Corporate Governance- The Compliance Issues

(Dissertation for Masterclass Director program of Institute of Directors-254th Batch)

By: Anil Kumar Mittal

December 2019

Project Objective and Goals

Recent corporate scandals worldwide and security of investment made by institutional investors has

made corporate governance in the organization an important agenda for the board room discussions.

Any organization is part of the eco-system in which it thrives and is dependent on other stakeholders

for its survival and growth. The responsibility of Board members to ensure implementation of

policies, guidelines, adequate disclosures and guard against adverse selection and moral hazard has

come to fore front compared to what it used to be few decades ago. The Board is ultimately

responsible to share holders for all the actions taken by its management and executives.

The objective of this dissertation is to study what Corporate Governance is, its need for an

organization, ill effects of not implementing them and various codes, measurement criteria and inter-

relation with various factors like shareholding pattern, debt component; study of acts which provide

framework for organizations to rise above the governance, various research that have happened in

this sector which have benefitted the organizations.

Introduction and Context

Corporate Governance is the process which adds value to its stakeholders for their continued interest

in the organization and this include shareholders, investors, employees, suppliers, environment and

the society at large who are the ultimate beneficiary of existence of any corporation and without

whom its existence would not have been possible and where the persons who manage the operations

of the firm also live and thrive for their existence. The research on corporate governance codes
addressed questions of dynamics, motivation and effectiveness of compliance and non-compliance

with the code guidelines, the impact of the country’s legal regime on the adoption and the efficiency

of the code, and the impact of compliance on a firm’s performance and stock valuation (Aluchna,

2018).

Project Scope- How its Implementation will Help the Organizations

In this dissertation, we have attempted to identify the parameters that affects the organization’s

profitability and other financial performance; the true meaning of compliance and have tried to de-

mystify the myth that good corporate governance will be costly and will take the control out of hands

of promoters. We have used the results of study of various researchers and compiled the main and

basic parameters that are of significance; how the compliance will help the organizations be more

respected by the shareholders and other stakeholders which will help them lower the cost of capital,

higher share prices on stock exchange and make the organization a running entity for a longer period

of time.

The Project-Specific details of the project and its implementation strategy

The project is to identify which factors are missing and how they can be implemented in the

organization under consideration. We will identify the gaps in disclosure norms, stakeholder

engagement and how the same can be implemented in any organization. We will identify various

tools that are available and adoption of same for easy disclosure and making the organizations more

compliant to good corporate governance.

So, the question arises what is corporate governance and why is it needed, how do we measure it and

what are the risks associated with lack of it?

Corporate Governance

Corporate Governance is the set of processes, laws of land which a firm has to follow, customs that

have been in existence for long and any other institution that requires the firm to act and operate in
the best interest of all of its stakeholders. Corporate Governance is an acceptance of the fact by the

management that the firm is truly owned by the shareholders and that they themselves are the

custodian and trustees of the company. In words of Prof. Mehul Raithala,

The term governance has been derived from the word ‘gubernare’, which means ‘to rule

or steer’. It originally meant to be a ‘normative’ framework for exercise of power and

acceptance of accountability thereof in the running of kingdoms, regions and towns.

However, over the years it has found significant relevance in the corporate world on

account of growing number and size of corporations, the widening base of their

shareholders, increasing linkages with the physical environment, and overall impact on

the society’s well-being. Governance is the process whereby people in power make

decisions that create, destroy or maintain social systems, structures and processes.

Corporate Governance is therefore the process whereby people in power direct, monitor

and lead corporations, and thereby either create, modify or destroy the structures and

systems under which they operate. (Prof. Mehul Raithatha, 2012)

According to James D. Wolfensohn, President of World Bank, “Corporate Governance is about

promoting corporate fairness, transparency and accountability.” (Prof. Mehul Raithatha, 2012). The

corporates should adopt corporate governance practices as part and parcel of their routines instead of

law prescribing them to do so. Though profitability of the corporate is the primary motive of the

corporation, however only those corporations are able to stand out distinctly and attract the loyalty,

of various shareholders and stake holders, who are seen to be transparent, follow various established

best practices of corporate governance so as to benefit not only in terms of return on money invested

but also overall benefit to stake holders like environment, society at large and entire social eco-

system where individuals including managers and stakeholders live and thrive on these best

practices. Research has proven that there may not be short term profitability for these corporates but
in the long term, they enjoy loyalty and support of various stakeholders who are willing to pay

premium if their rights are better protected which goes a long way in delivering the return to them.

Effective legal protection will assure the investors that they will be paid the profits instead of being

spent in proposals that will benefit the managers (Roy, 2017).

Corporate governance principles in India have been laid out in Chanakya’s Arthashastra as early as

4th century highlighting the need to provide alignment of shareholders and stakeholders interests.

A corporate is an independent legal person and is granted this status by statute. It can hold property

in its name, can file suit and can die only through a legal process. The corporation is governed by a

constitution that is its Memorandum and Articles of Association. All the real persons who manage

the operation of corporation are bound by these two documents, needless to mention by law of land

in the first place.

Need of Corporate Governance

The need of Corporate Governance arises due to structure of the corporate management where share

holders are separated from the managers whom they entrust the decision-making power in their best

interests. Thus, in order to achieve the objective of safeguarding the interest of shareholders, a

framework of best codes of practice is put in place which is called Corporate Governance. The board

has a key role to play in framing the organizations strategy, developing directional policy, appointing

and remunerating senior executives and ensuring accountability of the organization to its

shareholders authorities and investors (Raut).

The transparency and good governance are the keys to engage the stakeholders. If they find that the

corporation is being managed to deliver the expected outcomes, they will engage with the firm else

not. The result will be lack of confidence of various stakeholders in the stock market, higher interest

rates of capital raised and government intervention if it becomes chronic. Competitive advantage is
another reason why companies should adopt good corporate governance. Various ways in which

companies gain by corporate governance are (Madhani, 2009):

 A better managed company

 Increased management credibility

 More long-term investors

 Greater analyst following

 Improved access to, and lower cost of, capital

 The realization of a company's true underlying value

Circumstances that necessitated CG framework

Several key factors and developments in the world of corporate sector are behind the development of

sound CG principles:

1. Collapse of prominent businesses: Lack of Corporate Governance mechanism and weak

institutions was visible on a large scale in 1997 East Asian financial crisis when exit of

foreign capital from countries like South Korea, Philippines, Indonesia, Thailand and

Malaysia saw collapse of financial structure as property assets collapsed. Bankruptcy of

Enron and Worldcom in 2000, corporate scandals of Tyco, Adelphia Communications and

AOL led to passage of Sarbanes-Oxley Act of 2002 considered to be the most sweeping

corporate governance regulation in the past 70 years (Prof. Mehul Raithatha, 2012). The

corporates are now realizing the value of Corporate Governance principles.

2. Changing patterns of ownership: In USA and UK, the changing pattern of ownership has

led to more concentration in the hands of institutional investors. The same wave is catching

up in other countries as well. The institutional investors, due to substantial share holding

require sound pattern of corporate governance to secure their money.

 3. Technological advancements in communications: Due to global business canvass where

institutional investors now operate and due to faster means of communication, the investors

world over are agreeing to a common view of better corporate governance.

4. External funds: family owned, or investor owned businesses now require large scale funding

which may come from domestic or international resources. These resources in turn require

assurance of their investment by way of good corporate governance.

5. Legal perspective: Even though firms are operating in international environment, but firms

are still subject to national corporate governance from the legal perspective.

6. Country dynamics: Good corporate governance in a country brings confidence in its stock

market and economic environment as a whole creating more attractive investment

opportunities.

Risks associated with poor corporate governance:

With the scandals of Enron, AOL and Satyam in India, the risks associated with lack of good

corporate governance has taken the front seat. As the demand for investment increases way beyond it

used to be decades ago, the institutional investors is now a established class who can bring in this

volume of money. But this requires a safety net for their money and return on investment. This can

be achieved only with good corporate governance, more disclosures and transparency.

Corporate mis-governance causes information asymmetry which in turn reduces the value of its

assets and ultimately the value of the company. Investors invest money in companies with good

governance record to ensure that their assets are not downgraded. Under these situations, the equity

of the firm may be incorrectly priced. The information asymmetric arises in equity market because

dispersed shareholders cannot directly see the manager’s efforts which creates moral hazard problem

and adverse selection problem creating more agency risk and investors factor in these risks by
demanding higher premium and thus the cost of capital of the investment gets raised. Good

Corporate Governance limits this information asymmetric by increased monitoring of the

management’s action, controlling manager’s opportunistic behavior and improving the quality of

firm’s information flow (Madhani, 2009).

Codes and Guidelines

The master guideline that forms the basis of all other documents and codes framed till date is 1999

Organization for Economic Cooperation and Development (OECD) Principles of Corporate

Governance that was further revised in 2004. This document frames a benchmark of governance by

dividing fifty distinct disclosure items into 5 broad categories:

 Auditing

 Board and management structure and process

 Corporate responsibility and compliance

 Financial transparency and information disclosure

 Ownership structure and exercise of control rights

The World Business Council for Sustainable Development (WBCSD) in 2004 released its work on

the Corporate Governance particularly, accountability and reporting. The Cadbury committee code of

best practices in the U.K. in 1990, the combined code of London Stock Exchange, the Blue ribbon

committee of U.S.and joint framework by World Bank and OECD to develop benchmarks in

corporate governance have ensured that corporates now are slowly but becoming more aligned to the

best practices so prescribed.

International Finance Corporation and UN Global Compact released a report in 2009 titled

‘Corporate Governance - the Foundation for Corporate Citizenship and Sustainable Business’,

linking the environmental, social and governance responsibilities of a company to its financial
performance and long-term sustainability (Raut). The Indian corporate governance model slowly

picked up with the formation of various committees to give suggestions ultimately leading to

formation of Corporate Governance Code in India. The development took place in stages (Prof.

Mehul Raithatha, 2012)

 CII code on Corporate Governance (1998)

 Birla Committee on Corporate Governance (1999) set up by SEBI (Several of the

Committee’s

recommendations were incorporated in Clause 49 of the listing agreement of stock

exchanges)

 Naresh Chandra Committee report on corporate audit and governance (2002)

 Narayana Murthy Committee Report on the Corporate Governance (2003)

 Dr. J.J.Irani Report on New Company’s Act (2004/05)

Major Corporate Governance Principles as per OECD (Raut)

Rights and Equitable Treatment of shareholders: Organizations should respect the rights of

shareholders and help them exercise those rights by communicating easy to understand

information and encouraging them to participate in general meetings.

Interest of other stakeholders: Organizations should recognize that they have legal and other

obligations to all legitimate stakeholders.

Role and responsibilities of the board: The board need to have skill, time commitment to

deal with various business issues and challenge management performance.

Integrity and ethical behavior: Organizations should develop a code of conduct for its

directors and executives to promote ethical and responsible decision making instead of simply

relying on the integrity and ethics of individuals which is a recipe for failure.

Disclosure and Transparency: Organizations should make public know the roles and

responsibilities of board and management, set procedures in place to ensure verification and

integrity of its financial reporting system and the disclosure of company matters should be

timely and balanced to ensure that investors have access to clear and factual information.

Mechanisms and Controls: The corporate governance requires setting up such controls that

reduce inefficiencies arising from moral hazards and adverse selection. These controls can be

internal as also external.

Internal Corporate controls: The authority vested with board of directors to control

managers by way of their compensation and control over their jobs helps to exercise the

safety of wealth of investors. Internal auditors ensure compliance of governance and

internal control procedures. The balance of power between various functions ensure

checks and balances between various decision makings. The remuneration of CEO linked

with share capital has its advantages to the extent that S(he) works for the performance

improvement of the corporation but it has side effects on stakeholders outside the firm if

S(he) manipulates the growth for his/her advantage. A big debate goes on whether CEO

and Chairman of the board can be the same person and if yes, what control mechanism

prevents him/ her to influence the board decisions.

External Corporate Governance Controls: External controls are control that entities

external to the organization imposes on corporation. This is achieved by market

 competition, government regulations, labor laws, media, environment NGOs, and debt

covenants.

The corporate governance failure occurs basically due to tendency of human beings to twist rules to

their advantage instead of following or governing the corporations on principles which remain fixed

as north star (Raut). The corporate governance has six basic tenets of accountability. Termed as 6

D’s. These are:

 Diversity in composition of board in terms of gene pool and gender

 Dialogue as opposed to monologue

 Valuing Dissent

 Dispersion of authority (Separation of Chairman and (CEO)

 Dispersion of status quo (critical to counter cosiness)

 Fostering culture of full Disclosure to build trust

Corporate Governance, Risk Management and Compliance (Raut)

With more studies and forays in the field of corporate governance, CRG is the term coined to avoid

wasteful overlaps between governance, risk management and compliance activities. GRC typically

encompasses activities such as corporate governance, enterprise risk management (ERM) and

corporate compliance with applicable laws and regulations.

While governance is all about exercise of control by the executives in a timely manner over effective

and timely implementation of strategies and direction set out by executives, the risk management is

about identification, analysis and responding appropriately before it may affect the organizational

performance. The list of risks that organizations face is very large ranging from technological,

commercial and Information technology to legal and regulatory compliances which are of utmost
importance from GRC point. Compliance with regulations, laws, strategies is achieved by setting

internal processes; analyzing the risks and potential costs of non-compliance against projected

expenses to achieve compliance. The widespread interest in compliance was sparked off by

Sarbanes-Oxley Act and the need for US companies to design and implement suitable governance

controls for SOX compliance.

Corporate Governance measurement parameters

Various researchers have analyzed determining what are those parameters that have a profound effect

on the level of disclosures made by the corporates. Two techniques have been primarily used. First is

the impact of a single parameter on CG and another one is use of a CG index (CGI).

The findings of the first approach have been highlighted here:

 The audit committee was a significant factor associated with level of voluntary disclosure,

while the proportion of nonexecutive directors on the board was negatively associated by

Barako et al 2006 (Prof. Mehul Raithatha, 2012)

 Differences in disclosure pattern of financial information and governance attributes by

Subramanian 2006. The study used the Standard & Poor’s “Transparency and Disclosure

Survey Questionnaire” for collection of data. The study finally concluded that “there were

no differences in disclosure pattern of public/private sector companies, as far as financial

transparency and information disclosure were concerned. It had also been observed that

private companies disclose more information under the category of board and

management structure (Prof. Mehul Raithatha, 2012)

 Prof. Mehul Raithatha determined whether any relationship exists between the

compliance with Corporate Governance Code and a number of key company

characteristics like Market Capitalization, Net Profit Margin, Leverage Ratio, FII Stake

and Promoter Stake (Prof. Mehul Raithatha, 2012). The paper found that no such relation
 exists. The state of corporate governance in India is not an important factor for FII’s to

buy stake in Indian companies. It was also observed that myth surrounding small and

medium capitalization companies in India do not have sound corporate governance

practices was proved wrong. However, it was also found that creditors do a thorough

analysis of corporate governance mechanism in place before lending. This research also

confirmed the earlier version that Strength of Committee’ and ‘Competency level of

Board’ are two important sub parameters.

 Work done by Amitava Roy indicate that greater CG compliance is significantly

associated with firm’s market capitalization. Firm operating performance (measured by

ROA) has a positive association with CG and there also exists an association between

ROA, ownership structure variables and debt equity ratio (Roy, 2017).

The second approach in terms of CG index analyzes the impact of various parameters as a whole by

creating an index on the firm’s CG structure. It is also the view of researchers that creation of such an

index will facilitate the regulators to judge how the CG reforms are working it would be helpful to

companies to realize the benefit of adopting good CG practice and such a CGI can work as a rating

tool and CGI would be helpful to investors to pick well governed companies. The principal

international academic indices include; Gompers, Ishii and Metrick’s G-Index (2010);Bebchuk,

Cohen and Ferrell’s E-Index (2009) and Brown and Caylor’s Gov-Score Index (2006) (Roy, 2017).

Various indices have been developed by consultancy firms and rating agencies e.g. The Corporate

Library (USA), CLSA Ltd (Asia) and CRISIL (India). However, the commercial and academic

indices differ in the way the various CG level parameters are handled.

The various studies have reached a conclusion that CG is a complex environment and using a single

parameter to gauge the CG compliance of a firm may not give the real picture while multi-parameter
environment require formation of indices by the identification of accurate and relevant parameters,

the weights given to them and also incorporating influence of various external influences on them

Corporate Governance Compliance In India and deriving value to firm

Various studies thus concluded that compliance with best practices of corporate governance can be

measured by using various parameters and their affect on the profitability, engagement of stake

holders, credit rating and long-term advantage to keep the firm going as a profitable venture. CG

disclosures are made by the firm in compliance with the requirements of Companies Act and clauses

35 and 49 of SEBI guidelines (annexure-I). The CG disclosure requirements in India fall in two

categories, namely, mandatory and voluntary. Most of the SEBI’s clause 49 requirements are

mandatory. Some of these parameters which are directly related to the firm’s performance are:

1. Investors look for firms having sound compliance with CG principles as this give them

assurance of adequate accountability of directors, internal control systems and reliable

financial reporting system.

2. Beneficial influence of CG compliance is independent of ownership structure i.e. both family

owned businesses as well as share holder held categories both benefit by CG compliance.

However, evidence suggest that agency cost and risk can be reduced to a greater extent by

sharing ownership of the firm with large shareholders who have substantial investment at

stake and voting power enabling more compliance with CG (Roy, 2017).

3. The extent of debt in capital structure does influence the compliance with CG as more

diligence is exercised by lenders before they lend loan or debt to a firm related to its

mechanism to CG compliance. Sarkar and Sarkar (2012) observe that as the component of

institutional lending increases, it impacts firm performance in a significant way by increase in

the controlling and monitoring activities of the firm. (S. sarkar, 2012)

4. Greater CG compliance is associated with greater market capitalization.

 5. Public sector undertakings are a significant force in CG compliance

6. Firm operating performance like ROA, ownership structure and debt equity ratio have a great

degree of dependence on CG compliance

7. Existence of regulation has a positive impact on CG compliance. Absence of such regulations

require investor to demand higher premium on investment raising the cost of capital.

8. Flexible or voluntary regulation does not lead to much impact on CG compliance

9. No evidence of the number of years of operation of the company with better CG compliance

Corporate Governance and financial performance measure

Various recent studies have shown that corporate governance positively affects the performance

measure ratings like Tobin’s Q. Tobin’s Q is the ratio of market value to book value of assets. The

Tobin’s Q was found to be 56% basis points higher in case of firms with stronger shareholder’s

rights compared to otherwise. A study by Gompers, Ishii, and Metrick (2003) found that companies

with strong shareholder rights yielded annual returns that were 8.5 % greater than those with weak

rights. (Madhani, 2009)

Popular Models of Corporate Governance

Various models have been developed at international level. However, none is considered to

encompass all the best practices. However, the following models are considered to provide

framework for all other local and country wise codes and regulations. The OECD principles are

considered to be the most accepted framework. It not only acknowledges the importance of legal

protection but also other mechanisms of corporate governance. The popular models of corporate

governance are (Madhani, 2009):

1. The OECD Principles of Corporate Governance

They provide the framework for identifying key practical issues- rights and equitable

treatment of shareholders, Interest of other stakeholders, role and responsibilities of the

 board, Integrity and ethical behavior, Disclosure and Transparency, Mechanisms and

Controls. The OECD Principles are universally applicable to all types of corporate

governance systems in countries at all levels of economic development. The OECD Principles

have gained acceptance throughout much of the world as an appropriate framework for

analyzing the corporate governance environments of different markets and as a starting point

for developing approaches to evaluate the effectiveness of governance of individual

companies.

2. International Corporate Governance Network (ICGN)

ICGN comprises of investors, companies, financial intermediaries, academics and other

parties interested in the development of corporate governance practices. ICGN has furthered

the work of OECD by providing guidance on implementation of these OECD principles.

3. Council of Institutional Investors (CII)

The Council of Institutional Investors (CII) is an organization that represents large pension

funds in the U.S. They have developed a set of recommended corporate governance policies

which are targeted at publicly listed companies in the U.S.

4. Commission on Public Trust and Private Enterprise

The Conference Board is a non-profit research organization based in the U.S. They formed a

Commission on Public Trust and Private Enterprise which consists of 12 very highly

respected business and financial industry leaders such as the then Intel Chairman Andy

Grove, former SEC Chairman Arthur Levitt, former Chairman of the federal Reserve Paul

Volcker, Chairman of Vanguard Group John Bogle and others. This commission formulated a

set of recommended corporate governance standards which were released in January 2003.
Conclusion

In view of the large scale scams, rising cost of capital due to information asymmetric, it is important

that shareholders and managers are aware of the corporate Governance issues, capability to

implement guidelines and the openness to restrict themselves while managing the firm so that the

stakeholders get the information in transparent manner without any distortion, they get the profit of

the firm without manager’s investing in infructuous projects out of their fancies which only suits

them. Different firms may react differently to the changes and implementation of new norms

provided under various CG codes. In general, the codes appear to be more effective in countries

with a stronger stock market (Aluchna, 2018). The compliance with good corporate governance has

been found to be less effective in family owned or concentrated stock holding firms. The capital

structure and requirement to attract outside capital has positive correlation with CG. The corporate

governance system in transition and emerging markets is found to be insider dominated, closed and

based on hierarchies combined with poorly developed external mechanisms and weak investor

protection.

We were thus able to identify the linkage between improved performance of the firm with corporate

governance in place through this dissertation. We observed that corporate governance compliance is

not a burden but an attitude on the part of organizations. In the modern era, where organizations life-

cycle is very limited, it is prudent to adopt the good Corporate Governance principles in the early

stage of its life-cycle. The organizations cannot thrive without the support of institutional

investments who for the safety of their investments and good ROI, demand greater transparency,

financial disclosures and an effective board who can oversee the actions of executive.
 ANNEXURE-I

Corporate Governance – Legal Compliances in India (IOD, 2019)

The legal framework for corporate governance in India falls under two domains:
1. Regulations under SEBI (LODR) Regulation 2015
2. Companies Act 2013

Some of the salient features and sections of the two acts are as below:

Regulations Requirements Section of the Requirements

under SEBI
(LODR) Companies
Regulation 2015
Act 2013

4(d) Role of stakeholder in CG 166(2) Role of Director in CG

16 (b) Criteria of independence 149(6&7) Criteria of independence

17 Composition of BOD of listed 149 Composition of BOD

companies
17(2) Frequency of Board meetings 173 Frequency of Board meetings

17 (2A) Quorum for Board meetings 174 Quorum for Board meetings

176 (6) (a) Remuneration of Directors 197 Remuneration of Directors

18(1) Composition of audit committee 177(1) Composition of audit

committee
18(2) Meetings of audit committee 177 Meetings of audit committee

18(2) (C) Power of audit committee 292 (A) (7) Power of audit committee
of 1956 Act
20 Composition of stakeholder 178 (5) Composition of stakeholder
relation committee in a listed relation committee in a listed
entity entity
21 Risk management committee No such requirement under
this act
26(1) No of Directorships 165 No of Directorships
26(5) Disclosure wrt personal interest of 184 Disclosure if interest
members of management of
company
27 Report on corporate governance No such report required in
2013 Act
Schedule V Compliance certificate from No such report required in
auditors 2013 Act
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IOD. (2019). A Handbook on Corporate Governance. India: IOD Publishing.

Madhani, D. P. (2009, Nov). Corporate Governance from Compliance to Competitive Advantage. ICFAI
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Prof. Mehul Raithatha, D. V. (2012). Corporate Governance Compliance Practices of Indian Companies.
Research Journal of Finance and Accounting.

Raut, S. (n.d.). Corporate Governance – Concepts and Issues. Institute of Directors.

Roy, A. (2017). Corporate Governance Compliance, Governance Structures, and Firm. SSRN Electronic
Journal, 1-21.

S. sarkar, J. S. (2012). Corporate Governance in India. Sage Publications, 165-169.