Corporate Governance – the controlled way to success

Evalueserve is a Knowledge Partner of the Summit for the Future - May 3-5, 2006

by Sutithi Chakraborty, Prince Batheja, Hedda Pahlson-Moller, Evalueserve

Summary

In the wake of large-scale financial failures such as those of Enron and WorldCom, the world of business has woken up to the need for internal controls. Such internal controls are necessary to ensure equitable distribution of rights among various stakeholders and make every corporate participant accountable for their practices. In other words, the concept of corporate governance has started gaining acceptance and popularity. Corporate governance is a system, which provides sufficient controls to the way an organization is managed and hence ensures transparency. Sound corporate governance demands focus on long-term financial returns to all shareowners, full and accurate information disclosure, accountability of board of directors and constructive dialogue with the government and legislators. It also demands adherence to all applicable legislation prevalent in the country of operation. Therefore, the model of corporate governance followed by an organization depends on its geographic location and thus, varies between organizations. Though adherence to corporate governance directives is the onus of all stakeholders, it is the probably the highest for top-level managerial staff. While the practice of sound corporate governance undoubtedly enhances the goodwill of an organization and ensures financial stability, a careful balance needs to be maintained to ensure that excessive focus on controls do not straitjacket innovation and hence affect customer satisfaction.

Corporate Governance – the controlled way to success

‘I am not saying there won't be an Accident now, mind you. They're funny things – Accidents. You never have them till you're having them.' — Winnie-the-Pooh

Unpleasant occurrences, like their pleasant counterparts, always happen unexpectedly. Over the years, the world of business has witnessed many such unexpected successes and failures. Enron, Worldcom and Parmalat are some of the examples of the latter in the US and Europe. These corporate failures, and many more, have each caused insurmountable losses – loss of wealth, loss of livelihood, and most importantly, irreparable loss of goodwill. Why did these organizations falter? What went wrong? Could the disasters have been prevented? Could the process of atrophy be arrested at the very onset?

This brings us to the discussion of a very important concept - Corporate Governance. Corporate governance refers to the set of rules or regulations that govern the functioning of an organization. According to OECD, "Corporate governance is the system by which business corporations are directed and controlled. The corporate governance structure specifies the distribution of rights and responsibilities among different participants in the corporation, such as, the board, managers, shareholders and other stakeholders, and spells out the rules and procedures for making decisions on corporate affairs. By doing this, it also provides the structure through which the company objectives are set and the means of attaining those objectives and monitoring performance".

The history of corporate governance dates back to the Watergate Scandal, which effectively involved a series of political scandals over 1972-74 and the abuse of power by the Nixon administration in attempts to undermine political opposition. During this period, many companies in the US had engaged in secret political contributions and corrupt payments, thus diluting shareholder value in the long-term. Later, in the nineteen eighties, a number of business failures took place, which made it apparent that the organizations severely lacked proper internal controls and independent audits. In other words, companies were not following the requisite corporate governance directives and instances of corporate failures due to management negligence, non-transparency, unequal distribution of power, etc, were rampant.

In last few years, this trend has changed. Companies have started adopting systematic approaches to manoeuvre and manage their business operations. In other words, corporate governance has gradually become popular in the corporate world. Due to its apparent importance in shaping the economic health of corporations, and therefore society in general, corporate governance has also succeeded in attracting a good deal of public interest.

Corporate governance ensures accountability, transparency, fairness and responsibility of companies on legal, social and economic affairs. In today’s world, characterised by intense competition, these elements are all crucial for success. According to a survey conducted by McKinsey, shareholders in Latin America and Asia are willing to pay around 20-28% premium for shares of well-governed companies. Similarly, in Europe and the US, shareholders are willing to pay 17-23% and 16-19% premium respectively. Hence the importance of corporate governance can hardly be overemphasised.

Sound corporate governance demands the following;

· Focus on long-term financial returns to all shareowners
· Full and accurate information disclosure
· Ultimate ownership structure disclosure
· Accountable and qualified Board of Directors
· Consistent corporate remuneration policy
· Adherence to all applicable laws of the jurisdictions
· Constructive dialogue with the government and legislators

In order to ensure compliance to corporate governance, several ratings scales have evolved in the recent past. These scales have set parameters to monitor and judge the ratings of individual organizations on compliance parameters. Companies, which are rated low due to non-adherence, are therefore losing goodwill among stakeholders

Adherence to sound corporate governance is not only the onus of the owners of the company, or those who hold top managerial positions. It is the responsibility of all stakeholders. In general, the most important factor in any organization’s success is its employees, and the responsibility falls heavily on their shoulders.

The model of corporate governance followed by an organization depends, to a large extent, on its geographical location. Some of the reasons for this are as follows:

· Difference in structure of board – The structure of the board differs per country. Boards of organizations in certain countries, such as Germany, Netherlands and France, follow a two-tier structure; whereas those of organizations in the UK and Spain follow a unitary structure. The two tier structure allows the upper-tier to oversee the work of lower-tier, and hence leads to better adherence to corporate governance.
· Difference in creditor profile – Since creditors are key stakeholders, difference in creditor profiles lead to different corporate governance models being followed in different countries. For instance, in the US and the UK, equity is the dominant form of long-term finance. Banks are thus relatively less important and do not enjoy much control in the operations of organizations. On the other hand, the higher component of debt in organizations in Japan gives banks significant ownership and control in organizational matters.
· Difference in power of customers – The legal framework of certain countries, such as the US and the UK, vests significant rights to customers. For instance, the Citizen’s Charter in the UK states that public services have to develop and publish a charter, which clearly lays down the rights of the customers and performance standards expected from the company over a period of time.

Good corporate governance practices include the following:

· Flexibility of special meetings on needs basis, in addition to regular meetings
· Maintaining clarity in the positions and titles of directors
· Regular management executive meetings
· Creation of a system to clarify responsibilities of directors
· Creation of a corporate advisory committee for better transparency and objectivity
· Improvement in the auditing system
· Fair, appropriate, and timely disclosure of information regarding corporate activities (such as management policies, management objectives, and financial position) to all stakeholders
· Educating employees about business conduct guidelines

Amidst all the emphasis on corporate governance, organizations should remember that better governance is not an end in itself, but rather, the means to a different end – that is customer satisfaction. While tight governance can protect organizations from frauds, errors and undue risk, it can also threaten agility and innovation. Organizations should ensure that regulations and controls do not get in the way of nimble delivery of customer expectations. Customer expectations should not be compromised against adherence and the two should be carefully integrated to create a transparent organization delivering customer value at all times.

A recent example of good corporate governance is the Sarbanes-Oxley Act passed in the United States in 2002. In the wake of the large-scale financial meltdowns of powerful corporations such as Enron and WorldCom, which shook the very foundation of the financial world, this act was designed to review the out-dated legislative audit requirements. Considered to be one of the most significant amendments in the United States’ securities laws, the act specifies the establishment of public company accounting oversight board, auditor independence, corporate responsibility, and enhanced financial disclosure.

Some organizations which have successfully used corporate governance to their benefit include Swiss RE, GE, Shell and IDC. About a decade ago, the board of Swiss Re, a large re-insurer, carried the image of “advance guard of the enemy”. There was little transparency in the system and important issues were hidden from the board. All this underwent a sea change and now the company boasts of sound strategy and proper information flow, resulting in better transparency within the company. The performance of non-executive directors has also come under scrutiny and external coaching is made available to enhance their performance.

Corporate governance at IDC is based on two principles:

1. Management must have the executive freedom to drive the enterprise forward without undue restraints
2. This freedom should be exercised within a framework of effective accountability

What are the emerging trends in corporate governance? Companies have already started being more transparent and accountable, demarcating the role and responsibilities of the board and conducting performance appraisals of the board members. There is also a trend towards more external representation in boards and shorter tenure for such externally appointed board members.