Updated: Jun 14, 2020
Corporate Governance is cited as the pillar of the most important differentiators of a business that has impact on the viability, growth and even sustainability of business. Over the years various researchers have put forth the importance of organization’s culture, its policies, values and ethics, especially of the people running the business and the way it deals with various stakeholders as the value creator for businesses. Business has to create value but it also has to be sustainable in long-term keeping stock of interest of all stakeholders. This means that the business has to run and be seen to be run with degree of ethical conduct and good governance where compliance with code has to be in spirit.
As rightly pointed out by supporters of corporate governance, today India is at Crossroads of reform. Today corporate governance codes are being drafted with deep understanding of standards followed around the world and focusing at more India centric challenges. Indian companies in specific are evolving appropriate solutions keeping in mind the challenges faced.
As understood by many the major challenges to corporate governance reforms in India are:
Power of the dominant shareholder(s)
Lack of incentives for companies to implement corporate governance reform measures (no direct correlation between putting expensive governance systems and corresponding returns)
Under-developed external monitoring systems
Shortage of real independent directors
Weak regulatory oversight including multiplicity of regulators
In most of the western countries the problem that’s most challenging for corporate governance is that of ‘agency gap’: The divorce between the management and ownership. Most of the western corporate governance philosophy is aiming at solving this gap. And since most of the codes in Indian corporate governance are based on western understanding of governance we see a lot of disciplining the management.
We as practitioners find that in India the agency gap is more of that between the dominant shareholders and minority shareholders. In India the problem—since the inception of joint-stock companies—is the stranglehold of the dominant or principal shareholder(s) who monopolize the majority of the company’s resources to serve their own needs. It is also seen that much of global corporate governance norms focus on boards and their committees, independent directors and managing CEO succession. In the Indian business culture, boards are not as empowered as in several western economies and since the board is subordinate to the shareholders; the will of the majority shareholders prevails.
Therefore, most corporate governance abuses in India arise due to conflict between the majority and minority shareholders. This applies across the spectrum of Indian companies with dominant shareholders—PSUs (with government as the dominant shareholder), are led by bureaucrats rather than professional managers. Several strategic decisions are taken at a ministerial level, which may include political considerations of business decisions as well. Therefore, PSU boards can rarely act in the manner of an empowered board as envisaged in corporate governance codes. This makes several provisions of corporate governance codes merely a compliance exercise. Multinational companies (where the parent company is the dominant shareholder) are perceived to have a better record of corporate governance compliance in its prescribed form. However, in the ultimate analysis, it is the writ of the large shareholder (the parent company), which runs the Indian unit that holds sway, even if it is at variance with the wishes of the minority shareholders. Moreover, the compliance and other functions in an MNC are always geared towards laws applicable to the parent company and compliance with local laws is usually left to the managers of the subsidiary who may not be empowered for such a role. Private sector family-owned companies and business groups as a category are perhaps the most complex for analysing corporate governance abuses that take place. The position as regards family domination of Indian businesses has not changed; on the contrary, over the years, families have become progressively more entrenched in the Indian business milieu.
But having said this in an era of globalization when India’s businesses seek to expand worldwide, their ability to pursue acquisitions overseas and attract foreign capital depends on their adoption of the West’s approach. The move toward global harmonization of regulatory standards and accounting principles has intensified the perceived need by India’s business leaders to adopt Western best practice. Pragmatism and the pace of economic change are also helping expedite this process.
In Practice: Corporate governance at companies
“What’s good, right, and just for everyone?” The purpose of business, executives still believe, is business, and greed is good so long as the SEBI doesn’t find out.
The gulf between the theory and practice of ethics exists in business for several reasons: There is a big difference between what top management preaches and what frontline people do. There is vested interest to be served which do not match theory. Philosopher Plato once stated that, if a theory isn’t working, there must be something wrong with reality. People behave less ethically when they are part of organizations or groups. Individuals who may do the right thing in normal situations behave differently under stress. And common rationalizations, such as that you are acting in the company’s best interest, or justifications, such as that you will never be found out, lead to misconduct.
Different firms have different goals:
The firm’s investment and financing decisions are unavoidable and continuous. In order to make them rationally, the firm must have a goal or an objective, which will lead to how the firm decides. In most cases, the objective is stated in terms of maximizing some function or variable, such as profits or growth, or minimizing some function or variable, such as risk or costs. If an objective is not chosen, there is no systematic way to make the decisions that every business will be confronted with at some point in time. If we choose multiple objectives, we are faced with a different problem. A theory developed around multiple objectives of equal weight will create quandaries when it comes to making decisions.
There are a number of different objectives that a firm can choose between when it comes to decision-making. How will we know whether the objective that we have chosen is the right objective? A good objective should have the following characteristics.
a. It is clear and unambiguous. An ambiguous objective will lead to decision rules that vary from case to case and from decision maker to decision maker. Consider, for instance, a firm that specifies its objective to be increasing growth in the long term. This is an ambiguous objective because it does not answer at least two questions. The first is growth in what variable—Is it in revenue, operating earnings, net income, or earnings per share? The second is in the definition of the long term: Is it three years, five years, or a longer period?
b. It comes with a timely measure that can be used to evaluate the success or failure of decisions. Objectives that sound good but don’t come with a measurement mechanism are likely to fail.
c. It does not create costs for other entities or groups that erase firm-specific benefits and leave society worse off overall.
To make the right decisions, managers need to understand why a company exists—its raison d’être. While different firms have different goals it is often observed that Indian companies with dominant shareholders lean towards Profit maximization objective instead of Shareholders wealth or value maximization. This is due to the continued belief of earning profits for the dominant shareholders instead of company value maximization. The objective of a company specifies what a decision maker is trying to accomplish and by so doing provides measures that can be used to choose between alternatives.
Profit Maximization Objectives:
In the 19th century when the characteristic features of business structure were self-financing private property and single entrepreneurship the concept of Profit Maximization was evolved. The only aim of single owner then was to enhance his or her individual wealth and personal power, which could easily be satisfied by profit maximization objective. This could be one of primary criteria in India why corporate governance codes are difficult to implement. Though the modern businesses are financed by public shareholders and lenders the business is still controlled and directed by dominant shareholders who are patriarchy and run it as family business. If the objective of firm is Profit maximization the codes of corporate governance ensuring transparency and accountability by definition itself will not be upheld. For instance from a corporate governance standpoint, as stated by Rajesh Chakrabarti, William Megginson, and Pradeep K. Yadav family business groups involve “significant pyramiding and evidence of tunneling activity that transfers cash flow and value from minority to controlling shareholders.” Related-party transactions may be the norm, with social dynamics constraining directors from challenging the patriarchs, matriarchs, and their offspring who run the companies. Prevalent are inbred, insular decision-making processes in which family issues are inextricably intertwined with business matters. Beverley Jackling and Shireenjit Johl identify another possible dominant factor as blind loyalty—an attitude that directors work for those who brought them onto the board. These situations all run counter to corporate governance’s foundations of transparency, accountability, and boards’ effective stewardship—foundations that “go a long way in building trust of the shareholders.” Further the said objectives focuses on profitability rather than value. The rationale for this is that profits can be measured more easily than value, and that higher profits translate into higher value in the long run. But as evident there are at least two problems with this objectives. First, the emphasis on current profitability may result in short-term decisions that maximize profits now at the expense of long-term profits and value. Second, the notion that profits can be measured more precisely than value may be incorrect, given the leeway that accountants have to shift profits across periods. In its more sophisticated forms, profit maximization is restated in terms of accounting returns (such as return on equity or capital) rather than rupee profits or even as excess returns (over a cost of capital). It is feared that profit maximization behavior in a market economy may tend to produce goods and services that are wasteful and unnecessary from society’s point of view. Also it might lead to inequality of income and wealth.
Shareholders Wealth Maximization:
SWM means maximizing the net present value of a course of action to the shareholders. Net present value or wealth of a course of action is the difference between the present value of its benefits and the present value of its costs. A financial action that has positive NPV creates wealth for shareholders and therefore is desirable. A financial action resulting in negative NPV should be rejected since it would destroy shareholders wealth. Between mutually exclusive projects the one with the highest NPV should be adopted. Further to this NPV of a firms projects are additive and therefore the wealth will be maximized if NPV criterion is followed (principle of value-additive). It is seen that SWM is an appropriate and operationally feasible criterion to choose among the alternative financial actions. It is important that wealth maximization calculates time value for money and hence the future cash flows are discounted at an appropriate discount rate to represent present value. Thus risk and uncertainty factors are considered while deciding the discount rate.
Potential drawbacks of value Maximization: If the objective when making decisions is to maximize company value, there is a possibility that what is good for the company may not be good for society. In other words, decisions that are good for the company, insofar as they increase value, may create social costs. If these costs are large, we can see society paying a high price for value maximization, and the objective will have to be modified to allow for these costs. This is a problem however is likely to persist in any system of private enterprise and is not peculiar to value maximization. When dominant shareholders are the decision makers, there is the potential for a conflict of interest between promoters and minority interests, which in turn can lead to decisions that make dominant holders better off at the expense of minority shareholders. When the objective is stated in terms of shareholders wealth, the conflicting interests of shareholders and lenders have to be reconciled. Since dominant shareholders are the decision makers and lenders are often not completely protected from the side effects of these decisions, one way of maximizing shareholders wealth is to take actions that expropriate wealth from the lenders, even though such actions may reduce the wealth of the company. Finally, when the objective is narrowed further to one of maximizing share price, inefficiencies in the financial markets may lead to misallocation of resources and to bad decisions. For instance, if share prices do not reflect the long-term consequences of decisions, but respond, as some critics say, to short-term earnings effects, a decision that increases shareholders wealth (which reflects long-term earnings potential) may reduce the share price. Conversely, a decision that reduces shareholders wealth but increases earnings in the near term may increase the share price.
Multiple Stakeholders and Conflicts of Interest
The modern publicly traded companies in India is a case study in conflicts of interest, with major decisions being made by dominant shareholder whose interests may diverge from those of minority shareholders. Put simply, corporate governance as a sub-area in finance looks at the question of how best to monitor and motivate dominant shareholders to behave in the best interests of the company including Minority shareholders. In this context, a company where managers are entrenched and cannot be removed even if they make bad decisions (which hurt minority shareholders) is one with poor corporate governance. In the light of accounting scandals and faced with opaque financial statements, it is clear investors care more today about corporate governance at companies and companies know that they do. In response to this concern, it is often seen that companies have expended resources and a large portion of their annual reports to conveying to investors their views on corporate governance (and the actions that they are taking to improve it). But the larger question of in letter or in spirit still prevails. Some may be shortsighted in believing that a business only has responsibility to its primary owners but the fact is business are owned and operated by shareholders and lenders.
Investors in financial markets respond to information about the firm revealed to them by the managers, and firms have to operate in the context of a larger society. By focusing on maximizing stock price, corporate finance exposes itself to several risks. Each of these stakeholders has different objectives and there is the distinct possibility that there will be conflicts of interests among them. What is good for dominant shareholders may not necessarily be good for minority shareholders, and what is good for shareholders may not be in the best interests of lenders or debenture holders and what is beneficial to a company may create large costs for society. These conflicts of interests are exacerbated further when we bring in two additional stakeholders in the firm. First, the employees of the firm may have little or no interest in shareholders wealth maximization and may have a much larger stake in improving wages, benefits, and job security. In some cases, these interests may be in direct conflict with shareholder wealth maximization. Second, the customers of the business will probably prefer that products and services be priced lower to maximize their utility, but again this may conflict with what shareholders would prefer.
Thus in conclusion it may be sighted that the corporate governance of a company is majorly influenced by its objectives. Indian companies should be moved from the narrow objective of profit maximization to broader perspective of Shareholders wealth or value maximization. Of course there is an underside to value maximization and in Indian context market mechanism is also at question, still it is the versatile goal of the company and highly recommended parameter for assessing the performance of a business organization. Japanese companies have often been criticized for not being sufficiently capitalistic—that is, not returning enough capital to investors, not maximizing shareholder value in the short term, not moving quickly with offshoring, not laying off employees to reduce costs, not paying compensation that will incentivize top management. But the flip side is a continuing belief that the best Japanese companies live in harmony with society, have a social purpose in earning profits, pursue the common good as a way of life, have a moral purpose in running a business, and practice distributed prognosis.
Companies often behave as though they’re willing to do anything to survive, even if that means destroying the world in which they operate. Businesses would do better to pursue the common good—not because it’s right or fashionable but to ensure their sustainability. No company will survive over the long run if it doesn’t offer value to customers, create a future that rivals can’t, and maintain the common good. This is why corporate governance has an important role to play.