outside shareholders, financial development, politics and entrenchment, etc. Ownership is a key driver that determines the quality of governance. The first of the studies on the ownership of the global companies by Rafeal La Porta12 shows higher incidence of family ownership in global corporations that runs contrary to the earlier observation of widely held corporations analysed by Berley and Means. The study presents data on ownership structures of large corporations in 27 wealthy economies, making an effort to identify the ultimate controlling shareholders of these firms. The study found that except in economies with very good shareholder protection, relatively few of these firms are widely held. Rather, these firms are typically controlled by families or the State. Equity control by financial institutions or other widely held corporations is far less common. The controlling shareholders typically have power over firms significantly in excess of their cash flow rights, primarily through the use of pyramids and participation in management ownership issues; particularly the predominance of family owned companies remains an important issue in several emerging economies and forms an important aspect of the corporate governance reforms.
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Morck, Randall K, Steier, Llyod, 2005, the Global History of Corporate Governance, an Introduction, NBER Working Paper No 11062, January 2005. 12 La Porta, Rafael, Florencia Lopez-de-Silanes, Andrei Shleifer and Robert Vishny, 1999, Corporate Ownership Around the World, Journal of Finance (54(2), 445-70
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Franklin Yale and Dougles Gale13 (2002) discuss the term corporate governance that is used in two distinct ways. In Anglo-Saxon countries like the US and UK good corporate governance involves firms pursuing the interests of shareholders. In other countries like Japan, Germany and France it involves pursuing the interests of all stakeholders including employees and customers as well as shareholders. AngloSaxon capitalism has been widely analyzed but stakeholder capitalism has not. The authors argue that stakeholder capitalism can often be superior when markets are not perfect and complete. Paolo Fulghieri and Matti Suominen14 (2005) find that the quality of the corporate governance system may have a significant impact on the economy’s level of competition and its degree of industry concentration. Poor corporate governance and low investor protection may in fact lead to high industry concentration. Craig Doidge, G. Andrew Karolyi, and René M. Stulz15 (2006) showed that the incentives to adopt better governance mechanisms at the firm level increase with a country’s financial and economic development. Further, these incentives increase or decrease with a country’s investor protection depending on whether firm-level governance mechanisms and country-level investor protection are substitutes or complements. The study observes that when economic and financial development is poor, the incentives to improve firm-level governance are low because outside finance is expensive and the adoption of better governance mechanisms is expensive. A cross country study by Vidhi Chhaochharia and Luc Laeven16 (2007) shows that governance provisions adopted by firms beyond those imposed by regulations and common practices among firms in the country have a strong, positive effect on firm valuation. The study showed that, despite the costs associated with improving corporate governance at the firm level, many firms choose to adopt governance
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Allen, Franklin, Gale, Douglas, 2002, A Comparative Theory of Corporate Governance, Financial Institutions Center, Wharton University, 2002 14 Fulghieri, Paolo, Suominen, Matti, 2005, Does Bad Corporate Governance Lead to Too Little Competition?, Finance Working Paper No. 74/2005, March 2005, European Corporate Governance Institute. 15 Dodge, Craig, Karolyi, George Andrew, Stulz, Rene M, 2004, Finance Working Paper Ho. 50/2004, European Corporate Governance Institute, Charles A. Dice Center Working Paper No.2004-16 and Fisher College of Business Working Paper No.2006—03-008 16 Chhaochharia, Vidhi, Laeven, Luc, 2007, The Invisible Hand in Corporate Governance, Finance Working Paper No. 165/2007, April 2007
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provisions beyond what can be considered the norm in the country, and these improvements in corporate governance have a positive effect on firm valuation. An Empirical analysis by Leora F. Klapper and Inessa Love17 (2002) of the World Bank showed that better corporate governance is highly correlated with better operating performance and market valuation. They provide the evidence that firm level corporate governance provisions matter more in countries with weak legal environments. The results suggest that firms can partially compensate for ineffective laws and enforcement by establishing good corporate governance and providing credible and investor protection. Good corporate governance commands high premium18. A CLSA April 2003 study showed that over the past five years, high CG stocks (ranked in the 1st quartile) outperformed the Sensex by 169%. The out-performance was at over 40% even if one excluded the software stocks. A study by Wolfganag Dorbetz, University of Basel showed that an investment strategy that bought high-CGR firms and shorted low CGR firms would have earned excess returns of 12% compared to the DAX 100 during 1998-2000. A Lipper-GMI Mutual Fund Report showed that Mutual funds that invest in companies with higher CG ratings have been rewarded with superior returns According to a Harvard Law School study19, the disregard for shareholder rights caused lower firm valuations to the extent of 7 percent per annum and large negative abnormal returns during the 1990-2003 period; A Deutsche Bank research showed that European companies with improving governing standards outperformed a portfolio of deteriorating companies by 4.4 per annum. A joint study of the European Corporate Governance Institute and London Business School showed that the governance focused Hermes UK Focus Fund outperformed its benchmark by an average 4.8% each year from 1999 through 2004. The CLSA/ACGA Governance Score for 27 countries confirms that firms with better governance outperform significantly even in bull markets when governance usually has a lower priority with investors. All these show positive effects of the good governance A 2002 McKinsey
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Klapper, Leora F, Love, Inessa, 2002, Corporate Governance, Investor Protection and Performance in Emerging Markets, Policy Research Working Paper 2818, Development Research Group, The World Bank. 18 Corporate Governance Ratings and Audit, a presentation by ICRA, October, 2004 19 Bebchuk, Lucian, Cohen Alma, Ferrell, Alma, 2005, What Matters in Corporate Governance, Discussion Paper No. 491., revised 03/2005, Hardvard Law School, Cambridge, MA
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Survey revealed that investors then were willing to pay a premium of 23% for well governed companies in India which in the recent time came down to 5 to 10 percent due to overall improvement in the governance standards. Christian Leuz, Karl V. Lins, Francis E. Warnock20 (2006), in their study using a set of
foreign holdings by U.S. investors as a proxy for foreign investment that
analysed a sample of 4,411 firms from 29 emerging market and developed economies found that, foreigners invest significantly less in firms that are poorly governed, i.e., firms that have ownership structures that are more conducive to outside investor expropriation Interestingly, this finding is not simply a matter of a country’s economic development but appears to be directly related to a country’s information rules and legal institutions. The authors argue that information problems faced by foreign investors play an important role in this result. Supporting this explanation, they argue that foreign investment is lower in firms that appear to engage in more earnings management. An event study by Bernard Black & Vikramaditya Khanna21 (2007) showed that good corporate governance benefits faster growing firms (esp. mid sized ones) than others and cross-listed firms get the benefit more than others. Alexander Dyck, Adair Morse, Luigi Zingales22(2007)examine how external control mechanisms are most effective in detecting corporate fraud. The authors study in depth all reported cases of corporate fraud in companies with more than 750 million dollars in assets between 1996 and 2004 and found that fraud detection does not rely on one single mechanism, but on a wide range of, often improbable, actors. Only 6% of the frauds are revealed by the SEC and 14% by the auditors. More important monitors are media (14%), industry regulators (16%), and employees (19%). Before SOX, only 35% of the cases were discovered by actors with an explicit mandate. After SOX, the performance of mandated actors improved, but still account for slightly more than 50% of the cases.
20
Leuz, Christian, Lins, Karl V, Warnock, Francis E., 2006, Do Foreigners Invest Less in Poorly Governed Firms, Finance Working Paper No. 43/2004, Revised version: April 2006, European Corporate Governance Institute 21 Black, Bernand S, Khanna, Vikramaditya S., Can Corporate Governance Reforms Increase Firms’ Market Values? Event Study Evidence from India, Havard Law School 22 Dyck, Alexander, Morse, Adair, Zingales, Luigi, 2007, Who Blows the Whistle on Corporate Fraud,
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The Board and its committees are the key instruments in driving the scope, significance, quality of the governance in the companies. A board is defined as a group of individuals that are elected as, or elected to act as, representatives of the stockholders to establish corporate management related policies and to make decisions on major company issues. Such issues include; the hiring/firing of executives, dividend policies, options policies and executive compensation. Every public company must have a Board of Directors. The Board of Directors should be a fair representation of both management and shareholder's interests, because too many insiders serving as directors would mean that the board will make decisions more beneficial to management. On the other hand, too many independent directors may discourage management of decision-making process that may demotivate good managers. The board structure can be in the form of unitary board, dual board and mixed board. US has the unitary board structure so as in India. Other countries where unitary board structures are prevalent included, Australia, Brazil, Canada, Egypt, India, Italy, Japan, Malaysia, Norway, Philippines, Singapore, South Africa, South Korea, Sweden, Thailand, Turkey,U.S., Ukraine, United Kingdom, Zimbabwe. Dual board structure where share holders elect a supervisory board that in turn appoints and supervises a management board, are more prevalent in European countries such as Germany, Austria, Belgium, China, Croatia, Czech Republic, Denmark, Estonia, Georgia, Germany, Holland, Indonesia, Latvia, Mauritius, Poland, Spain, Taiwan, where as mixed board structures are more evident in countries like Bulgaria, Finland, France, Switzerland. In the aftermath of several codes of corporate governance coming into force in several countries, the Board and its various committees, in particular the role and functions of the Audit Committee have been extensively implemented and analysed. This chapter discusses major aspects in regard to the board in various aspects of composition, structure, independence, as also one of the most importance committees of the board, namely the Audit Committee. Recent academic and analytical exercises on the various aspects of the board of directors, shows that (a) board size and independence have increased since SOX (Chhaochharia and Grinstein23, (2005)} (b) Busy boards donot harm shareholder 23
Chhaochharia, Vidhi, Yaniv Grinstein, 2005, Corporate Governance and Firm Value: The Impact of 2002 Governance Rules, Working Paper, Cornell University.
17
wealth (Ferris, Jagannathan and Pritchard24, (2003) (c) Board’s ability to monitor is compromised at firms with several busy directors (Fich and Shivdasani25,2004) (d) cozy board relationships limit effective monitoring (Larcker, Richardson, Tuna and Seary26, 2005) (d) financial expertise on boards limits the likelihood of accounting restatements (Agrawal and Chadha27, 2005) (e) market attaches more credibility to earnings announcement when boards and audit committees are both independent and active (Booth, Deli,28 1999) (f) presence of commercial bankers on boards is associated with the size of loans, whereas on the presence of investment bankers is associated with more frequent outside financings and larger public debt issues (Guner, Melmendier and Tate29 (2005) (g) presence of financial experts does not necessarily improve shareholder value (h) Excess compensation paid to directors is associated with excess CEO compensation (Brick, Palmon and Wald30) (i) Excess compensation is associated with poor future performance (j) excess compensation for directors compromise their independence and leads to overpayment of CEOs (k) proportion of outside directors, the number of board meetings and the tenure of the board chair are associated with the incidence of fraud (Chen, Firth, Gao, and Rui31). The board structure indicates risk elements on the evident of the following trends. •
Chairman not independent upon appointment
•
Less than half of the board are non-executives
•
Board turnover has been greater than 25% over the previous year or more than three new people (excluding internal promotions) have joined the board in the same period
•
Fewer than three executive directors
•
No senior independent director on the board
•
Chairman of the company chairs audit committee
24
Ferris, Stephen P., Murali Jagannathan and A.C. Pritchard, 2003, Too Busy to Mind the Business? Monitoring by Directors with Multiple Board Appointments, Journal of Finance, 58, 3, 1087-1112. 25 Fich, Eliezer and Shivdasani Anil,, 2004, Are Busy Boards Effective Monitors? Finance Working Paper No. 55/2004, European Corporate Governance Institute 26 Larcker, David F., Scott A. Richardson, Andrew Seary and A. Irem Tuna, 2005, Back Door Links Between Executives and Executive Compensation, Working Paper, The University of Pennsylvania. 27 Agrawal, Anup and Chedda, Shaiba, 2005, Corporate Governance and Accounting Scandals, Journal of Law and Economics. 28 Booth, James, Deli, Daniel N, 1999, On Executives of Financial Institutions as Outside Directors, Journal of Corporate Finance 5, 227-250. 29 Guner, A. Burak, Ulrike Malmendier,m Geoffrey Tate, 2005, The Impact of Board with Financial Expertise on Corporate Policies, Working Paper, Stanford University. 30 Brick, Ivan E., Oded Palmon and John Wald, CEO Compensation, Director Compensation and Firm Performance, Evidence of Cronyism. 31 Chen, Firth, Gongmeng Gao and Rui, Ownership Structure, Corporate Governance and Fraud: Evidence from China.
18
•
Executives on the audit committee.
•
Remuneration risk indicators:
•
Any Insight votes against or abstentions on the company’s remuneration report in the past three years
•
Any Insight votes against or abstentions on the company’s share schemes in the past three years.
Board evaluation forms an important aspect of assessing the performance as also sharing important aspects that will lead to better functioning of the board. Board performance review is emerging as an important aspect of strengthening the board structure and performance. Another aspect assuming importance in regard to the board structures in particular its composition, is the representation of women. Gender equality in boards is assuming significance, though women representation in the boards remains at very low levels in many countries. Norway made a major breakthrough in this regard by introducing from January 2003, that enterprises that are subject to statutory audit to prepare an annual report are required to be specific in that report the state of the gender equality in that enterprise and what measures have been or planned to be implemented to promote gender equality. The percentage of women on the boards increased from 6 percent in 2004 to 25 percent by January 2007. and thirty eight percent of the 500 odd public limited companies in the private sector were able to fulfill the gender requirements in the board. Special databases have been created to find companies find competent women as board directors and several activities to promote women participation in the boards such as arranging training courses to develop women directors are being carried out. Stringent action is provided for companies not complying with women representation in the board. The Public Limited Companies Act, the Norwegian law provides for the liquidation and dissolution of the company found failing to meet the statutory requirements regarding women representation in the board. 5. Assessments on Corporate Governance in India From the year 2003 onwards CLSA and Asia Corporate Governance Network32 together collaborated in bringing performance scores of countries in the Asian 32
Allen, Jamie, 2007,.The Benefits of Corporate Governance to Emerging Economies, Asian Corporate Governance Network.
19
region in regard to corporate governance. The first of the report, CG Watch 2003, had an interesting title, “Faking It : Board Games in Asia “ perhaps most appropriate at that time in the background of global meltdown of stock markets brought about by severe inadequacies and abuses in corporate conduct and disclosure standards. The 2004 report had a more promising title “Spreading the Word. Changing Rules in Asia “reflecting changing landscape of the corporate governance brought out in the backdrop of Sarbanes-Oxley and a host of regulatory reforms that came into being in a number of countries. The CG Watch 2005 had the title “Holy Grail: Quality at Reasonable Price (QARP) showing growing commitment towards, better corporate governance.
The 2007 report had a much more
encouraging theme “On a Wing and a Prayer: Greening of the Governance” that brought out the significant changes in the corporate governance practice in the Asia region. The 2007 survey assessed the quality of corporate governance in Asian markets that included Japan for the first time, and provided aggregate data from 582 companies in the region.
Corporate governance scores improved sizeably in many countries of Asia. India now ranks third after Singapore and Hong Kong in regard to performance in corporate governance. The slight decline in the 2007 score is not due to lowering of standards but due to inclusion of a larger number of parameters for evaluation, that was common to all the countries. The 2007 study has also included Japan in among the countries assessed. The “CG Watch 2007” has this to say on the quality of governance standards in India “A large population (hence low GNI per-capita); economic reform started much later than China (1991) vs 1978); yet corporate governance reform started early by regional standards (1998) and the country has some pockets of world-class corporate governance”.
20
Table3 : India ranks high among Asia governance league tables Country33 Singapore Hong Kong India Malaysia Taiwan Korea Thailand Philippines China Indonesia
2000 75 71 56 32 57 52 28 29 36 29
2001 74 68 54 37 53 38 37 33 34 32
2002 74 72 59 47 58 47 38 36 39 29
200334 77 73 66 55 58 55 46 37 43 32
200435 75 67 62 60 55 58 53 50 48 40
200536 70 69 61 56 52 50 50 48 44 37
2007 65 67 56 49 54 49 47 41 45 37
Source: “CG Watch”, a joint report by CLSA Asia- Pacific Markets and ACGA.
Table 4: Matching Rules and Regulations Question
China
HK
India
SKorea Mala ysia Yes Yes
Phil
Sing
Tai
Thai
Yes
Indo nesia Yes
Is quarterly reporting mandatory Are Auidt committees mandatory? Must ownership stakes above 5% be disclosed? Detailed disclosure of material transactions? Is the national code of CG based largely on International standards?
Yes
No
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Some
Yes
Yes
Yes
No
Yes
Yes
Yes
Yes
Some
Yes
Yes
Yes
Yes
Som e
Yes
Some
Yes
Yes
Some
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Some
Yes
Yes
Yes
Yes
Yes
Yes
Is there n national policy to converge with IAS/IFRS?
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Yes
Source: CLSA/ ACGA “CG Watch 2005: The Holy Grail”.
33
Ranked in descending order according to 2005 score First year in which ACGA collaborated with CLSA 35 Introduced more rigorous scoring methodology in 2004 36 Enhanced methodology further in 2005 34
21
An assessment by the Institute of International Finance37 (Corporate Governance in India, An Investor Perspective, February 2006) brings out the following features of governance practice in India. •
Corporate governance-related requirements in India are largely based on the recommendations of the Cadbury and Higgs Reports and the SarbanesOxley Act. SEBI has been proactive in keeping India’s corporate governance rules and regulations in line with the best practices in the world.
•
The state of corporate governance in India has improved over the last four years particularly among the large cap Indian companies.
•
In many large Indian companies, globalization- and not regulatory requirements- has served as an impetus for adoption of corporate governance best practices.
•
High market premiums that the stock of these (good corporate governance) companies command has reinforced the belief among Indian investors and, more importantly, other Indian companies that better corporate governance contributes to a high stock price and provides access to cheaper capital.
•
Improvements in corporate governance in Indian companies seem largely to be voluntary and driven by globalization
•
Companies that wish to access markets for capital or that wish to become leading global suppliers to corporations in developed markets are becoming increasingly transparent and more willing to adopt higher corporate governance standards. These governance changes are having a trickle-down effect on smaller Indian companies.
•
Stock exchanges are viewed as being at the front line of the surveillance function for compliance with all listing requirements, including those that pertain to corporate governance.
37
Institute of International Finance, Inc, Corporate Governance in India, An Investor Perspective, IIF Equity Advisory Group, Task Force Report, February 2006
22
An assessment by the World Bank on the corporate governance standards in India, along with specific recommendation in cases where it is required is given below. India is found to be observing/largely observing 16 of the 22 standards with continuous improvements in these as well as other remaining standards in the last three years. Table 5: Corporate Governance Assessment and Policy Recommendations for India World Bank, 2004 I
II.
III.
IV.
V.
The Rights of Shareholders Basic Shareholder rights Rights to participate in fundamental decisions: Shareholders’ AGM rights: Disproportionate control disclosure: Markets for corporate control should be allowed to function Cost/benefit to voting* Equitable Treatment of Shareholders All shareholders should be treated equally$ Prohibit insider trading # Board/Mgrs. disclose interests** Role of Stake holders in Corporate Governance Stakeholder rights respected Redress for violation of rights Performance enhancement Access to information Disclosure and Transparency Disclosure standards: Standards of accounting & audit Independent audit annually Fair & timely dissemination: Responsibilities of the Board Acts with due diligence, care: Treat all shareholders fairly: Ensure compliance w/ law: The board should fulfill certain key functions The board should be able to exercise objective judgment Access to information
OBSERVED OBSERVED OBSERVED LARGELY OBSERVED OBSERVED MATERIALLY NOT OBSERVED PARTIALLY OBSERVED PARTIALLY OBSERVED PARTIALLY OBSERVED OBSERVED PARTIALLY OBSERVED OBSERVED OBSERVED LARGELY OBSERVED LARGELY OBSERVED PARTIALLY OBSERVED OBSERVED LARGELY OBSERVED LARGELY OBSERVED OBSERVED LARGELY OBSERVED PARTIALLY OBSERVED OBSERVED
*Regulators should consider introducing an obligation that institutional investors acting in a fiduciary capacity adopt and disclose their corporate governance and voting policy.- Regulators should also disclose to the public how they manage material conflicts of interest that may affect the exercise of their corporate governance rights.- Shareholder activism among retail investors should be encouraged. $ Depository receipt contracts should provide owners with same rights to vote as are accorded to holders of underlying shares.- Consider strengthening regulators’ enforcement power to offset backlog and delays of court procedures. #Implement SEBI’s initiative of a unique client code for each investor.- There should be greater cooperation between NSE and BSE on surveillance. - Publish share trading by directors and senior management in the newspaper.- Successfully prosecute one insider trading case to enhance perception of market integrity. **While audit committees should pre-vet related party transactions, ultimate responsibility of judging whether a related party transaction is in the best interest of the company should remain with the board. Source : World Bank.
23
6. Concepts and Principles in Corporate Governance in India India has advanced significantly in adopting better governance standards and its standing in the world is quite high in regard to designing effective policies and procedures. Several companies go beyond the mandatory requirements in fulfilling the corporate governance objectives. Companies have developed philosophies governing the governance practices that were introduced in their respective companies and the outcome that is being expected from these initiatives. Some of the modern governance practices such as separation of the Chair and the CEO, constitution of boards, representation of independent directors, meetings of the board and audit committees, discussion on the corporate governance practices in the annual reports, disclosure through a wide range of media and company sources etc., have greatly enhanced the image of the quality of corporate governance in India. India currently is ranked third in Asia for the overall quality of corporate governance. Practice of corporate governance has progressed in a big way in Indian companies. There are several companies which made proactive initiatives in introducing good governance norms and standards even before these became mandatory.
For
instance, in its corporate governance report, Wipro, mentions about some of the pioneering efforts made by it in setting good governance standards such as; instituting stock ownership in 1984, constitution of sub-committees of the Board of Directors for Audit, compensation and benefits in 1986 and preparation of consolidated financial statements in 1983, the first year in which it established a subsidiary company. Similarly, good governance in Tata Power is governed by “Leadership with Trust” a principle that has been in practice since long; where as Tata Motors began Tata Business Excellence Model and the Tata Code of Conduct long back. Ranbaxy voluntarily adopted several best practices in good governance in 1999 that included; majority independent directors in the composition of the board, constitution of board committees for oversight and guidance concerning key decisions and soundness of decision making processes connected with the functioning of the company, timely dissemination of information to shareholders and a code of conduct. Infosys not only complies with Indian governance standards but also Euro shareholders Corporate Governance Guidelines 2000 and the recommendations of the Conference Board Commission on Public Trusts and
24
Private Enterprises in the United States. It also adheres to the UN Global Compact Programme. ACC has instituted a Chair for Business Ethics at the Management Center for Human Values at the Indian Institute of Management, Kolkata.
The
objectives of the corporate governance of the companies included in this paper are given along with the corporate governance practice profiles of the respective companies. The governance practices set out by the Reliance Energy beyond the regulatory requirements include; Values and Commitments, Code of Ethics, Business Policies, prohibition of insider trading, prevention of sexual harassment, whistle blower policy, environment policy, risk management, SA 8000 (standard for social accountability), six sigma, OHSAS 18001 (for establishment of occupational and safety management system) etc., Some of the innovations in the boardroom practices that were detailed in the corporate governance report included; Board charter, tenure of independent director, Interaction of non-executive, including independent directors with the chairman, lead independent directors, independent director’s interaction with shareholders, meeting of independent directors without the management, independent director on the risk management committee, commitment of directors, evaluation of the board etc. The next round of reforms in the corporate governance would be in the realm of strengthening evaluation processes of the functioning of the board and its subcommittees, in particular the audit committee, as also greater discussion on the executive compensation policies, ombudsman for reviewing whistle blower policies etc. As Indian companies assume greater responsibilities in expanding business in domestic and global markets, compensation issues will become pertinent.
7. Corporate Governance Practice in India India has been ranked high on several aspects of corporate governance such as shareholder rights, creditor rights, disclosure requirements, liability standards and quality of regulation; whereas it displays limitations on aspects such as enforcement, corruption, red tape, ease of doing business, hiring and firing staff, quality of credit information, contract enforcement. India’s position in regard to key indicators of standards in governance and securities law is given in annexure.
25
The above trends could be better explained by Indian companies winning global accolades for the corporate governance on one hand and the securities market regulator show causing some companies, including the public sector, to tone up the governance parameters on the other.
In September 2007. World Council for
Corporate Governance, a UK based organisation, announced global awards in the emerging markets category for ONGC, NTPC, Jubilant Technologies and GTL. Several others awarded in the national category included; LIC India (Insurance); Punjab National Bank (Banking); Hindustan Construction Company (Construction); India Travel House (Hospitality); KPIT Ltd (IT); Power Finance Corporation (Power); Hindustan Construction Company Ltd (Petroleum); Hindustan Zinc, Ltd (Metal) and Shree Cement (Manufacturing). In a related development, Infosys Technologies, Kotak Mahindra Bank, Satyam Computer Services and Grasim Industries were figured in the IR Global Rankings: 2007 announced by the IR Global Rankings, a global investor relations web company. Around the same time, Securities and Exchange Board of India, has initiated proceedings against 20 companies for non compliance of corporate governance, among which five were reported to be the public sector undertakings. This paper discusses the results of a review on the corporate governance practices in 42 companies taken from 12 major sectors with these companies together accounting for over 80 percent of the stock market capitalization (October 2007). These companies represent 77 percent of the Sensex and 64 percent of the Nifty (50) constituents. Data collected from the annual reports of these companies is analysed in certain aspects of practice of corporate governance, a summary of which is given below.
26
Table 6: A Snapshot of Corporate Governance Con Dur
FMCG
Petro Mine
Cem ent
Tel com
Diver sified
Particulars
Metals
Average No of Directors %companies where the chairman is non executive Proportion of Non Executive Directors in the above Cos Proportion of Independent Directors in the above Cos. % of companies where the chairman is executive proportion of non executive directors in the above Cos. Proportion of Independent Directors in the above Cos. % companies in which the chairman is Independent Director No of Board Meetings held in FY07 No of Audit Committee Meetings held in FY07 Number of Investor Grievances Comm Meetings hled in FY07
12.33
9.7
9
12.6
12.33
11
11
10.4
14
12
14.5
14.33
83
66
50
na
66.6
33.3
50
80
100
33.3
na
33
73
74
50
na
50
67
74
60
67
80
na
81
42
43
33.3
na
61.5
33.3
48
42
33.3
40
na
45
17
33
50
100
33.3
33.3
50
20
na
67
100
67
59
83
67
57
36.4
47.6
76
75
na
89
62
72
50
50
33.3
41
36.4
38.1
71
75
na
50
55
50
100
na
na
na
1
1.33
2
1.2
8.33
1.33
3
2
8
4.66
18
8
Promoter Shareholding %
61.46
54.75
76.34
62.58
27.1
58.63
38.87
40.21
39.14
59.28
34.38
39.39
FII Share holding %
12.67
12.2
2.03
13.29
32.02
14.06
23.94
15.79
21.93
13.76
15.58
22.34
Individual share holding % Space devoted to Corporate Governance in Annual Report
13.57
17.8
9.28
7.52
8.25
9.57
10.95
19.73
19.91
1.99
20.12
14.45
7.93
16
11.58
13.37
9.55
11.16
10.63
14.77
16.71
11.26
10.15
11.08
Banks
Energy
IT
Pharma
7.5
5.33
12
11.4
8.33
8.67
6.5
5.4
7.33
7.67
8
6.33
5.33
5
4.5
7.8
8.33
7
6
4.6
6.33
5.33
7.5
8
Sectors : Metals; Fast Moving Consumer Goods, Consumer Durables, Petroleum and Mining, Banks, Energy, Information Technology, Pharmaceuticals, Cement, Telecommunications, Diversified and Automobiles
The average number of directors range from 9 in the Consumer Durables to 14.5 in the Diversified industry sector. Average No of Directors 16 12 8 4
Diversified
Cement
Technology
Information
Pharmaceuticals
Telecommunications
Automobile
Energy
Financial Services
Petroleum & Mining
Consumer Durables
FMCG
0 Metals
Auto
Sectors
27
In companies where the chairman is non executive, it was found that 69.53 are non executive directors and 44.28 percent are independent directors. There are 3 companies all belonging to the Pharmaceuticals in which the chairman is non executive as also independent director.
Composition of the board when the Chairman is Non executive 140 120 100 80 60 40 20 0 Consume Petroleu Metals
FMCG
r
m&
Durables
Mining
Financial Services
Energy
Automob ile
Telecom municati ons
Pharmace uticals
Informati on
Cement
Diversifie d
Technolo
Proportion of Independent Directors
42
43
33.3
0
61.5
33.3
45
40
42
48
33.3
0
Proportion of Non Executive Directors
73
74
50
0
50
67
81
80
60
74
67
0
In companies where the Chairman is executive, it is found that 63.42 percent are non executive and 46.7 percent are independent. The proportion of independent directors when the chairman is executive is short of the mandatory requirements in sectors like energy, financial services and petroleum in mining. In all these sectors, the company specific data indicates that public sector undertakings face constraints in filling up the positions of the non independent directors in the board since they are appointed by the Government.
Composition of Board when the Chairman is executive 160 140 120
%
100 80 60 40 20 0
Consu Petrole Financi Teleco Pharma Inform Autom Cemen Diversif mer um & al Energy mmuni ceutica ation obile t ied Durabl Mining Service cations ls Techno
Metals
FMCG
Proportion of Independent Directors
50
50
33.3
41
36.4
38.1
50
50
75
71
0
55
Proportion of Non Executive Directors
59
83
67
57
36.4
47.6
72
89
75
76
0
62
Sectors
28
The average meetings of Board and the Audit Committee works out to 7.76 and 6.24 per company, which is higher than the stipulated number of meetings required to be held as per the Clause 49 Listing Agreement. Table7: Average number of meetings held
Sector
Average Number
Average
Average Number
of Board
Number of
of Investor
Meetings held
Audit
Grievances
Committee
Committee
Meetings
Meetings
Automobile
6.33
8
8
Cement
7.33
6.33
8
Consumer Durables
12
4.5
2
Diversified
8
7.5
18
Energy
8.67
7
1.33
Banks
8.33
8.33
8.33
FMCG
5.33
5
1.33
Information Technology
6.5
6
3
Metals
7.5
5.33
2.33
Petroleum and Mining
11.4
7.8
1.2
Pharma
5.4
4.6
2
Telecom
7.67
12.33
4.66
Indian companies are relatively closely held as could be evident from the high percent of promoter holdings in most of the sectors. Higher levels of promoter holdings is a feature widely prevalent in the Asian corporates as brought out by several studies in this regard.
29
Shareholding Pattern 90 80
Percentage
70 60 50 40 30 20 10 0
Consume Petroleu Metals
FMCG
r
m&Minin
Durables
g
Financial Services
Energy
Automob ile
Telecom
Pharmac euticals
Informati on
Cement
Technolo
Diversifi ed
FII Holding (%)
12.67
12.2
0.01
13.29
32.02
14.06
22.34
13.76
15.79
23.94
21.93
15.58
Promoter Group Holding (%)
61.46
54.75
76.34
62.58
27.1
58.63
39.39
59.28
40.21
38.87
39.14
34.38
Sectors
Cement, FMCG and Pharma companies devoted greater amount of space for corporate governance (in terms of no pages on governance discussions in the total annual report) discussion as proportion to all aspects included in the annual report.
Diversified
Cement
Information Technology
Pharmaceuticals
Sectors
Telecommunications
Automobile
Energy
Banks
Petroleum & Mining
Consumer Durables
FMCG
18 16 14 12 10 8 6 4 2 0 Metals
%
Space devoted to Corporate Governance in Annual Reports
30
8. Recent Trends in Corporate Governance in India A few of the major trends evident in the realm of corporate governance practice are discussed below. a. Separation of Chairman and CEO Separation of Chairman and CEO are increasingly recognized as a best practice that the companies should absorb. Several companies now have separate Chairman and the CEOs. In the sample of 42 companies that this study has analysed in regard to corporate governance practices, more than half of them have chairman separate from the chief executive officer and this trend is rising in several companies. b. An Independent Board Given the importance of independence of the board, the scope of non executive directors and independent directors assume great significance. This study revealed that about 65 percent of the directors are non executive and about 46 percent are independent directors. There are three companies in which the chairman is non executive as also independent. There is a growing trend of making the board structure more independent.
Companies with foreign shareholding in the
pharmaceutical industry have non executive and independent directors as chairmen. c. Lead Independent Directors Big corporations are now designating lead independent directors who will coordinate the work of the independent directors as also review the progress of the company and set its business agenda. The role of the Lead Independent Director in one of the top Indian companies is defined as below: •
To preside over the meetings of Independent Directors
•
To ensure that there is adequate and timely flow of information to Independent Directors
•
To liaise between the Chairman and Managing Director, the Management and Independent Directors
31
•
To preside over meetings of the Board and Shareholders when the Chairman and Managing Director is not present or where he is an interested party
•
To perform such other duties as may be delegated to the Lead Independent Director by the Board/Independent Directors.
It can be seen that companies are beginning to give more weightage to the scope and functions of the independent directors and in this process identifying a Lead Independent Director, who could be a catalyst in deriving the best from this process. Some companies have more than one Lead Independent Directors with different directors looking at different aspects of the governance and growth of the companies. For instance, in one company, one Independent Director each is vested with the responsibilities of the driving agenda for the Board, improving board processes, corporate strategy, financial and internal controls, risk management and compliance and one independent director identified as the Chief Ombudsman for the Whistle Blower Policy of the company. d. Independent Directors Independent Directors are the major instrument of the corporate governance in the modern corporates. Many companies, excepting a few public sector have complied with the requirement in regard to proportion of the representation of the independent directors in the boards. Though big corporates find good quality independent directors with relative ease, the same is emerging as a major challenge for the mid and small cap companies who appear to be facing sizeable problem in finding right number of directors with right qualities and qualifications. At present, nominee directors are treated as independent directors, but SEBI is proposing not to consider nominee directors as independent directors, in which case, the challenge becomes much tougher for a host of companies. In view of the representation of independent directors becoming a prominent aspect of the corporate governance, it is important that companies take this aspect with greater focus and seriousness. In March 2007, the Union Cabinet of the central government gave its approval to the guidelines on Corporate Governance for Central Public Sector Enterprises
32
(CPSEs) as per which, the board of directors of a company shall have an optimum combination of executive and non executive directors with not less than 50 percent comprising non executive directors.
On implementation, it would improve the
compliance standards of the public sector enterprises. e. Board Committees Companies are taking keen interest in constituting various subcommittees of the board in addition to the strengthening of the board. In addition to the mandated ones such as the audit committee and investor grievances committee and remuneration committee etc., companies are found to set up a wide range of sub committees as per their specific requirements. Names of the few sub committees in the corporate analysed in the study include; project appraisal committee, ethics committee, human resources policy committee, investment committee, safety, health and environment committee, planning and projects committee, contracts committee, projects evaluation committee, establishment committee, financial management committee, marketing strategy committee, technology committee, rural
sector
committee,
business
committee,
asset-liability
risk
management
management committee,
committee,
special
directors
committee
for
monitoring large value frauds, board management committee, credit approval committee, customer service committee, management controls committee, science committee, banking and organization committee, intellectual property rights committee, f. Meetings Companies have shown good progress in respect of the number of meetings of the Board and the Audit Committee held in a year. The number of meetings held are normally higher than the mandatory requirement in most of the companies. g. Periodic Evaluation of the Performance Good governance requires periodic evaluation of the performance of the Board and Audit Committees by an internal process or an external agency. Though big corporations take elaborate care and processes in identification and selection of the members of the board, not all companies have a well defined process of
33
performance evaluation. Infosys has put in place, where in an annual performance evaluation exercise; each non executive board member has to make a presentation to the Board on the major contribution made by him leading to an assessment that will determine the further scope of the members participation in the board. Such structured processes are not evident in a large number of companies. h. Related Party Transactions OECD defines related party transactions as those that involve between a parent company and subsidiary, employees, an enterprise and its principal owners, management or members of their immediate families; and affiliates (OECD Principles, IAS 24(9); FASB Statement No.57). Related party transactions can take various forms including; transfer pricing, asset stripping, inter company loans and guarantees; sale of receivables to special purpose vehicle; leasing or licensing agreement between a parent and a subsidiary. In view of the extensive family holding of Indian companies, concerns exist on the accuracy and authenticity of the declarations and statements made to the board on the related party transactions. Governance professionals express the scope for further refinement and reforms in the information pertaining to related party transactions. i. Annual Reports Annual Reports are important documents for assessing and analyzing the company performance in regard to corporate governance standards and compliance. There is vast improvement in the quality of content in the Annual Reports, but scope exists for presenting the data in a manner that is easy to locate and understand. Even in respect of the corporate governance reports, though the number of aspects on which information is required to be given is uniform, companies present information in different formats making it rather cumbersome for the readers who look at the documents of a number of companies. j. Corporate Governance Reports Corporate Governance Reports are important part of the Annual Reports. Many companies in addition to giving the compliance on various parameters also some
34
times discuss the philosophy and objectives of the corporate governance thus setting the background for the spirit and letter of governance that is reported. k. Corporate Social Responsibility It is also found that several leading Indian companies undertake corporate social responsibility, which they report in the annual reports in a separate section. It is interesting to note several companies taking interest in corporate social responsibility. l. Statement of the Policies Most of the disclosures that are found in the companies annual reports are mandatory in nature. Many companies tend to fulfill the regulatory or compliance norms rather than taking a proactive initiative in discussing and disclosing pertinent policies and procedures on a wide range of issues that the company deals with. For the purpose of an illustration, a global major corporate, in its corporate governance report discussed and disclosed the following. Such disclosures and discussions are however, evident only in major corporations in India. a. Board Reserves one full day per year to discuss strategic questions b. Average duration of the Board Meetings c. Average attendance at the Board Meeting d. Working of the Compensation Committee. e. Information Policy f. Specific guidelines/ policy in regard to 1. Dealing with the people, 2. Relationships with suppliers and customers, 3. Legal compliance, 4. Gender equality and empowerment, 5. Health and safety, 6. Environment and public good, 7. Conflict of interest 8. Protection of confidential information, 9. Use of company facilities, 10. Leading by example and 11. Buying and selling of company stock.
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m. Promoter Holding A recent report of the Moody’s quoted in the media showed that 17 of the 30 companies in the Sensex are family controlled. The report observed that family controlled companies face corporate governance challenges in the future. Family controlled companies came up for criticism during the economic and financial crises in the South East Asia, wherein problems accentuated because of lesser disclosure standards prevalent in family owned firms. Growth of stock markets may induce reduction in the family holding and ownership in companies. n. Directors Training Companies are found to disclose the importance of training for their directors and mention the same in the corporate governance reports. While some companies explain the specific nature of training that is usually imparted to the directors, some make a broad reference to it. There is however no mention of the specific time spent by the directors on training. o. Whistle Blower Policy Being a non mandatory disclosure, companies mention about the Whistle Blower policy in place, but no record of any specific activity or incidence in this regard. Some companies put an independent director to look into the implementation of the policy p. Scope for improvement in Compliance Though the design of the corporate governance framework in India is considered matching that of the advanced countries, on aspects of enforcement and quality of supervision, scope exists for significant improvement. According to the information provided by the Ministry of Corporate Affairs, almost 30000 companies came under its scanner default in filing of annual returns for the year ended March 2006. As mentioned earlier in this report, Securities and Exchange Board of India has initiated adjudication proceedings against 20 companies for non compliance with the corporate governance of which five belong to the public sector. In a statement to the Parliament, Finance Ministry informed that 13 of the Group A companies of
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the Bombay Stock Exchange have not complied with the Clause 49 stipulations. Seven of the Nifty 50 companies were found short of fulfilling corporate governance norms.
At the same time, it is important to note that things are
improving at a good pace and governance environment could see significant improvements in the near future. It is also pertinent to note that India is not an exception to these shortcomings as these are quite general to Asia as also several other countries. 9. Emerging Challenges While corporates have been quite successful in placing effective processes that will ensure compliance with the listing norms, several challenges exist in the governance landscape. Though the Chairman and CEO are separated in several companies, in certain instances, it is found that a family member who is a non executive director is chairman and another family member is the CEO. Such arrangements meet the compliance requirements in letter but not in spirit. Similarly, in some it was found that meetings of several committees are clubbed together to save on time. Though time is an important element that needs to conserved with great care, the focus of the discussion should not be lost in trying to save time, which might lead to a situation where committees are called in a routine manner to fulfil the regulatory requirement. Significant improvements are required in respect to the reporting of subsidiary company operations as also related party transactions, a general feeling that is commonly shared by most of the practicing community on the corporate governance. Evaluation of the performance of the Board and the sub committees in particular the Audit Committee needs to be further strengthened and streamlined. In view of the sizeable representation of the public sector enterprises in the stock market capitalization, it becomes important to speed up the process of placing required number of independent directors in these companies. These companies being big in size and having significant growth, it is important that the short coming on the proportion of independent directors should not place them in a disadvantageous position in regard to compliance standards. Companies should endeavour to extend the range of disclosures beyond the mandatory norms to areas such as management processes, corporate social responsibility etc. The next round of reforms might focus on the compensation and remuneration committees since they will assume greater significance in the background of enormous growth of the companies and
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their operations extending beyond the national boundaries entailing greater challenges for management. Experts are of the view that the next round of major discussion and disclosures will be centered on compensation disclosure analysis to discuss the parameters governing the compensation for the executive directors as also designing effective structures for executive compensation. 10 . Looking Ahead Corporate governance both in respect of policy and practice made a quantum leap in India. On the policy side, India has one of the best frameworks for corporate governance. On the practice side, there is great improvement in the standards of reporting, disclosure and compliance of companies. Given more than one hundred thousand companies registered, of which about 5000 are listed, monitoring corporate governance in Indian companies is an intensely challenging task. Notwithstanding the size of numbers, improvements are evident in various aspects of governance. Companies are found to be increasingly complying with the governance standards and norms. Sustained efforts to step up the quality of governance are in place. SEBI expressed its unwillingness to allow any relaxation of the Clause 49 Listing norms for public sector undertakings despite their limitations in finding required number of independent directors, as defined by the norms. Similarly SEBI came up with further curbs on insider trading by proposing surrender of profits made by insiders of a company in any equity-based securities transaction of the company leading to short term profits. To help companies to expand the scope of corporate governance reports in the annual reports, SEBI has allowed company secretaries to certify the report in addition to the statutory auditors. Indian economy is experiencing unprecedented growth and receiving intense interest of the international investing community. Indian companies can derive huge benefits from this extremely conducive environment by strengthening the company performance as also its governance standards. International investing is increasingly governed by quality governance as evidenced from a number of studies and it becomes imperative for Indian companies to sustain the pace of reforms in corporate governance. While Clause 49 deals with what is mandatory, good
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companies can go an extra mile in devising effective ways of governance that could lead to efficient markets. Good governance is required for business growth, expansion and in pursuing global aspirations.
It is also important to bring in qualitative improvement in the
corporate environment in India that will induce others also to adopt best practices. Good corporate governance in big companies will be a guiding force for mid and small companies to devise effective governance frameworks that will result in further strengthening of the governance environment. The society at large as well as the stakeholders of the companies will the biggest beneficiaries of this outcome.
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Annexure Indices of Regulation of Securities Markets
This table shows the securities laws variables for each country covering the areas of (a) disclosure requirements (b) Liability standards (c) Supervisor characteristics (d) Rule making power of the Supervisor (e) Investigative powers of the Supervisor (f) Orders to issuers, distributors, and accountants (f) Criminal sanctions applicable to directors, distributors, and accountants and (g) Public enforcement
Company
Symbol
English Legal Origin Australia Canada Hong Kong India Ireland Israel Kenya Malaysia New Zealand Nigeria Pakistan Singapore South Africa Sri Lanka Thailand USA United Kingdom Zimbabwe Mean
AUS CAN HKG IND IRL ISR KEN MYS NZL NGA PAK SGP ZAF LKA THA USA GBR ZWE
Disclosure requirements
0.75 0.92 0.92 0.92 0.67 0.67 0.50 0.92 0.67 0.67 0.58 1.00 0.83 0.75 0.92 1.00 0.83 0.50 0.78
Liability standard
0.66 1.00 0.66 0.66 0.44 0.66 0.44 0.66 0.44 0.39 0.39 0.66 0.66 0.39 0.22 1.00 0.66 0.44 0.58
Supervisor characteristics
0.67 0.67 0.33 0.33 0.00 0.67 0.33 0.33 0.33 0.67 0.67 0.33 0.33 0.33 0.67 1.00 0.00 1.00 0.48
Rule making power 1.00 0.50 1.00 0.50 1.00 0.00 1.00 0.50 0.00 0.50 1.00 1.00 0.00 1.00 1.00 1.00 1.00 0.00 0.67
Investigative powers
1.00 1.00 1.00 1.00 0.00 1.00 0.50 1.00 1.00 0.00 1.00 1.00 0.50 0.50 1.00 1.00 1.00 0.00 0.75
Orders
1.00 1.00 1.00 0.67 0.00 1.00 1.00 1.00 0.00 0.00 0.17 1.00 0.00 0.00 0.33 1.00 1.00 0.08 0.57
Criminal Sections
0.83 0.83 1.00 0.83 0.83 0.50 0.67 1.00 0.33 0.50 0.08 1.00 0.42 0.33 0.58 0.30 0.42 1.00 0.65
Public enforcement
0.90 0.80 0.87 0.67 0.37 0.63 0.70 0.77 0.33 0.33 0.58 0.87 0.25 0.43 0.72 0.90 0.68 0.42 0.62
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Company
Symbol
French Legal Origin Argentina ARG Belgium BEL Brazil BRA Chile CHL Colombia COL Ecuador ECU Egypt EGY France FRA Greece GRC Indonesia IDN Italy ITA Jordan JOR Mexico MEX Netherlands NLD Peru PER Philippines PHL Portugal PRT Spain ESP Turkey TUR Uruguay URY Venezuela VEN Mean
Disclosure requirements
0.50 0.42 0.25 0.58 0.42 0.00 0.50 0.75 0.33 0.50 0.67 0.67 0.58 0.50 0.33 0.83 0.42 0.50 0.50 0.00 0.17 0.45
Liability standard
0.22 0.44 0.33 0.33 0.11 0.11 0.22 0.22 0.50 0.66 0.22 0.22 0.11 0.89 0.66 1.00 0.66 0.66 0.22 0.11 0.22 0.39
Supervisor characteristics
0.67 0.00 0.33 0.33 0.33 1.00 0.67 1.00 0.67 0.33 0.67 0.33 0.00 0.33 0.67 0.67 0.67 0.67 0.67 0.67 0.33 0.52
Rule making power 1.00 0.00 1.00 1.00 1.00 1.00 0.00 0.50 0.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00 0.00 1.00 1.00 1.00 0.79
Investigative powers
1.00 0.25 0.50 0.75 0.75 0.25 0.25 1.00 0.25 1.00 0.25 1.00 0.25 0.50 0.75 1.00 1.00 0.50 1.00 0.25 1.00 0.64
Orders
0.08 0.00 0.75 0.42 0.33 0.08 0.17 1.00 0.17 0.25 0.00 0.67 0.00 0.00 1.00 1.00 0.25 0.00 0.00 0.50 0.08 0.32
Criminal Sections
0.17 0.50 0.33 0.50 0.50 0.42 0.42 0.33 0.50 0.50 0.50 0.00 0.50 0.50 0.50 0.50 0.00 0.50 0.50 0.42 0.33 0.40
Public enforcement
0.58 0.15 0.58 0.60 0.58 0.55 0.30 0.77 0.32 0.62 0.48 0.60 0.35 0.47 0.78 0.83 0.58 0.33 0.63 0.57 0.55 0.53
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Company
Symbol
German Legal Origin Austria Germany Japan Korea Switzerland Taiwan
AUT DEU JPN KOR CHE TWN
Scandinavian Legal Origin Denmark DNK Finland FIN Norway NOR Sweden SWE Mean
Disclosure requirements
Liability standard
Supervisor characteristics
Rule making power
Investigative powers
Orders
Criminal Sections
Public enforcement
0.25 0.42 0.75 0.75 0.67 0.75 0.60
0.11 0.00 0.66 0.66 0.44 0.66 0.42
0.33 0.33 0.00 0.33 0.33 0.33 0.28
0.00 0.00 0.00 0.00 1.00 1.00 0.33
0.00 0.00 0.00 0.00 1.00 1.00 0.17
0.00 0.00 0.00 0.08 0.00 0.17 0.04
0.50 0.50 0.00 0.33 0.33 0.83 0.42
0.17 0.22 0.00 0.25 0.33 0.52 0.25
0.58 0.50 0.58 0.58 0.56
0.55 0.66 0.39 0.28 0.47
0.00 0.67 0.00 0.00 0.17
1.00 0.00 0.00 1.00 0.50
0.50 0.25 0.25 0.25 0.31
0.33 0.17 0.33 0.67 0.38
0.00 0.50 1.00 0.38 0.52
0.37 0.32 0.32 0.50 0.38
Mean all countries 0.60 0.47 0.45 0.66 0.60 0.38 0.50 0.52 Source: What Works in Securities Laws? Rafael La Porta, Florencio Lopez-de-Silanes, and Andrei Shleifer*, Dartmouth College, Yale University, and Harvard University, June 11, 2004
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