IT major Infosys has been in the news after the company's founders expressed concerns over transparency and corporate governance. They have questioned the compensation package of Chief Executive Officer (CEO) Vishal Sikka and the severance package to its former chief compliance officer David Kennedy.
Infosys founder N R Narayana Murthy has asked how the company would achieve the $20-billion target by 2020, as set by Sikka, in an uncertain global environment, said sources. Last month, Murthy, Nandan Nilekani and Kris Gopalakrishnan raised their concerns with the board. Last year, promoters of Infosys had abstained from voting to give an extension to Sikka for another two years. The extension also came with an increase in compensation. This renews concerns about issues with corporate governance within the realm of Indian industry.
Corporate governance is the system by which business corporations are directed and controlled. The corporate governance structure specifies the distribution of rights and responsibilities among different participants in the corporation, such as the board, managers, shareholders and other stakeholders, and spells out the rules and procedures for making decisions on corporate affairs. By doing this, it also provides the structure through which the company objectives are set, and the means of attaining those objectives and monitoring performance.
However corporate governance has wider implications and is critical to economic and social well-being, firstly in providing the incentives and performance measures to achieve business success, and secondly in providing the accountability and transparency to ensure the equitable distribution of the resulting wealth.
Significance of corporate governance
The significance of corporate governance for the stability and equity of society is captured in the broader definition of the concept offered by Sir Adrian Cadbury (2002): "Corporate governance is concerned with holding the balance between 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 interests of individuals, corporations and society."
The current wave of reform of corporate governance commenced with the Cadbury Code of Practice published by the London Stock Exchange in 1992; proceeded with an OECD inquiry in 1997-99, and the publication of OECD guidelines on corporate governance which have been adopted in national codes by all of the industrial countries, and with the assistance of the World Bank and Asian development bank, by many developing countries.
The urgency of this endeavour was increased by the Asian financial crisis of 1997-98 that revealed the danger of systemic corporate governance failure. These codes have been reinforced by the influence of the market through investment institutions, and national regulators. Even with the efforts towards comprehensive reform serious weaknesses in corporate governance still occur as with the HIH Insurance and One-Tel collapse in Australia, and the failure of a series of major corporations in the United States in 2001/2002 commencing with Enron and WorldCom. So why is good corporate governance so important?
Effective corporate governance ensures the optimal use of resources both intra-firm and inter-firm. With effective systems of corporate governance, debt and equity capital will go to those corporations capable of investing it in the most efficient manner for the production both of highly demanded goods and services as well as those with the highest rate of return. This helps to protect and nurture scarce resources thereby ensuring that societal needs are met. In all probability this will mean that incompetent managers are replaced. These efficiency effects both as to scarce resources and the quality of managers should apply whether a firm is a state owned enterprise, a private closely held firm owned by a family group, or a publicly traded corporation on a stock exchange.
Effective corporate governance also helps to lower the cost of capital by improving the confidence of both foreign and domestic investors that their assets will be used for the purposes agreed. A survey of institutional investors found that they would willingly pay on average well over ten percentage points more for a “well-governed” company, all other things being equal. In competitive markets, this means that managers must constantly evolve new strategies to meet the changing circumstances. This requires that managers be empowered to make decisions.
However, as observed by that famous 18th century economist Adam Smith, managers may have incentives to act in their own self-interest under such circumstances. Other researchers have found that when firm ownership is separated from control, the manager’s self-interest may lead to the misuse of corporate assets, for example through pursuit of overly risky or imprudent projects. Therefore, we need to have in place rules and regulations to protect the best interests of the providers of capital. They include the following:
i. Independent monitoring of management
ii. Transparency about the performance, ownership and control of the corporation
iii. Participation in certain fundamental decisions by the shareholders
When corporate governance is effective, it provides managers with oversight and holds boards and managers accountable in their management of corporate assets. This oversight and accountability combined with the efficient use of resources, improved access to lower-cost capital and increased responsiveness to societal needs and expectations should lead to improved corporate performance. Effective corporate governance should make it more likely that managers focus on improving firm performance and are replaced when they fail to do so.
A study carried out by Millstein and MacAvoy in the United States (US) analyzing data from 1991-1995 found that U.S. corporations with active and independent boards of directors generated higher economic profit hence supporting the reasonable assumption that corporate governance matters to corporate performance. Effective corporate governance also helps to reduce corruption in business dealings by making it difficult for corrupt practices to develop and take root in a company.
In the developed countries, the elements of effective corporate governance include well positioned and regulated securities markets; laws which recognize shareholders as the legitimate owners of corporations whilst at the same time ensuring the equitable treatment of minority and foreign shareholders; enforcement mechanisms protecting the rights of shareholders; laws to protect against fraud on investors; sophisticated courts and regulators; an experienced accounting and auditing sector and significant corporate disclosure requirements.
In addition to this, the developed countries also have well-developed private sector institutions such as organizations of institutional investors, professional associations of directors, corporate secretaries and managers, as well as rating agencies, securities analysts and a sophisticated financial press.
On the other hand, many emerging countries have not yet developed fully their legal and regulatory systems, enforcement capacities and private sector institutions required for effective corporate governance.
There is in many of these countries, a need for further development of the stock exchange, systems for registering share ownership, enactment of laws for the protection of minority shareholder interests, the empowerment of a vigilant financial press, the improvement of audit and accounting standards and a paradigm shift in the mindset against the widespread tolerance of bribery and corruption as an unavoidable cost of doing business in some of these countries.
According to the Millstein Report, corporate governance takes place within the corporation and as such it depends very much on investors, boards and managements for its successful implementation. The report noted that for corporate governance to be effective in attracting capital, it must focus on four important areas:
a. Fairness by ensuring the protection of shareholder rights in particular the rights of minority and foreign shareholders. These rights can be strengthened by ensuring the enforceability of contracts made by the providers of capital.
b. Transparency by the timely disclosure of adequate, clear and comparable information concerning corporate performance, governance and ownership.
c. Accountability by clarifying governance roles and responsibilities and by means of voluntary efforts to ensure the convergence of managerial and shareholder interests as monitored by the board of directors.
d. Responsibility by ensuring corporate compliance with other laws and regulations reflecting the extant society’s values.
In summary therefore, the Millstein Report (1998) urged the promotion and articulation of the four core standards of corporate governance: fairness, transparency, accountability and responsibility.
As a response to the Millstein Report (1998) recommendations to promote and articulate the four core standards, the OECD set up a Task Force to operationalize the findings. In April 1999, the Task Force issued a set of corporate governance principles building on the four essential components articulated by the earlier Millstein Report (1998).
The principles provide useful working guidelines to countries seeking to further strengthen the foundations of their corporate governance practices by expanding on the core concepts identified earlier by the Millstein Report (1998).
Protecting shareholder rights
In relation to this core concept, two separate principles were developed. The first principle states that ‘the corporate governance framework should protect the rights of shareholders’. This includes both their proprietary as well as their participatory rights. Effective corporate governance depends on laws, procedures and practices that protect their property right and ensure the security of ownership as well as the unfettered transferability of shares. This principle also recognizes their participatory rights on key corporate decisions such as the election of directors and the approval of major mergers or acquisitions.
The second principle states that ‘the corporate governance framework should ensure the equitable treatment of all shareholders including the minority and foreign shareholders and that all shareholders should have the opportunity to obtain effective redress for violation of their rights’. This means that the legal framework should include laws that protect the rights of the minority shareholders against misappropriation of assets or self-dealing by the controlling shareholders, managers or directors.
The third principle states that ‘the corporate governance framework should recognize the rights of stakeholders as established by law and encourage active cooperation between corporations and stakeholders in creating wealth, jobs and the sustainability of financially sound enterprises’. This means that corporations must abide by the laws and regulations of the countries in which they operate.
However, laws and regulations impose only minimal expectations as to conduct and corporations should be encouraged to act responsibly and ethically with special consideration for the interests of stakeholders particularly the employees.
It is now acknowledged that socially responsible corporate conduct is consistent with the principle of shareholder wealth maximization. In numerous countries around the globe, the practice of corporate social responsibility accounting is now well established with corporations going beyond the legal requirements to provide health care and retirement benefits, financially supporting education and formulating and adopting environmentally friendly technologies. Similarly other companies strive to avoid practices, which are socially undesirable even if not prohibited under the law.
The fourth principle states that ‘the corporate governance framework should ensure that timely and accurate disclosure is made on all material matters regarding the corporation including the financial situation, performance, ownership and governance of the company’. This is in recognition of the fact that both investors and shareholders need information regarding the financial and operating performance of the company as well as information about their corporate objectives and material risk exposures. This information should be prepared in accordance with internationally acceptable accounting and auditing standards and should be subject to an independent audit, which is conducted annually.
The use of internationally accepted accounting standards would enhance comparability and assist both investors and analysts in comparing corporate performance and decision-making based on their relative merits. Likewise information about the company’s governance such as share ownership, voting rights, identity of board members, key executives and executive compensation is also a critical component of transparency.
The fifth principle states that ‘the corporate governance framework should ensure the strategic guidance of the company, the effective monitoring of management by the board as well as the board’s accountability to the company and the shareholders’. This principle implies a legal duty on the part of the directors to the company and its shareholders.
The directors are said to have a fiduciary relationship to both the shareholders and the company, which requires that they avoid self-interest in their decision-making and act diligently and on a fully informed basis. This principle also recognizes the duty of the board to oversee the professional managers who have been entrusted to run the company and who are accountable to the board for the use of firm assets. Thus the board acts as a mechanism for minimizing the agency problem inherent in the separation of ownership and control.
If the board is to be an effective monitor of managerial conduct it must be suitably distinct from the management in order to be objective in its assessment of management. This requires that some of the directors are neither members of the management team nor closely related to them through family or business ties.
A critical aspect of effective corporate governance is the quality of the directors. Objective oversight therefore necessitates the participation of professionally competent non-executive and independent directors on the board. The latter must have the capability, fiduciary commitment and objectivity to provide strategic guidance and monitor performance on behalf of the shareholders. In order for the board to be able to play their roles effectively, they should meet often, at least once every three months and if possible more often.
Additionally, for the non-executive directors to be effective and to ensure that independent oversight has meaning, they must have access to important information in advance of board meetings. In the developed countries, board committees have played an important role in performing detailed board work. In these countries, it is common to rely on an audit committee, remuneration committee and a nomination committee staffed either wholly or primarily with non-executive or independent directors.
In view of these observations, the board of directors at Infosys needs to take into account stakeholder concerns in order to ensure effective corporate governance. The former founders may have relinquished control but are still entitled to comment when they are legitimately concerned about the well-being of the company’s shareholders.
The Board of Directors must keep in mind that their duty lies, first and foremost, to the shareholders of the company. If questions are being raised about the governance standards they must be addressed in an open and transparent manner. That is the only way to bolster investor confidence in the well-being of the company.
(The author is the founder of Hammurabi & Solomon and a visiting fellow at the Observer Research Foundation)
Updated Date: Feb 11, 2017 07:25 AM