UPSC IAS exam preparation - Ethics and Values - Lecture 21

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Corporate governance - Part 1

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1.0 INTRODUCTION

Corporate governance as a concept focuses on to the system by which corporations are directed & controlled, and specifies the distribution of rights and responsibilities among various stakeholders. It provides the structure through which corporations set and pursue their objectives taking the social context into account. 

Consequent to various scams that happened in corporate America, there was a renewed interest in the corporate governance practices of modern corporations, particularly in relation to accountability. Corporate scandals of various forms have maintained public and political interest in the regulation of corporate governance. In the aftermath of the collapse of Enron Corporation and MCI Inc. (formerly WorldCom) in the US, the  federal government passed the Sarbanes-Oxley Act in 2002, intending to restore public confidence in corporate governance. Comparable failures in Australia are associated with the eventual passage of the CLERP 9 reforms. Similar corporate failures in other countries stimulated regulatory interest.

2.0 PRINCIPLES OF CORPORATE GOVERNANCE

The theories and principles of corporate governance were first raised in The Cadbury Report (UK, 1992), the Principles of Corporate Governance (OECD, 1998 and 2004), and the Sarbanes-Oxley Act of 2002 (US, 2002). The Cadbury and OECD reports present general principles around which businesses are expected to operate to assure proper governance. The Sarbanes-Oxley Act, informally referred to as Sarbox or Sox, is an attempt by the federal government in the United States to legislate several of the principles recommended in the Cadbury and OECD reports. The following are some of the principles that have been enunciated:

1. Rights and equitable treatment of shareholders: Organizations should respect the rights of shareholders and help shareholders to exercise those rights. They can help shareholders exercise their rights by openly and effectively communicating information and by encouraging shareholders to participate in general meetings.
2. Interests of other stakeholders: Organizations should recognize that they have legal, contractual, social, and market driven obligations to non-shareholder stakeholders, including employees, investors, creditors, suppliers, local communities, customers, and policy makers.
3. Role and responsibilities of the Board: The board needs sufficient relevant skills and understanding to review and challenge management performance. It also needs adequate size and appropriate levels of independence and commitment.
4. Integrity and ethical behavior: Integrity should be a fundamental requirement in choosing corporate officers and board members. Organizations should develop a code of conduct for their directors and executives that promotes ethical and responsible decision making.
5. Disclosure and transparency: Organizations should clarify and make publicly known the roles and responsibilities of board and management to provide stakeholders with a level of accountability. They should also implement procedures to independently verify and safeguard the integrity of the company's financial reporting. Disclosure of material matters concerning the organization should be timely and balanced to ensure that all investors have access to clear, factual information.

Corporations are created as legal persons by the laws and regulations of a particular jurisdiction. These may vary in many respects between countries, but a corporation's legal person status is fundamental to all jurisdictions and is conferred by statute. This allows the entity to hold property in its own right without reference to any particular real person. It also results in the perpetual existence that characterizes the modern corporation. The statutory granting of corporate existence may arise from general purpose legislation (which is the general case) or from a statute to create a specific corporation, which was the only method prior to the 19th century. However, this differentiation between the corporation and the manager has often been misused to create situations where the manager becomes wealthy whereas the corporation remains poor, unable to cope with the rude shocks of recession.

3.0 LEGISLATION FOR CORPORATE GOVERNANCE

3.1 The Cadbury Committee recommendations

The Corporate Governance Committee was set up by the Financial Reporting Council, the London Stock of Exchange and the accountancy profession in May 1991 by the Financial Reporting Council, the Stock Exchange and the accountancy profession in response to continuing concern about standards of financial reporting and accountability. The main Objective was to addressthe financial aspects of Corporate Governance. Other objectives included: 

1. uplift the low level of confidence both in financial reporting and in the ability of auditors to provide the safeguards which the users of company's reports sought and expected; 
2. review the structure, rights and roles of board of directors, shareholders and auditors by making them more effective and accountable; 
3. address various aspects of accountancy profession and make appropriate recommendations, wherever necessary; 
4. raise the standard of corporate governance; etc. Keeping this in view, the Committee published its final report on 1st December 1992.

The committee was chaired by Sir Adrian Cadbury and had a remit to review those aspects of corporate governance relating to financial reporting and accountability. The final report 'The financial aspects of corporate governance' (usually known as the Cadbury Report) was published in December 1992 and contained a number of recommendations to raise standards in corporate governance.

3.2 Sarbanes-Oxley Act of 2002 (US)

The Sarbanes-Oxley Act of 2002 (often shortened to SOX) is legislation enacted in response to the high-profile Enron and WorldCom financial scandals to protect shareholders and the general public from accounting errors and fraudulent practices in the enterprise. The act is administered by the Securities and Exchange Commission (SEC), which sets deadlines for compliance and publishes rules on requirements. Sarbanes-Oxley is not a set of business practices and does not specify how a business should store records; rather, it defines which records are to be stored and for how long.

The legislation not only affects the financial side of corporations, it also affects the IT departments whose job it is to store a corporation's electronic records. The Sarbanes-Oxley Act states that all business records, including electronic records and electronic messages, must be saved for "not less than five years." The consequences for non-compliance are fines, imprisonment, or both. IT departments are increasingly faced with the challenge of creating and maintaining a corporate records archive in a cost-effective fashion that satisfies the requirements put forth by the legislation. The law required, along with many other elements, that:

1. The Public Company Accounting Oversight Board (PCAOB) be established to regulate the auditing profession, which had been self-regulated prior to the law. Auditors are responsible for reviewing the financial statements of corporations and issuing an opinion as to their reliability.
2. The Chief Executive Officer (CEO) and Chief Financial Officer (CFO) attest to the financial statements. Prior to the law, CEOs had claimed in court they hadn't reviewed the information as part of their defense.
3. Board audit committees have members that are independent and disclose whether or not at least one is a financial expert, or reasons why no such expert is on the audit committee.
4. External audit firms cannot provide certain types of consulting services and must rotate their lead partner every 5 years. Further, an audit firm cannot audit a company if those in specified senior management roles worked for the auditor in the past year. Prior to the law, there was the real or perceived conflict of interest between providing an independent opinion on the accuracy and reliability of financial statements when the same firm was also providing lucrative consulting services.

3.3 OECD principles

 

In the OECD Council Meeting at Ministerial level on 27-28 April 1998 a demand was raised to develop, in conjunction with national governments, other relevant international organisations and the private sector, a set of corporate governance standards and guidelines. The OECD Principles of Corporate Governance were originally developed in response to this. These Principles, agreed to in 1999 have formed the basis for corporate governance initiatives in both OECD and non-OECD countries alike. Moreover, they have been adopted as one of the Twelve Key Standards for Sound Financial Systems by the Financial Stability Forum.

Companies listed on the New York Stock Exchange (NYSE) and other stock exchanges are required to meet certain governance standards. 

In April, 2004, the Organization for Economic Cooperation and Development (OECD) publicly released the revised OECD Principles of Corporate Governance.

The principles are non-binding and intended to assist member and non-member governments in their efforts to evaluate and improve the legal, institutional and regulatory framework for corporate governance in their countries, and to provide guidance and suggestions for stock exchanges, investors, corporations, and other parties that have a role in the process of developing good corporate governance. As such, the Principles are intended to provide a set of guidelines for the implementation of an effective corporate governance framework; not only for companies themselves but rather for an entire system of legislation, regulation and guidelines. The basic areas addressed are: The Rights of Shareholders and Key Ownership Functions; The Equitable Treatment of Shareholders; The Role of Stakeholders in Corporate Governance; Disclosure and Transparency; and The Responsibilities of the Board. Some of these principles are:

1. Board members should be informed and act ethically and in good faith, with due diligence and care, in the best interest of the company and the shareholders.
2. Review and guide corporate strategy, objective setting, major plans of action, risk policy, capital plans, and annual budgets.
3. Oversee major acquisitions and divestitures.
4. Select, compensate, monitor and replace key executives and oversee succession planning.
5. Align key executive and board remuneration (pay) with the longer-term interests of the company and its shareholders.
6. Ensure a formal and transparent board member nomination and election process.
7. Ensure the integrity of the corporations accounting and financial reporting systems, including their independent audit.
8. Ensure appropriate systems of internal control are established.
9. Oversee the process of disclosure and communications.
10. Where committees of the board are established, their mandate, composition and working procedures should be well-defined and disclosed.

3.4 Other guidelines

The investor-led organisation International Corporate Governance Network (ICGN) was set up by individuals centered around the ten largest pension funds in the world 1995. The aim is to promote global corporate governance standards. The network is led by investors that manage 18 trillion dollars and members are located in fifty different countries. ICGN has developed a suite of global guidelines ranging from shareholder rights to business ethics.

The World Business Council for Sustainable Development (WBCSD) has done work on corporate governance, particularly on accountability and reporting, and in 2004 released Issue Management Tool: Strategic challenges for business in the use of corporate responsibility codes, standards, and frameworks. This document offers general information and a perspective from a business association/think-tank on a few key codes, standards and frameworks relevant to the sustainability agenda.

In 2009, the International Finance Corporation and the UN Global Compact released a report, 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.

Most codes are largely voluntary. An issue raised in the U.S. since the 2005 Disney decision is the degree to which companies manage their governance responsibilities; in other words, do they merely try to supersede the legal threshold, or should they create governance guidelines that ascend to the level of best practice. For example, the guidelines issued by associations of directors, corporate managers and individual companies tend to be wholly voluntary but such documents may have a wider effect by prompting other companies to adopt similar practices.

The main issues in Corporate Governance are stakeholder interests, control and ownership. Structures and issues arising out of family control.

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