Corporate governance is the key to safeguard minority shareholder rights
By: Tavaga Research
On October 21, business news readers were greeted by the news of trouble brewing at Infosys, one of India’s marquee tech companies. An anonymous group, ‘Ethical employees’ levelled charges against the company, about accounting malpractices to inflate margins.
Even an allegation of such a lapse in corporate governance was enough to drag down the large cap company’s stock by 16 percent the next day, shaving off around Rs 56,000 crore of its market capitalisation in a single trading day.
The weeks following it, of course, have again stirred up the discourse on corporate governance, in a country still smarting from the PMC Bank scam, the Chanda Kochhar related-party transactions, and the Indigo top management spat.
For Infosys, its recent trouble joined a growing list of questionable corporate governance practices at the company.
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So, what is corporate governance?
Corporate governance means or can be defined as an internal system guiding a company to take decisions that are fair and ethical for all its stakeholders, while working to generate profit.
It is usually realised with a framework of processes, rules and guidelines. Depending on the country, it could be regulated by governing agencies too, making certain practices legally-enforceable.
Purpose of corporate governance
Corporate governance serves to define the rights, roles and responsibilities of an organisation’s stakeholders, from its promoters and employees to its external shareholders.
The conflict leading to lapses in corporate governance arises because of two different stakeholders in a company — principal and agent. The steering group, that is the top management, is the agent responsible for taking the company forward and for its day to day activities to achieve its objectives. The principal refers to the different kinds of stakeholders of the company who stand to gain or lose from such activities.
The checks and balances, and incentives a company needs to reduce and manage the conflicting interests between stakeholders are made stronger with good corporate governance practices.
Corporate governance in relation to business ethics
Ethics when applied to situations in business is termed as business ethics. Corporate governance is a way of making a company’s progress more ethical.
But business ethics has a broader relevance than corporate governance. Business ethics would also include, in this day and age, the duty of an enterprise towards an its environment — both physical (matters related to climate change, conservation, pollution) and financial (matter related to economic growth, local job creation).
Corporate governance would be more sharply defined and legally-binding than business ethics.
What purpose does corporate governance serve?
As corporate governance is the system by which a company is directed and controlled, it plays an important role in the company being fair and efficient in its trade practices.
The board of directors are responsible for maintaining the governance of the company, it becomes an important for shareholders to pick up appropriate board and auditors so that they can be satisfied that the corporate governance in the company is in check.
The four pillars of corporate governance
There are corporate governance principles which dictate the scope of the rules and practices under corporate governance. These are often called the four pillars of corporate governance, and they are:-
Accountability — Accountability in corporate governance refers to the principle that decisions and actions taken by an enterprise should be subject to oversight to ensure they meet predefined objectives and don’t veer off the course.
Such accountability is ensured through the board of directors. They are held accountable for the company’s actions and decisions. The board of directors acts as a proxy for the different kinds of shareholders of an enterprise. It has an obligation to oversee the management of the company and is responsible to the shareholders for ensuring operations and processes meet the stated goals all the shareholders collectively agreed to.
Fairness — Fairness in corporate governance is ensuring the shareholders’ rights are upheld in an equitable way, without anyone getting an upper hand in profiting off an enterprise’s operations.
The corporate governance framework is expected to ensure fair and equitable treatment of all shareholders, including minority and foreign shareholders.
Related-party transactions and insider trading threaten fairness in corporate governance.
All shareholders should have access to the same amount of information and also the same opportunity of seeking effective redress for a violation of their rights.
Transparency — Transparency in corporate governance refers to the timely and ready access to information.
The availability of information on various aspects of a company goes a long way establishing its standard of corporate governance.
A company is expected to disclose all facts, both financial and non-financial to all the stakeholders in a timely manner.
This principle also emphasises that the remuneration paid to the key managerial personnel of the company be disclosed.
This was an area where Infosys has been seen to trip up as have other Indian companies.
Responsibility — Responsibility in corporate governance refers to the awareness of each of the stakeholders’ roles in ensuring the enterprise functions and proceeds in a fair and transparent way towards agreed-upon goals.
The responsibilities are myriad and include the mandate for the board of directors to steer the company while maintaining good corporate governance.
The board members should understand their responsibility towards all the stakeholders of the company and should try to cooperate and work together with them for the development of the organisation.
The board of directors also have the additional responsibility of trying to align the interests of all stakeholders towards common goals.
Responsibilities also include the role of shareholders to appoint a non-partisan board of directors and auditors to oversee the checks and balances at their enterprise.
Responsibilities include the task of auditors to check for aberrations and conformity to stated objectives and processes at a company.
Of course, corporate governance is not a voluntary system that companies can opt in. They are legally-bound to adhere to many of its regulations.
Regulations guiding corporate governance
India is not bereft of a regulatory framework to guide enterprises on corporate governance. There are regulatory vigilants and laws which define and safeguard the tenets of corporate governance.
We list the mainstay laws and guardians:-
1.The Companies Act, 2013
The Companies Act has fair corporate governance guidelines, covering issues like the independence of the board of directors, fair opinion of the auditors, related-party transactions, disclosure of facts in financial statement related to corporate governance.
2.Securities Exchange Board of India (Sebi)
Sebi being the regulatory body of Indian financial markets, acts as a watchdog and regulates the companies through various regulations to protect the interest of the shareholders.
3. Institute of Chartered Accountants of India (ICAI)
The constitutional body for chartered accountants stipulates the accounting standards and dos-and-don’ts for the community to follow. Auditors and forensic auditors, who play crucial roles in corporate governance compliance, are expected to adhere to these rules.
4. Institute of Company Secretaries of India (ICSI)
Similar to ICAI, ICSI has issued secretarial guidelines for company secretaries to dispense their duties ethically.
5. Whistle Blowers Protection Act, 2014
India defines the whistleblowing as revealing unethical practices of an enterprise (or corruption or misuse of power in governments and agencies) under the Companies Act, 2013. A whistleblower, then, is anyone who exposes such wrongdoing, of course, with evidence. The Whistle Blowers Protection Act of 2014 (often called the Whistleblower Act) provides the much-needed protection of identity and against victimisation for a whistleblower. It is meant to work in tandem with governance rules set by Sebi for listed, private and government sector companies and the Companies Act.
Of course, to prevent baseless allegations, if proven wrong, the whistle blower may face incarceration.
Examples of poor corporate governance
Despite a mandatory legal regulatory framework, owing to weak enforcement, lapses in corporate governance continue. Take Infosys, for example.
The recent trouble ensued when the employee group of whistleblowers sent a letter to both the Securities Exchange Commission (market regulator in the US) and the management board of Infosys. The letter mentioned visa costs being suppressed to show improved margins despite its auditors’ objections, the CEO ignoring board reviews on large deals, some of which did not add to the margins, and ignoring other costs to the company to prop up the balance sheet.
Infosys has faced visa fraud allegations since 2013, when it had to pay $34 million to the US federal government for being charged with misusing the B-1 business visitor visa programme. Despite its promise for better corporate compliance, it was again in trouble in 2017 when the New York state alleged it fudged visa paperwork to bring in foreign employees. It paid $1 million to settle it.
In 2017, Infosys’ then-MD and CEO Vishal Sikka resigned abruptly citing continuous distractions as the cause. It came after disagreements between the company and its founders, over the board’s decisions including the high pay to the CEO and severance package for the top management. Apart from these, there have been issues of visa fraud exposed by whistleblowers at Infosys as well.
The tremors at the IT company are seen in the timeline below, which caught all its minority shareholders unawares:-
In July, 2019, India’s largest passenger airline Indigo’s parent company, Interglobe Aviation, saw a high-voltage spat between its co-founders. Rakesh Gangwal wrote to Sebi, the market regulator, for an intervention and probe into corporate governance lapses. Gangwal issued a public comment saying that even a “paan ki dukaan” (betel shop) would have managed matter with more grace. Co-founder Rahul Bhatia, at the receiving end of the rebuke, denied all of it. The feud, which is yet to be settled and awaiting arbitration, even saw independent directors questioning Chairman M Damodaran on his ability to safeguard minority shareholder rights during the conflict.
One of the landmark cases of poor corporate governance that shook India, was of course, that of Satyam which broke in December, 2007. The promoters had inflated revenue and profit, resulting in a false balance sheet which contained non-existent assets and cash reserves and did not record liabilities that existed. It brought under the spotlight on how damaging top management colluding with auditors (PWC in this case) could get for stakeholders.
Satyam is also a testament to the problems with enforcing the legal framework in India when it comes to corporate governance. Its US stakeholders took it to court with a class action suit, and made both Satyam and PWC pay for damages suffered from its cooked books. Satyam’s Indian shareholders, meanwhile, did not have any such recompensation coming their way.
The NPAs at banks like PMC, PNB and defaulters colluding with bank officials, are also, unfortunate examples of lax corporate governance, which have affected not just shareholders’ wealth but also the customers of those banks.
Scope of corporate governance — Why it is crucial for investors
With a patchy record of systemic redressal, it makes sense for shareholders to seek out prevention of, rather than a cure for, poor corporate governance at companies they invest in.
It is near impossible for a company with a poor corporate governance structure or record to perform well in the long run. Bad business ethics catches up with companies.
Prospective and existing shareholders cannot afford to stop keeping an eye on their companies’ corporate governance practices.
The International Finance Corporation, a World Bank Group advisory and asset management firm specialising in emerging markets, polled investment firms in such markets on the need for corporate governance in investing.
All of the surveyed investors said their investment firms would be willing to pay a premium for companies with better corporate governance.
The corporate governance measures such as disclosure, related-party transactions were scored as very important by the respondents in the survey, along with other traits as listed below:-
We round up the practices any good corporate governance practitioner would be following straight up:-
Appropriate disclosure of related-party transactions (RPTs)
Chanda Kocchar, CEO of ICICI Bank, had to resign late in 2018, six months after numerous allegations of RPTs over a loan sanctioned to the beleaguered Videocon came to light, even as the loan turned out to be an NPA. Kochhar was accused of nepotism and non-disclosure when extending loans to Videocon in lieu of the business group extending favours to Nupower, a company that had her husband as the majority shareholder, without disclosing the kickbacks. Earlier she was in the crosshairs of the law for loans given to the fraud jeweller, Gitanjali Group.
Kochhar’s resignation revved up the bank’s stock by 5.8 percent to Rs 320.90 on that day, a sign of the relief in the market and among shareholders, especially in the wake of official statements of support for her issued by ICICI Bank earlier.
Good corporate governance necessitates ready disclosure of all RPTs, as they are often of material significance to the shareholders.
Independence of the board of directors
Satyam’s scandal showed just how crucial it was for a board of directors, who could function independently without the top management’s influence. Not just the auditors, Satyam’s directors were equally at fault as its promoters for cooking the books to such a large extent.
Independence of the auditors
This would include the audit committee on the board that coordinates with auditors, as well. All the material facts and information has to be provided to the auditors of the company.
A fair company would disclose the reasons for resignation of any of its auditors, as well. Unfair or corrupt practices have seen auditors resign in protest in many a company.
The recent acceptance of the Uday Kotak report is significant in the current environment. It will give authorities more teeth to enforce corporate governance in listed companies.
In August, 2019, Sebi strengthened the corporate governance regulations for listed companies even further by accepting key measures suggested in a report tabled by a committee headed by banker Uday Kotak (executive vice chairman and managing director of Kotak Mahindra Bank). Forty out of 80 proposals were accepted without changes and 15 with changes.
Among the accepted changes are rules for more stringent disclosure of RPTs, reduction in the number of directorships an independent director can hold across companies, excluding those related to the promoter group from independent directorship, mentioning the expertise needed in directors and naming the directors with such skills, enhanced roles of audit, risk management, remuneration and nomination committees, improved disclosure of utilisation of funds from funding rounds, disclosure of auditor details like credentials, fee, and reasons for resignation, greater obligation to share information about subsidies, and the separation of CEO/MD and chairperson roles that is prevalent at many companies, including large caps(for the top 500 market cap companies, initially by April 1, 2020).
Of course, just as a single news break can shave off crores from a company’s valuation, if it has a strong corporate governance foundation or shows its earnestness in fixing matters, the valuations will recover with time. Perception among shareholders and information to allay their fears go a long way in helping a company bounce back from bad corporate governance press.