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Corporate Governance - An Introduction

A company without corporate governance is like an aircraft without control or safety mechanisms. While the captain of an aircraft is responsible for a successful and safe flight, he is aided by numerous guidelines, safety standards and policies he must follow. It is not that it was not possible to fly airplanes before those guidelines and standards came into being, but in today’s world aircrafts are unlikely to be allowed to fly if they don’t comply.

Corporate governance is quite similar to this – some corporate governance standards are imposed by law – through the Companies Act, regulations and notifications issued by the Registrar of Companies, Ministry of Corporate Affairs and sectoral regulators. The rest of the governance process is developed within a company, by shareholders, directors and officers – so that a company can be operated and controlled in the interest of its shareholders without mismanagement, corporate sabotage, misuse of power, position or resources of the company, violation of law, misappropriation or even unintentional mistakes that can lead to compromise the interest of shareholders or the company in general.

This is why in case of listed companies, SEBI as well as stock exchanges impose very detailed and strict corporate governance norms. While private and unlisted public companies benefit from flexibility in corporate governance, they must develop their own norms. Failure to do so can lead to heavy costs for the company, all stakeholders such as shareholders and employees, anyone who enters into contracts with such a company as well as the general public. A flagrant example of this would be Satyam – which led to great loss of value of the company, untold losses for the shareholders and loss of jobs for many employees.

In a public company, especially in case of a listed one, focus on corporate governance is usually higher, due to legal requirements as well as for the reason that such companies are required to hire specialists and professionals responsible to ensure high level of corporate governance. Although questions have been raised in light of recent scams in major public companies such as Reebok, Satyam and most recently of DLF having advanced huge sums to Robert Vadra without any apparent legitimate reason – lack of corporate governance in smaller, often private companies (many being family controlled) is a significant reason for concern.

While mismanagement and failure of corporate governance in private companies rarely make headlines – it should be top in the priority list of founders, promoters, investors, acquirers and senior decision makers. Clear understanding of corporate governance factors and norms are equally necessary for entrepreneurs, managers who want to climb the corporate ladder as well as lawyers who advise them or negotiate deals and prepare investment, merger or acquisition agreements

The Prime Concerns in Corporate Governance
i. Protection of shareholders’ interest By definition, a company is a separate legal entity from the shareholders. Shareholders invest their money in the company, and in return receive the right to share profits of the company. However, holding shares of a company itself does not ensure any real participation in the company’s affairs (beyond participation in shareholders’ meetings) unless one is a majority shareholder. Often, companies are managed by professionals appointed by shareholders. While professional management and separation of management and equity is one of the benefits of company as a form of business, this creates a distance between shareholders and the management.

Interests of the shareholders and the management do not always coincide. The management may want to create a reserve out of profits and use the same to expand the business while shareholders may want to take out the profit as dividend. The management may also be interested in extending loans to other companies in which they hold stakes – which may not be in interest of the company over all and may be at the cost of many other shareholders who do not have any interest in the company receiving the loan. The management may even take out money from the company in the form of huge compensation packages and corporate perks. While the shareholders collectively have the right to fire managers if they do not act in interest of shareholders, in reality, the management may be the majority shareholders.

For instance, Mark Zuckerberg holds 53% shares of Facebook. Given these circumstances, even if the rest of the shareholders are displeased with the way Zuckerberg is functioning, they cannot fire him as the CEO or director. He may also appoint all the directors, thus having pervasive control over the company. When the company is not making any profits, he may sanction extremely high salary and bonus for himself even if all the other shareholders of Facebook oppose him. In essence, he can take decisions to which even a single other shareholder does not give consent, and execute them (please treat this as a hypothetical situation. Also note that Facebook is a public company and corporate governance norms with respect to public companies in US and India significantly differ).  

Hypothetically, if Zuckerberg decides that Facebook should donate half of its profit to the election campaign fund of Mitt Romney, the rest of the shareholders will not be able to stop him by default. In that case, what can be done to protect interests of the minority shareholders?

These issues have surfaced many times, especially in the US, in companies with much diffused shareholder base – where it was extremely difficult to mobilize enough number of shareholders simply due to sheer number and wide geographical distribution of the shareholders, even though there was no tyrannical majority. As a result, management of the company, who themselves did not have any significant shareholding, could take decisions which were very unpopular with large numbers of shareholders.

Similarly, minority investors in case of closely held companies, for instance family controlled companies, or companies in which the promoter group holds a clear majority of shares, must be careful to protect their interests.

Hence, one of the major concerns of corporate governance is protecting legitimate interests of shareholders, especially minority shareholders.  
ii. Protection of employees and protection from employees

Business of a company must be carried out by employees. While directors, who may be employees themselves, make decisions, effective implementation of those decisions is another concern. Good corporate governance must address this issue as well. On the other hand, the management of the company should not direct employees in such a way that they would commit legal violations, or violate the legal rights of the employees themselves. While some of this may be addressed by labour laws of the country, good corporate governance can not omit this aspect as it must ensure compliance with the law in the first place.

iii. Protection of outsiders who enter into contracts with company and consumers  

The internal management of the company has a lot of effect on the treatment of consumer as well as those who enters into contracts with the company. For instance, a mismanaged company may not be able to consistently adhere to safety standards which may put consumers at risk. Similarly, mismanagement and lack of governance may lead to undesirable contracts being entered into by representatives of the company or defaults on the obligations of the company under contracts it has entered into. These are some major concerns of corporate governance.

iv. Protection of public at largeCorporate governance should also ensure that activities of the company do not harm the public at large, for instance, through environmental degradation or by releasing poisonous gasses in the air.

Apart from protecting these interests, corporate governance also must strive to promote profitability, decisiveness and efficiency of the business organization processes.

Instruments of Corporate Governance

While laws, regulations, notifications etc. are a major source of corporate governance practices and norms, especially in case of private companies, all the stakeholders involved must develop a good corporate mechanism in the areas which remain uncovered by law or government diktat. The primary instruments in this respect are investment agreements – such as shareholders’ agreement and share purchase agreements to a limited extent – as even a minority shareholder may claim veto rights on important decisions, obtain rights to appoint directors and receive information etc. Similarly, the regulations provided in the articles of association are crucial, and the articles should be amended from time to time to ensure that these regulations, which often form the basis of very important corporate governance processes, are in sync with situation and the business of the company.

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