Notes on Corporate Governance Law PDF

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NOTES ONLAW ON CORPORATE GOVERNANCEFor9 th Semester BBA LLB(Hons.)Collaborated By on 23/06/ADITHYA RAGHUNADHAN, ANUSREE S, ANSU SARA MATHEW & AJAY RATNAN9/5 BBA LLB(Hons.)GOVERNMENT LAW COLLEGE, KOZHIKODEDisclaimer: This document is a compilation of extracts from various sources. The materia...

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NOTES ON

LAW ON CORPORATE GOVERNANCE For 9th Semester BBA LLB(Hons.)

Collaborated By

on 23/06/2018

ADITHYA RAGHUNADHAN, ANUSREE S.V, ANSU SARA MATHEW & AJAY RATNAN

9/5 BBA LLB(Hons.)

GOVERNMENT LAW COLLEGE, KOZHIKODE

CONTENTS Title

Page No.

MODULE 1 MODULE 2

2-32 33-54

MODULE 3 MODULE 4

55-68 69-95

MODULE 5 MODULE 6

96-116 117-136

Disclaimer: This document is a compilation of extracts from various sources. The material is intended for personal use and for educational purposes only ( Free of charge). Reproduction of the material for any purposes other than what is intended is prohibited. Use this material at your own risk. Although the authors and publishers have made every effort to ensure that the information in this document was correct, the authors and publishers do not assume and hereby disclaim any liability to any party for any loss, damage, or disruption caused by errors or omissions, whether such errors or omissions result from negligence, accident, or any other cause

NOTES ON CORPORATE GOVERNANCE

Module 1 Sources of Corporate Governance Rules – External & Internal Control over Corporate SOURCES OF CORPORATE GOVERNANCE RULES The concept of governance is as old as human civilization and the word 'governance' has come in to use from the time of Chaucer in the fourteenth century. It has only recently come to prominence in the business world because of conflicts of interest between the shareholders and the business managers of the firm. Economic aspects necessitate the existence of firms because they either avoid or internalize some of the transaction costs using price mechanisms. Modern legal systems a foster the growth of the firms because they permit incorporation of firms as a separate legal entity, separate from the owners of the company. In this process there is transfer of power from the owners to the managers of the firm resulting in the formation of two groups; the first being shareholders (principal) who are the legal owners; the second being managers (agents) who are appointed by the shareholders because managers have greater expertise to run the affairs of the firm. This eventually results in managers deriving discretionary powers to operate the firm. Over a period, managers develop the tendency to become de facto owners rather than the de jure owners pursing their own interests rather than that of shareholders. The shareholders also cannot directly observe all the actions of the managers, resulting in information asymmetries and moral hazard. Managers also have incentives to expropriate the firm’s assets benefiting themselves thereby impacting shareholder’s wealth. The following quote of Adam Smith in ‘The Wealth of Nations’ (1776) encapsulates the managerial behaviours mentioned above: “The directors of companies, being managers of other people's money than their own, it cannot well be expected that they should watch over it with the same anxious vigilance with which the partners in private co-partnerships frequently watch over their own”. Various academicians and practitioners of Corporate Governance have put forward different definitions emphasizing on the primary role of mangers which is to enhance the wealth of the firm, thereby benefitting all the stakeholders of the firm. Corporate Governance: Definition There is no universal definition of Corporate Governance. In this regard the objective of studying various definitions is to come to an understanding of what constitutes good governance, quantification of the attributes and its implications on firm performance. The divergence in these definitions can be attributed to two important factors; economic diversity and cultural diversity. In Anglo-Saxon countries, such as the U.S and the U.K, good Corporate Governance process means pursuing the interest of shareholders. In countries like Japan, Germany and France, Corporate Governance is concerned with the interests of a wider set of stake holders, employees, customers and shareholders. Following are some of the definitions which reflect these perspectives.

Prepared by ADITHYA RAGHUNADHAN, ANUSREE S.V., ANSU SARA MATHEW & AJAY RATNAN Page | 2

NOTES ON CORPORATE GOVERNANCE Corporate governance is the system of rules, practices and processes by which a company is directed and controlled. Corporate governance essentially involves balancing the interests of a company's many stakeholders, such as shareholders, management, customers, suppliers, financiers, government and the community. Since corporate governance also provides the framework for attaining a company's objectives, it encompasses practically every sphere of management, from action plans and internal controls to performance measurement and corporate disclosure. “Corporate Governance is the application of best management practices, compliance of law in true letter and spirit and adherence to ethical standards for effective management and distribution of wealth and discharge of social responsibility for sustainable development of all stakeholders” Institute of Companies Secretaries of India (ICSI) “Corporate governance is the system by which businesses are directed and controlled.” The United Kingdom’s 1992 Cadbury Report ‘s often quoted definition “Corporate Governance is holding the balance between economic and social goals. The governance framework is to encourage the efficient use of resources, its accountability and finally its stewardship. The aim is to align as nearly as possible the interests of individuals, corporations and society. The incentive to corporations is to achieve their corporate aims and to attract investment and the incentive for states is to strengthen their economics and discourage fraud and mismanagement (Sir Adrian Cadbury, 1992). “Corporate Governance is the process by which corporations are made responsive to the rights and wishes of stakeholders” (Demb & Neubauer, 1992) Narayana Murthy committee’s report, 2003, states that Corporate Governance is beyond the realm of law. It stems from the culture and mindset of management and cannot be regulated by legislation alone. It is about openness, integrity and accountability. Legislations can lay down a common framework, the ‘form’ to ensure standards. The ‘substance’ will ultimately determine the credibility and integrity of the process. The “substance” is inexorably linked to the mindset and ethical standards of management. Theories of Corporate Governance 1) Agency theory: This theory is about the conflicts that arise between the Principal and the Agent because of differences in the goals resulting in additional costs to the firm thereby eroding the wealth of the firm and its shareholders. 2) Stewardship theory: Stewardship theory has a more social-oriented perspective on Corporate Governance. Although agency theory appears to be the dominant paradigm underlying most governance research and prescriptions, researchers in psychology and sociology have suggested theoretical limits of agency theory because of its focus on only economic assumptions. There are non-economic assumptions supporting stewardship theory. The dominant non-monetary motive, which directs managers to accomplish their job, is their desire to perform excellently because their reputations are at stake. Drawing from Maslow’s hierarchy theory, self-actualization motivates manager to successfully perform challenging

Prepared by ADITHYA RAGHUNADHAN, ANUSREE S.V., ANSU SARA MATHEW & AJAY RATNAN Page | 3

NOTES ON CORPORATE GOVERNANCE tasks and gain recognition (McClelland, 1961). Based on this premise, stewardship theory favours boards having a majority of ‘specialist’ executive directors rather than a majority of ‘non-specialist’ independent directors who will supplement the organizational knowledge resources. 3) Resource dependence theory: This theory focuses on the resources the directors can provide to the firm for its effective operations and profitability. Boards have a critical role to play in achieving economic efficiency and since some directors may have access to some strategic resources required by the firm, they may be appointed to the board. 4) Stakeholder Theory: This theory states that the success of the firm is dependent on the relationship that a firm has with its stakeholders. The potential stakeholders may be divided into two groups: (1) the primary stakeholders - shareholders/investors, creditors, customers, suppliers and employees; (2) secondary stakeholders - the government, trade associations, political groups and the community. Stakeholder theory states that, managers and entrepreneurs must take into account the legitimate interests of those groups and individuals who can affect or be affected by their activities. 5) Managerial Hegemony Theory: Managerial hegemony theory states that CEOs and Management dominate the boards of directors resulting in passive roles for Non-Executive Directors and independent directors. This is because CEOs dominate the director selection process and therefore control the board. It is also skeptical about the ability of outside directors to make independent judgments on firm performance due to the dominant role played by CEOs in selecting outside directors. All these may negatively influence the board cohesiveness since Non-executive and independent directors are involved in the decision-making process of the firm and, at the same time, act as monitors of management. This conflict of interest will impair the efficiency of the firm despite being dominated by outside directors. Need for Corporate Governance: 1. Corporate Governance deals with the manner the providers of finance guarantee themselves of getting a fair return on their investment. 2. Corporate Governance clearly distinguishes between the owners and the managers. The managers are the deciding authority. 3. In modern corporations, the functions/ tasks of owners and managers should be clearly defined, rather, harmonizing. 4. Corporate Governance deals with determining ways to take effective strategic decisions. It gives ultimate authority and complete responsibility to the Board of Directors. 5. In today’s market- oriented economy, the need for corporate governance arises. Also, efficiency as well as globalization is significant factors urging corporate governance. 6. Corporate Governance is essential to develop added value to the stakeholders. 7. Corporate Governance ensures transparency which ensures strong and balanced economic development. 8. This also ensures that the interests of all shareholders (majority as well as minority shareholders) are safeguarded. Prepared by ADITHYA RAGHUNADHAN, ANUSREE S.V., ANSU SARA MATHEW & AJAY RATNAN Page | 4

NOTES ON CORPORATE GOVERNANCE 9. It ensures that all shareholders fully exercise their rights and that the organization fully recognizes their rights. 10. Corporate Governance has a broad scope. It includes both social and institutional aspects. Corporate Governance encourages a trustworthy, moral, as well as ethical environment. The need for corporate governance is highlighted by the following factors: (i) Wide Spread of Shareholders: Today a company has a very large number of shareholders spread all over the nation and even the world; and a majority of shareholders being unorganised and having an indifferent attitude towards corporate affairs. The idea of shareholders’ democracy remains confined only to the law and the Articles of Association; which requires a practical implementation through a code of conduct of corporate governance. (ii) Changing Ownership Structure: The pattern of corporate ownership has changed considerably, in the present-day-times; with institutional investors (foreign as well Indian) and mutual funds becoming largest shareholders in large corporate private sector. These investors have become the greatest challenge to corporate managements, forcing the latter to abide by some established code of corporate governance to build up its image in society. (iii) Corporate Scams or Scandals: Corporate scams (or frauds) in the recent years of the past have shaken public confidence in corporate management. The event of Harshad Mehta scandal, which is perhaps, one biggest scandal, is in the heart and mind of all, connected with corporate shareholding or otherwise being educated and socially conscious. The need for corporate governance is, then, imperative for reviving investors’ confidence in the corporate sector towards the economic development of society. (iv) Greater Expectations of Society of the Corporate Sector: Society of today holds greater expectations of the corporate sector in terms of reasonable price, better quality, pollution control, best utilisation of resources etc. To meet social expectations, there is a need for a code of corporate governance, for the best management of company in economic and social terms. (v) Hostile Take-Overs: Hostile take-overs of corporations witnessed in several countries, put a question mark on the efficiency of managements of take-over companies. This factors also points out to the need for corporate governance, in the form of an efficient code of conduct for corporate managements. (vi) Huge Increase in Top Management Compensation: It has been observed in both developing and developed economies that there has been a great increase in the monetary payments (compensation) packages of top level corporate executives. Prepared by ADITHYA RAGHUNADHAN, ANUSREE S.V., ANSU SARA MATHEW & AJAY RATNAN Page | 5

NOTES ON CORPORATE GOVERNANCE There is no justification for exorbitant payments to top ranking managers, out of corporate funds, which are a property of shareholders and society. This factor necessitates corporate governance to contain the ill-practices of top managements of companies. (vii) Globalisation: Desire of more and more Indian companies to get listed on international stock exchanges also focuses on a need for corporate governance. In fact, corporate governance has become a buzzword in the corporate sector. There is no doubt that international capital market recognises only companies well-managed according to standard codes of corporate governance. Benefits of Corporate Governance: 1. Good governance leads to congruence of interests of boards, management including owner managers and shareholders. 2. Good governance provides stability and growth to the company. 3. Good governance system builds confidence among investors. 4. Good governance reduces perceived risks, consequently reducing cost of capital. 5. Well governed companies enthuse employees to acquire and develop company specific skills. 6. Adoption of good corporate governance practices promotes stability and long-term sustenance of stakeholder’s relationship. 7. Potential stakeholders aspire to enter into relationships with enterprises whose governance credentials are exemplary. 8. Static efficiency of markets which guarantees Pareto optimality, an equilibrium condition in which no one can any longer be made better off through an exchange without someone else being made worse off. 9. Dynamic efficiency of the market which establishes consumer sovereignty in which consumers determine through their consumption choice what products are to be produced. 10. Dynamic efficiency also ensures full employment since competition clears all markets including labour. Models of Corporate Governance Depending upon the business practices, customs and culture, the process of Corporate Governance differs from country to country. Besides, the variety of capitalism in which countries are embedded with, explains the considerable variations in Corporate Governance models around the world. While there are different models, many of them can be clustered into the following broad groups and each model has its own distinct features. The Japanese model (J-Form): Many firms of Japan are a part of intricate shareholding structures called keiretsus. A Japanese Keiretsu is a network of different businesses that hold interest in each other to form a type of security blanket. In a horizontal keiretsu firms are financed by a main bank with a system of cross-shareholding and horizontal network of Prepared by ADITHYA RAGHUNADHAN, ANUSREE S.V., ANSU SARA MATHEW & AJAY RATNAN Page | 6

NOTES ON CORPORATE GOVERNANCE interlinked corporations. While the central figure in a horizontal Keiretsu is a central bank, in a vertical Keiretsu it would be a big manufacturing company such as Toyota. Managers do not have a fiduciary responsibility only to shareholders but also to the stakeholders. In practice the managers are expected to pursue the interests of a wider set of stakeholders, including employees, customers and Shareholders who are considered part of it. German Model: In the German model of Corporate Governance even though the shareholders own the corporation, they do not directly control the governance mechanism. In fact, in Germany the legal system is quite explicit that firms do not have a sole duty to pursue the interests of shareholders because of the system of codetermination. In large corporations employees have an equal number of seats on the supervisory board of the company which is ultimately responsible for the strategic decisions of the company. Half of the supervisory board is elected by the labour unions which ensure that the workers participation in the governance mechanism is ensured. Another feature is that there is a heavy presence of banks in the equity structure of German firms. Chaebols of South Korea: Chaebol refers to a South Korean form of business conglomerate. They are powerful global multinationals owning numerous international enterprises. The traditional structure of Korean chaebol can be explained by two of their features; their absolutely closed concentration of ownership within the family of the founder, and their highly diversified business structure. The founding family possesses bulk of the stocks and holds the decision making right as top management. Chaebols suffer from a number of problems such as entrenchment, agency conflicts, tunnelling, etc. Anglo-American Model: The traditional Berle-Means (1932) model of Corporate Governance is characterized by a separation of ownership and management. It is considered as a liberal model which is common in Anglo-American countries, which tends to give priority to the interests of shareholders. The CEO has broad powers to manage the corporation on a daily basis but needs to get board approval for certain major actions, such as hiring his/her immediate subordinates, raising money, acquiring another company, major capital expansions, or other expensive projects. Other duties of the board may include policy setting, decision making, monitoring management's performance, or corporate control. Evolution of Corporate Governance Ever since the concept of corporate entity was recognized, corporate governance in various manifestations has been in existence. The Foreign Corrupt Practices Act, 1977 (USA) made specific provisions regarding establishment, review of systems of internal control. In 1979, US Securities Exchange Commission prescribed mandatory reporting on internal financial controls. Due to high profile failures in the US, In 1985 the Tread Way Commission constituted highlighted the need of putting in place a proper control environment, desirability of constituting independent boards and its committees and objective internal audit function. As a consequence,

Prepared by ADITHYA RAGHUNADHAN, ANUSREE S.V., ANSU SARA MATHEW & AJAY RATNAN Page | 7

NOTES ON CORPORATE GOVERNANCE In 1992 the Committee of Sponsoring Organizations was formed which prescribed a control framework. After the Enron debacle of 2001, came other scandals involving large US Companies such as WorldCom, Owest, Global Crossing and the auditing lacunae that eventually led to the collapse of Andersen. These developments triggered another phase of reforms in the area of corporate governance, accounting practices and disclosures - this time more comprehensive than ever before. In July 2002, less than a year from the date when Enron filed for bankruptcy, the SarbanesOxley Act pop...