Corporate Governance: Meaning and Importance

Corporate Governance: Meaning& Importance • Evolution of Corporate Governance • Principles of Corporate

Governance • Theories of Corporate Governance • The role and purpose of the corporation • Globalization and
Corporate Governance )
Corporate governance is
 the system of rules, practices, and processes
 by which a firm is directed, monitored and controlled
 to attain its goals and objectives.
 It is guided by a set of principles, ethics, values, morals, laws, rules and
regulations.
Corporate governance refers to the mechanisms, processes, and relations by
which corporations are controlled and operated. It means establishing an
internal structure of a firm to give strategic direction, ensure accountability, and
curb acts of misconduct. Corporate governance is key in guiding decision-
making processes and creating set boundaries in which businesses can
responsibly operate.
The term corporate governance refers to how companies are run and for what
purpose.

Corporate governance also defines an organisation’s power structure,

accountability structure, and decision-making process. It is essentially a set of
tools that enables management and the board to run an organisation more
efficiently and effectively.
Environmental awareness, ethical behaviour, corporate strategy, compensation,
and risk management are all aspects of corporate governance.
Boards of directors are the primary force determining corporate
governance.
There are three key players in the corporate governance sector, i.e.,
(i) Shareholders – who have invested their money in the corporation;
(ii) Executive Management – who runs the business and is responsible to
the board of directors; and
(iii) Board of Directors – who is elected by the shareholders and is
accountable to them.
o The major objective of the corporate governance is to maximise the
shareholder value in a company and also to ensure the transparency and earn
the trust and confidence of the investors, customers, employers, the
government and the people. This is possible when there is transparency,
openness, boldness, fairness and justice
o It essentially involves balancing the interests of a company's many
stakeholders, such as shareholders, senior management executives,
customers, suppliers, financiers, the government, and the community.
o It provides the framework for attaining a company's objectives, hence it
encompasses practically every sphere of management, from action plans and
internal controls to performance measurement and corporate disclosure.
o It includes the processes through which corporations' objectives are set and
pursued in the context of the social, regulatory and market environment.
o In the Indian context, corporate governance is defined in the following ways:
According to Securities Exchange Board of India (SEBI) “corporate
governance is all about recognition by management about their role as corporate
trustees and immutable rights of shareholders as they are the real owners of the
company. It is all about dedication to carry out good business performance
through proper ethics and values by differentiating corporate and personal
resources in the process of company management”.
o The Institute of Company Secretaries of India (ICSI, 2003) defines
corporate governance as “a blend of rules, regulations, laws and voluntary
practices that enable companies to attract financial and human capital,
perform efficiently and thereby maximise long term value for the
shareholders besides respecting the aspirations of multiple stakeholders
including that of the society”. A company’s operation and profitability can be
negatively impacted by poor governance.

Cadbury Committee Report

 The Cadbury Report, officially titled Report of the Committee on the Financial Aspects of
Corporate Governance, was published in December 1992 by the Committee chaired by
Sir Adrian Cadbury.
 It focused on improving corporate governance practices in the UK, particularly in
response to a series of high-profile corporate failures.
 The report introduced a "comply or explain" approach, requiring companies to either
adhere to its recommendations or explain why they didn't.

 The Board of Directors

1. The board should meet regularly, retain full and effective control over the
company and monitor the executive management.
2. 'There should be a clearly accepted division of responsibilities at the head
of the company, which will ensure a balance of power and authority, such
that no one individual is vest with unfettered powers of decision.' Ideally the
roles of Chairman and Chief Executive should be separated, although this
may not always be practical, in which case there 'should be a strong and
independent element on the board'.
3. The board should include non-executive director's 'sufficient caliber and
number for their views to carry significant weight in the board's decisions'.

 Non-executive Directors

1. Role: Non-executive or 'outside' directors as the committee's chairman preferred

to call them, should 'bring an independent judgment to bear on issues of
strategy, performance, resources including key appointments and standards
of conduct'.
2. The majority of non-executive directors should be 'independent' of
management and free from any business or other relationship which could
materially interfere with the exercise of their independent judgment, apart
from their fees and shareholding.
3. Non-executive directors should be appointed by a formal process and their
appointment should be a matter for the board as whole. Appointments
should be for specified terms and re-appointment should not be automatic.

 Executive Directors

1. Directors' service contracts should not exceed three years without

shareholders' approval.
2. Executive Directors' pay and emoluments, including pension contributions and stock
options and the amount and the basis for any performance-related element,
should be fully disclosed and subject to the recommendations of a
remuneration committee consisting mainly or wholly of non-executive
directors and preferably chaired by a non-executive director.

 Reporting and Control

1 . It is the board's duty to present a balanced and understandable assessment

of the company's position.
2. The board should ensure that an objective and professional relationship is
maintained with the auditors.
3. The board should establish an audit committee which should consist of at
least three non-executive directors. Originally the committee referred to the
annual audit as 'one of the cornerstones of corporate governance'.
4. The directors should report on the effectiveness of the company's system
of internal control.
5. The directors should report that the business is a going concern, with
supporting assumption or qualifications necessary.
 Narayan Murthy Committee Report

The Committee on Corporate Governance, headed by Shri Narayanmurthy was

constituted by SEBI, to evaluate the existing corporate governance
practices and to improve these practices as the standards themselves were
evolving with market dynamics. The committee’s recommendations are based
on the relative importance, fairness, accountability, transparency, ease of
implementation, verifiability and enforceability related to audit committees,
audit reports, independent directors, related parties, risk management,
directorships and director compensation, codes of conduct and financial
disclosures.
The key mandatory recommendations focus on
Strengthening the responsibilities of audit committees
At least one member should be ‘financially knowledgeable’ and at least one
member should have accounting or related financial management proficiency.
Quality of financial disclosures
Improving the quality of financial disclosures, including those related to party
transactions.
Proceeds from initial public offerings
Companies raising money through an IPO should disclose to the Audit
Committee, the uses / applications of funds by major category like capital
expenditure, sales and marketing, working capital, etc.
Other recommendations
 Requiring corporate executive boards to assess and disclose business risks in
the annual reports of companies.
 Should be obligatory for the Board of a company to lay down the code of
conduct for all Board members and senior management of a company.
 The position of nominee directors: Nominee of the Government on public
sector companies shall be similarly elected and shall be subject to the same
responsibilities and liabilities as other directors
 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.
Whistle Blower Policy
Personnel who observe an unethical or improper practice should be able to
approach the audit committee without necessarily informing their superiors.
Implementation issue
A primary issue that arises with implementation is whether the
recommendations should be made applicable to all companies immediately or in
a phased manner, since the costs of compliance may be large for certain
companies.
Another issue is whether to extend the applicability of these recommendations
to companies that are registered with BIFR. In the case of such companies, there
is likely to be almost little or no trading in their shares on the stock exchanges.

Significance of Corporate Governance

The Committee on Corporate Governance that was constituted in India in 2003
under the chairmanship of Narayana Murthy in its report states that “if
management is about running businesses, governance is about ensuring that it is
run properly.” It is important that the companies are properly governed and
managed as it is of great significance in recent times, not only to the business
entity but also to the government, the various stakeholders and the society at
large.
Corporate governance is necessary to:
1. Accountability: Bring clarity to the respective responsibilities of directors,
company managers, shareholders and auditors and enhance the
accountability so as to strengthen trust in the corporate system vis-a-vis
 capital market. A strong corporate governance A framework ensures that the
company’s executives and board members are held accountable for their
decisions and actions. This mitigates the risk of mismanagement and
corruption. Establish board of management’s accountability to the enterprise,
stakeholders and society at large.

2. Attract investors – both local and foreign – and assure them that their
investments
will be secure and efficiently managed, and in a transparent and accountable
process
(i.e. strengthening capital market). Transparent governance policies help
build trust among investors and stakeholders. When companies are clear
about their decision-making processes, investors feel more secure about the
safety of their investments.

3. Guarantee Ethical Business Practice: Prevent fraud and malpractices or

unethical behaviour by companies. Corporate governance promotes ethical
behavior by setting clear boundaries between acceptable and unacceptable
business practices. This helps mitigate risks associated with unethical
conduct, such as fraud or conflicts of interest.
4. Create competitive and efficient companies and business enterprises.
5. Enhance the performance of those entrusted to manage corporations.
6. Promote efficient and effective use of limited resources.
7. Ensure long-term value creation, performance, and sustainability of the
company
which will be in the interests of large stakeholders.
8. Build public confidence in the corporation.
9. Facilitate efficient use of resources, which in turn promotes economic
development.
10.Ensure compliance of the needed regulatory requirements, laws and
regulations.
11.Create confidence among the stakeholders.
12.Promote shareholder activism. The investor has a key role in the present
governance
system. The faith and trust of the investor can be secured through
information
dissemination, participation and transparency in activities of enterprise; and
13.Risk Management: Effective governance structures enhance the company’s
ability to identify and manage risks, whether operational, financial, or
reputational. The board of directors plays a crucial role in monitoring risks
and guiding the company through crises.
14.Long-Term Sustainability: Governance focused on sustainability ensures
that companies not only chase short-term profits but also work towards long-
term growth and societal impact, benefiting future generations.
15.Long-Term Sustainability: Governance focused on sustainability ensures
that companies not only chase short-term profits but also work towards long-
term growth and societal impact, benefiting future generations.

The corporate frauds and governance failure occurring globally, make it

necessary for institutionalising proper norms and laws with international
requirements for governing a company.

Evolution of Corporate Governance

principles of corporate governance:

There are no globally accepted set of principles that can be applied to
corporates. However, across the world many of the corporates, governments,
practitioners and academicians have laid down certain basic principles for
corporate governance.
There are 4 major principles of corporate governance
FAIRNESS/ ACCOUNTABILITY/ RESPONSIBILITY/
TRANSPARENCY
1. Fairness
o Fairness is a principle that emphasizes equitable treatment for all
stakeholders and shareholders.
o This includes ensuring minority shareholders receive equal treatment and
that all stakeholders have opportunities to voice their concerns within the
corporation.
o Shareholders should receive equal consideration in proportion to their
respective shareholdings
o Fairness in corporate governance also extends to transactions and decisions
being conducted and made impartially, respecting the rights and interests of
everyone involved.

2. Transparency
o Transparency refers to a company’s openness and willingness to disclose
clear information to shareholders and stakeholders .
o Transparency involves the clear and timely disclosure of all material matters
regarding the corporation, including its financial situation, performance,
ownership, and governance.
o This ensures that all investors are given clear factual information that
precisely reflects the financial, social and environmental position of the
organisation.
o It builds trust and confidence with stakeholders and ensures that the
decisions made by the corporation are easily understandable and accessible.

3. Responsibility
o Responsibility in corporate governance refers to the recognition and respect
for the interests of all stakeholders, including shareholders, employees,
customers, and the broader community. It means that the company acts
ethically and is accountable for its actions, with a commitment to making
decisions that are sustainable and beneficial to all.
o The Board of Directors have authority to act on behalf of the company,
hance they should assume complete responsibility and exercise the authority
accordingly.
o The BOD is responsible for overseeing management of the business,
company affairs, appointing the chief executive and monitoring the
company’s performance.

4. Accountability
o Corporate accountability refers to the obligation and responsibility to explain
the purpose of the company’s action and conduct and their results.
o The BOD should present a balanced and comprehensible assessment of
the company’s position and prospects and it should employ prudent risk
management and internal control systems.
o It should communicate with stakeholders at regular intervals a fair,
balanced and comprehensible assessment of the company’s actions toward
achieving its business objectives.
o Accountability is closely linked to the concepts of fairness and transparency
and ensures that individuals and companies are held answerable for their
actions.
o It requires a clear delineation of roles and responsibilities within the
corporation and mechanisms in place to monitor and enforce those
responsibilities. It means that the company acts ethically and is
accountable for its actions, with a commitment to making decisions that are
sustainable and beneficial to all.
 5. Risk Management
Effective risk management involves identifying, evaluating, and mitigating
risks that could threaten the organization's assets, reputation, and success. Good
corporate governance integrates risk management into the company's strategic
planning and operational processes, enabling it to anticipate potential challenges
and seize opportunities responsibly. Corporate governance is a framework of
internal and external mechanisms, rules, processes and practices that help
prevent and mitigate risks.

6. Independence
Independence means the ability to make decisions freely without being unduly
influenced. Decisions should be made freely without having any personal
interest in the company. It ensures the reduction in conflict of interest.
Corporate governance suggests the appointment of independent directors and
advisors so that decisions are taken responsibly without influence. It ensures
that decisions are made without undue influence from vested interests,
promoting fairness, transparency, and accountability. Independent directors, free
from conflicts of interest, play a vital role in safeguarding shareholder interests
and enhancing corporate performance. Independence, in the context of
corporate governance, refers to the ability of individuals, particularly directors
and managers, to make decisions free from bias, undue influence, or conflicts of
interest. It's about having the freedom to act in the best interests of the company
and its stakeholders, rather than being swayed by personal relationships,
financial ties, or other external pressures.

7. Corporate Social Responsibility

Corporate Social Responsibility (CSR) is commonly defined as a business

model in which companies integrate social and environmental concerns in
their business operations and interactions with their stakeholders instead of only
considering economic profits.
It's a commitment to operate ethically and contribute to societal well-being. This
involves considering the impact of business decisions on various stakeholders,
including employees, customers, communities, and the environment. It
emphasizes on considering the needs and expectations of all stakeholders, not
just investors.
Theories of Corporate Governance
1. Agency Theory:
Agency Theory is used to Understand Relationship between Agents and
Principals.
The owners and shareholders are the Principals of the company and they
hire agents. These agents are usually the employees or managers. This type
of relationship is called principal-agent relationship where owners are principals
and Board of Directors are agents.
Manpower, Moner and Raw Materials are resources that determine a
Company’s Performance.
The agents handle the business functions. They represent the owners in
different transactions and dealings. Also, these agents must make decisions
and act as per the principal's interests. Their decisions shall outline the
owner's goals for all dealings.
This theory highlights the potential for conflicts of interest between these
groups, as agents may prioritize their own interests over those of the principals.
Humans are self-interested and do not want to sacrifice their personal interests
for others’ interests.
Agency theory views managers as agents who may prioritize their own
interests over those of the shareholders and stakeholders, perpetually
acting out of self-interest, neglecting to recognize the ethical and social
obligations of organizations. This situation generates agency conflicts and
mistrust and the business suffers.
Hence, they require mechanisms like monitoring and incentives to align
their interests.
Monitoring: To reduce the conflicts between owners and managers,
Independent Directors act as an important monitoring device to reduce the
problems generated due to principal-agent relationship.
Careful appointment: If owners are able to identify good directors who are
truthful and honest, they may resort to activities that are beneficial to their
principal. But the practical problem is choosing directors and senior managers
who are ethical and capable to run the company. Shareholders have the
responsibility to take every care in the appointment of their agents.
Incentivisation: Appropriate incentives can be designed for the agents which
will motivate them to act in favour of the principal.
Ex.

2. Stewardship Theory
In corporate governance, a "steward" refers to a person, typically a manager or
board member, who acts in the best interests of the company and its
stakeholders, rather than prioritizing personal gain.
In contrast to Agency theory, stewardship theory presents a different model of
management and it advocates that managers are good stewards of the
company who are motivated to act in the best interest of the owners of the
Company prioritizing the organization's long-term success and stakeholder
interests above their own Interests. A steward takes responsibility for the
company's assets and performance, aiming to leave them in a better state
than they inherited them.
Managers are viewed as being loyal to the company and are interested in
achieving high performance.
The theory is developed using the fundamentals of social psychology and
focuses on the behaviour of executives. It has been argued that the steward’s
behaviour is pro-organizational and collectivist, which has higher efficacy
than individualistic self-serving behaviour. The steward’s behaviour will take
care of the interest of the organization and seeks to attain the objectives of the
organization.
When organisation achieves success and shareholder wealth is maximized, the
utilities of steward’s are maximized too.
This theory emphasizes trust, leadership, and a healthy organizational culture
as key business growth and sustainability drivers.
The steward theory states that a steward protects and maximises shareholders
wealth through firm Performance. Stewards are company executives and
managers working for the shareholders, protects and make profits for the
shareholders. The stewards are satisfied and motivated when organizational
success is attained. It stresses on the position of employees or executives to act
more autonomously so that the shareholders’ returns are maximized. The
employees take ownership of their jobs and work at them diligently.
Long-Term Vision: Stewardship implies a commitment to the long-term
success of the organization, often beyond the tenure of individual managers or
board members. This means considering the impact of decisions on future
generations.

Key Differences from Agency Theory:

 Agency Theory:
Assumes a conflict of interest between owners (principals) and managers
(agents), necessitating monitoring and control mechanisms.
 Stewardship Theory: Assumes alignment of interests and advocates for a
more decentralized and trusting governance structure.
 Monitoring: Agency theory relies on monitoring and control systems, while
stewardship theory emphasizes trust and empowerment.
 Motivation: Agency theory assumes managers are primarily motivated by
self-interest and financial incentives, while stewardship theory posits that
managers are motivated by intrinsic rewards and a desire to contribute to the
organization's success.
 Managers: According to Agency Theory, managers are at risk, whereas
Stewardship Theory sees managers as partners. This prompts collaboration
by executives and stakeholders to make decisions together. However, it does
not consider room for conflict between management and shareholders. It
also assumes that every manager in corporate governance acts ethically,
which is not guaranteed.

Implications for Corporate Governance:

 Reduced Monitoring Costs:
By fostering trust and aligning interests, stewardship theory can lead to reduced
monitoring costs associated with agency relationships.
 Enhanced Innovation and Risk-Taking:
A trusting environment can encourage managers to take calculated risks and
pursue innovative opportunities for long-term growth.
 Improved Stakeholder Relations:
Stewardship theory promotes a stakeholder-centric approach, fostering positive
relationships with all stakeholders, including employees, customers, and the
community.
 Sustainable Business Practices:
The long-term focus of stewardship theory can lead to more sustainable
business practices and a greater emphasis on environmental and social
responsibility.

3. Resource Dependence Theory

Resource Dependence Theory (RDT) in corporate governance suggests that a company's
structure and actions are heavily influenced by its need to secure and manage resources
from its external environment. Organizations depend on various resources like raw
materials, Goods, services, funding, and even customers, and these dependencies shape
their governance practices as they strive to maintain access to these critical
resources. Resource dependency theory is based on the principle that an organization, such
as a business firm, must engage in transactions with other actors and organizations in
its environment in order to acquire resources.

Resource dependence theory is a design circle that predicts that businesses need
external resources to grow and survive in the market. Companies depend on
suppliers, investors, and government policies to keep running. They are responsible
for obtaining the necessary resources and building partnerships to help their
businesses prosper in an ever-competitive marketplace.

In this theory, organizations concentrate on links and relationships with the experts
who can benefit them. Alliances help firms in resource access effectively. This
theory is too focused on external factors and misses on internal factors like
company culture and leadership. This also assumes that businesses cannot
manage external risks properly.

One important assumption of the RDT is that firms cannot be fully self-sufficient with
regards to strategically critical resources for survival. They need to depend on
resources from outside parties to compete (Heide, 1994) and carefully manage this
dependency with other firms to strive for sustainable development.

The basic argument of resource dependence theory can be summarized as follows:

 Organizations depend on resources..

 These resources ultimately originate from an organization's environment.

 The environment, to a considerable extent, contains other organizations.

 The resources one organization needs are thus often in the hand of other
organizations.

 Resources are a basis of power.

  Legally independent organizations can therefore depend on each other.

 Power and resource dependence are directly linked:

Organization A's power over organization B is equal to organization B's dependence

on organization A's resources.

 Power is thus relational, situational and potentially mutual.

Organizations depend on multidimensional resources: labor, capital, raw material,

etc. Organizations may not be able to come out with countervailing initiatives for all
these multiple resources. Hence organization should move through the principle of
criticality and principle of scarcity. Critical resources are those the organization must
have to function. For example, a burger outlet can't function without bread. An
organization may adopt various countervailing strategies—it may associate with
more suppliers, or integrate vertically or horizontally.

4. The stakeholder theory

This theory posits that a company's success depends on its ability to create
value for all its stakeholders, not just shareholders. This theory emphasizes
that businesses have a responsibility to consider the interests of various groups,
including employees, customers, suppliers, the community, and the
environment, when making decisions.
With the stakeholder theory, corporations are accountable to myriad groups and
must try to mitigate or reduce conflicts between them. The theory also
incorporates the interests of any third parties that are in some way dependent on
the corporation.
Stakeholders that fall under this theory may be:
 Internal stakeholders, such as corporate directors, managers and employees.
 External stakeholders, including creditors, vendors, auditors, customers, the
community and government agencies.
While stakeholders are not directly involved in the governance process,
stakeholders influence how the company operates. All stakeholders engage with
the corporation to some degree, expecting that the corporation will deliver on
some level, whether that is a paycheck, dividends, a bonus, additional orders,
tax revenue or a job.
What are the principles of the stakeholder theory?
 Multiple stakeholders: The idea that a company has various stakeholders
shapes the model. Boards must consider anyone who is or can be affected by
the company.
 Sustainability: Many companies have justified the means (unethical or
damaging business practices) with the ends (financial success). The
stakeholder model instead emphasizes a company’s long-term sustainability
in terms of the environment and the well-being of the company, its
employees and its broader ecosystem.
 Ethics: Boards following the stakeholder model must strive to be ethical.
Prioritizing ethics ensures decisions are fair to all parties and upholds the
integrity of the board and the company.
 Strategy: The corporate strategy must also reflect all stakeholders’ interests,
including aligning business activities with stakeholders’ values and
expectations, which can help the organization achieve long-term success.

Stakeholder theory incorporated the accountability of management to a broad

range of stakeholders. It states that managers in organizations have a network of
relationships to serve – this includes the suppliers, employees and business
partners.
The theory focuses on managerial decision making and interests of all
stakeholders have intrinsic value, and no sets of interests is assumed to
dominate the others.
Key features of this theory are:
Broader Scope: Unlike the shareholder theory, which prioritizes maximizing
shareholder value, the stakeholder theory expands the focus to include the
interests of all parties affected by the company's operations.
Long-Term Value Creation: By considering the needs and concerns of all
stakeholders, the theory suggests that companies can build stronger, more
sustainable relationships and achieve long-term success.
Ethical Considerations: Stakeholder theory often incorporates ethical
considerations, encouraging businesses to act responsibly and contribute to the
well-being of society.
Balanced Approach: The theory acknowledges that there may be conflicts
between different stakeholder interests and advocates for a balanced approach
that considers the needs of all groups.
In essence, the stakeholder theory suggests that a company's success is
intrinsically linked to the well-being of all its stakeholders, and that responsible
corporate governance should reflect this interconnectedness
5. Transaction Cost Theory:
Transaction cost theory (TCT) considers the transaction as the most basic unit of measure and
focuses on how much effort, resources, or cost is necessary for two parties to complete an
exchange (Williamson, 1981). Transaction costs are defined as the costs beyond the cost of
the product or service that are required to exchange a product or service between two entities
(Sarkis et al., 2011). The goal is to maximize transaction performance and minimize costs.
This theory focuses on the costs associated with making transactions, both within the
company and with external parties. It suggests that companies will choose the governance
structure that minimizes these costs.

6. Political Theory:
This theory views corporate governance as a political process, where different stakeholders
compete for influence and control. It highlights the importance of power dynamics and
political strategies in shaping corporate decisions.

The role and purpose of Corporation

Globalization and Corporate Governance