Why Corporate Governance matters?

Written by Margret Syriac (margret.tapmimpl2022@learner.manipal.edu)

Corporate governance holds immense significance for businesses and society as a whole. The recognition of massive corporate collapses resulting from weak governance systems has underscored the need for international improvements and reforms in corporate governance. Instances such as Enron and Parmalat have prompted countries worldwide to take pre-emptive measures to address similar issues within their domestic frameworks.

The USA responded swiftly to these failures by enacting the Sarbanes-Oxley Act in July 2002. Similarly, the UK published the Higgs Report and the Smith Report in January 2003 in direct response to recent corporate governance failures. These events have elevated corporate governance to become one of the most frequently discussed topics in the global business arena.

The importance of a strong and functional corporate governance can be further explained using instances where its absence led to collapse of largest companies on the face of Earth.

The high-profile collapse of Enron in 2001, one of America’s largest companies, has drawn international attention to corporate failures and highlighted the role that strong governance plays in preventing such incidents. Corporate governance encompasses both formal and informal institutions, including private and public entities, that govern the relationship between corporate insiders (those managing corporations) and all other stakeholders who invest resources in various companies.

Essentially, corporate governance comprises a set of rule-based processes, laws, policies, and accountability mechanisms that regulate the interactions between investors (shareholders) and the management of investee companies. The significance of corporate governance gained prominence in the aftermath of the Asian financial crisis in 1997–1998 and the corporate scandals of the early 2000s, such as Enron and WorldCom.

The Enron case highlighted several corporate governance problems. Unrestrained power in the hands of the CEO was a key issue, as well as unethical activities that continued to be revealed after the company’s downfall. For example, Enron’s energy traders manipulated markets where California purchased electricity, which became evident through released documents. Overall, Enron’s corporate governance was weak in various aspects, with a board lacking moral character and engaging in fraudulent behaviour.

The collapse of Enron led to significant reactions in the USA and the UK, prompting a focus on corporate governance weaknesses. The long-term impact of Enron’s collapse should ideally result in a cleaner and more ethical corporate environment worldwide. Regular updates to corporate governance codes and systematic reviews of checks and balances are essential to prevent similar incidents in the future.

Corporate governance checks and balances can help detect unethical practices, but they cannot cure them entirely. The intangible nature of fraud and the subjective nature of human behaviour create complexities in addressing issues of fraud and ethical breakdown. Sheldon Zenner, an American white-collar criminal and civil lawyer, emphasised the challenges in defining right and wrong during the Enron trial.

Unfortunately, after the threat of global financial crises waned, corporate governance took a backseat in academic research. However, the enduring lessons from these incidents serve as a reminder of the ongoing importance of robust corporate governance practices to ensure the stability and integrity of businesses and financial systems.

Let’s dive into events where corporate governance changed the future of the companies for good.

In the early 2000s, Nestlé, a renowned multinational food and beverage company, found itself entangled in a controversy surrounding unethical marketing practices and a perceived lack of transparency. These allegations had the potential to significantly impact the company’s reputation and, subsequently, its stock performance. However, Nestlé swiftly responded to the situation by implementing robust corporate governance measures, ultimately turning the tide in its favour.

Recognising the importance of addressing the concerns raised, Nestlé took proactive steps to improve its corporate governance framework. One notable action was the adoption of the Nestlé Corporate Business Principles, a comprehensive set of guidelines outlining the company’s commitment to ethical behaviour, respect for human rights, and environmental sustainability. By establishing clear principles and values, Nestlé demonstrated its dedication to responsible corporate conduct.

Furthermore, Nestlé recognised the significance of transparency in rebuilding trust with its stakeholders. The company strengthened its sustainability reporting practices, providing comprehensive and detailed information about its environmental and social performance. This commitment to transparency allowed investors and the public to gain a deeper understanding of Nestlé’s efforts in areas such as water management, climate change mitigation, and responsible sourcing of raw materials.

The implementation of stronger corporate governance measures had a positive impact on Nestlé’s stock performance. Investors appreciated the company’s proactive approach in addressing the allegations and its commitment to ethical conduct and sustainability. The enhanced transparency reassured stakeholders that Nestlé was taking the necessary steps to align its practices with societal expectations.

Transparency of corporate practices plays a significant role in influencing the stock prices of a company. Transparent companies tend to attract more investors, enjoy higher market confidence, and benefit from a positive reputation. On the other hand, a lack of transparency can erode investor trust, increase perceived risk, and negatively impact stock prices. Investors value transparency as it enables them to make informed decisions and assess the long-term prospects and sustainability of a company.

Facing scrutiny over its weak governance practices in the late 2000s, Samsung undertook significant reforms. These included appointing independent directors, enhancing disclosure practices, and strengthening internal controls. These efforts contributed to increased investor trust and positively impacted Samsung’s stock performance.

In India, the structure responsible for overseeing corporate governance initiatives consists of two key entities: the Ministry of Corporate Affairs (MCA) and the Securities and Exchange Board of India (SEBI). The role of SEBI is to monitor and regulate the corporate governance practices of companies listed on stock exchanges in India. This regulatory oversight is carried out through the implementation of Clause 49, which is incorporated in the listing agreement between stock exchanges and companies. Compliance with the provisions of Clause 49 is mandatory for listed companies.

On the other hand, the Ministry of Corporate Affairs, in collaboration with various committees and forums, facilitates the exchange of knowledge and ideas related to corporate governance. One such forum is the National Foundation for Corporate Governance (NFCG), which operates as a non-profit trust. The NFCG serves as a platform for corporate leaders, policymakers, regulators, law enforcement agencies, and non-governmental organisations to share their experiences and perspectives on corporate governance.

The Desirable Corporate Governance Code introduced by the Confederation of Indian Industry (CII) in 1998 brought forth the concept of independent directors and their compensation in listed companies. The Kumar Mangalam Birla Committee, in 2000, recommended that if a company had an executive Chairman, at least half of the board should consist of independent directors, while in other cases, at least one-third should be independent directors.

The Clause 49, which was updated based on the report by the Narayana Murthy Committee, provides a more detailed definition of independent directors. It also mandates listed companies to have an optimal mix of executive and non-executive directors, with non-executive directors accounting for at least 50% of the board.

In 2013, the Companies Act introduced the requirement of appointing a resident director and a woman director. The Act also defined the term “Key Managerial Personnel” to include positions such as Chief Executive Officer, Managing Director, Company Secretary, and Chief Financial Officer, among others. The Act introduced new concepts like performance evaluation of the board, committees, and individual directors.

The revised Clause 49, implemented in 2013, states that the compensation paid to non-executive directors, including independent directors, must be determined by the Board and approved by shareholders in a General Meeting. There are also limits placed on stock options granted to non-executive directors, and these details must be disclosed in the company’s annual report. Independent directors are required to adhere to a Code of Conduct and affirm their compliance with it annually.

Countries like India, experiencing rapid growth, have attracted significant investments from international investors and large domestic financial institutions seeking global expansion. As a result, corporate governance standards in investee companies have made notable advancements. Numerous research reports have demonstrated that companies with robust governance systems have delivered favourable risk-adjusted returns to their shareholders. Therefore, if a company wishes to attract institutional investor participation, it must demonstrate a compelling commitment to enhancing the quality of its corporate governance practices.

Indian companies should adopt best practices, such as the OECD Corporate Governance Principles revised in 2004, which serve as a global benchmark. Given the prevalence of concentrated corporate ownership in countries like India, it becomes crucial to treat all shareholders, including domestic and foreign institutional investors, fairly and equitably.

Institutional investors are expected to actively engage in the voting process during Annual General Meetings (AGMs) for the shares they hold in their portfolio companies. Additionally, they should publicly disclose their voting records, including the reasons behind any non-disclosures. It is also essential for institutional investors to provide explanations for their support or opposition to any Board Resolution of their portfolio companies, which should be made available on their websites.

Under the 2013 Act, it is now compulsory for companies with over one thousand shareholders, debenture-holders, deposit-holders, and other security holders at any point in a financial year to establish a Stakeholders Relationship Committee. This committee will be composed of a non-executive director serving as the chairperson, along with other members as determined by the Board. The primary objective of this committee is to address and resolve any concerns or complaints raised by the company’s security holders.

Corporate governance is a critical driver of stock market trading. By fostering transparency, accountability, and ethical behaviour, it builds investor confidence, protects shareholder rights, and mitigates risks. Moreover, effective governance practices contribute to long-term value creation and sustainable growth. As investors, it is imperative to assess a company’s governance structure before making investment decisions. Likewise, companies must prioritise corporate governance to maintain a competitive edge and attract investment.

Remember, a well-governed company not only benefits its shareholders but also contributes to the overall stability and integrity of the stock market.