Effective Corporate Governance : Role of Board of Directors
The primary goal of a corporation is to maximise the shareholders wealth in a legal and ethical manner.
Players
The shareholders : invest the capital The directors : answerable to shareholders The management : runs the company and is answerable to the directors.
Role of Board of Directors
BoD = governs the Company within the limits of law
and decency. BoD directs but not manages the affairs of the Company.
Corporate Governance = system of making directors accountable to shareholders for effective management of the company in the best interest of the company and shareholders along with concern for ethics and values.
I would like to speak to you briefly about corporate governance at Alcan. In the current environment, shareholders of public corporations must inform themselves about their company's governance practices. Alcan has always been committed to be and remain a leader in this area. The Board believes that this commitment is essential to Alcan's success and to its ability to enhance Shareholder value. Allow me to give you three examples of our leadership in this area: (1) the roles of Chairman and CEO were separated in 1995 well before this practice became a fundamental precept of corporate governance; (2) also, since 1995, Alcan's Board has been composed entirely of unrelated Directors with the exception of the CEO, and (3) the involvement of the fully-independent Audit Committee of the Board in the audit of the Company and in its financial reporting, became a practice long before it became best practice in the corporate world. From an address by L. Yves Fortier, Chairman of the Board, Alcan Inc. to the 101st Annual General Meeting of Shareholders, Montreal, Canada
Board of Directors : constituents
Executive Directors Independent (Non executive) Directors Nominees of Financial Institutions Various committees : audit, compensation, etc Company Secretary
BoD its role
Monitor: By acting thro its committees, Board can keep abreast of developments inside and outside the corporation, bringing to the managements attention developments it might have overlooked.
A Board should atleast carry out this task.
BoD its role
Evaluate and influence : A Board can examine management proposals, decisions and actions, agree or disagree with them, give advice and offer suggestions, outline alternatives. More active Boards perform this task in addition to the monitoring one.
BoD its role
Initiate and determine : A Board can dileate a corporations mission and specify options to its management. Only the most active Boards take on this task in addition to the two previous ones.
BoD : its responsibilities
Setting corporate strategy, overall direction, mission or vision. Hiring and firing the CEO and top management. Controlling, monitoring or supervising top management. Reviewing and approving the use of resources. Caring for shareholders interests.
What will BoD do to fulfill its duties ?
Ensuring prudent management of the assets Selecting and appointing the chief executive Delegating all duties of management not specifically reserved to the boards Reviewing and appraising the performance of the chief executive and other executive directors Reviewing its own performance
What will BoD do to fulfill its duties ?
Reviewing strategies and policies Discussing thoroughly any action that might have a significance impact on the future of the company Approving auditors and other advisors Ensuring the company stays within law Reviewing the compensation paid to senior officers in the company.
What is never a problem, difference lies in how part that makes the board effective.
Todays forces in which the Boards operate :
Deregulation : competitive market Disintermediation: financial sector reforms, depend on market for capital Institutionalisation : Institutionalisation of capital markets Globalisation : higher standards of disclosure and corporate governance Tax reforms: Tilted the balance away from black market transactions
What went wrong at Tata Finance Ltd
Please go through the case provided and think on following lines of BoDs role:
Monitor : Evaluate and influence : Initiate and determine :
Role of Board : industrial economy vs developing economy
Legal framework and information system is transparent Financial markets are developed
vs
Oriental value system Social hierarchy acting as a deterrent to professionalism in Board Encourages passive or indifferent or reluctant participation in guiding commercial destiny of company.
In a study conducted of 246 central public sector Boards, it was found :
1. 40% had more than 50% slots vacant. 2. 49% had vacancy between 20-50% slots. 3. 40% of Boards did not appoint any sub committees
4. Instead of optimal size of 12, it was 7. 5. Instead of average 12 meetings a year, it was 7. 6. 40% boards did not have any sub committees. and so on
A study conducted at select 30 large Indian public corporations inferred that : Profits have no relation with the kind of Corporate governance model followed in the sample companies. Directors in most of the companies are found ineffective in monitoring the managements performance. Better corporate governance is driven by collective conscious and not by stakeholders demands or market forces.
Changes expected in Boards of India:
Independence of Directors Agenda setting Quality of debate Providing direction Developing strategic thinking Moderating companies growth path Communicating with shareholding and non shareholding constituencies
In India, more often than not, if the Board is active, it is occupied with operating and not strategic decision making.
What went wrong at Tata Finance Ltd
Let us now discuss the case based on these three roles of BoD.
Monitor : Evaluate and influence : Initiate and determine :
Important issues related to BoD
Structure of Board : Process of review : Culture :
Legal requirements:
Indian Companys Act, 1956 provides for : Legal rights to shareholders : a. Vote on every resolution placed before AGM b. Elect Directors c. Determine remuneration of Directors and CEO d. Removal of Directors e. Appoint auditors to provide an external check on financial statements. f. Take active part in AGM SEBI (1992) had made certain recommendations which has impacted directly corporate governance.
Category of Directors:
Promoter Executive Non executive Independent non executive : directors with no business relationship with the company. Nominee
Ideal board:
Optimum combination of executive and non executive directors Not less than 50% of the Board consisting of non executive directors If non-executive Chairman, atleast one third of the Board be Independent directors If executive Chairman, atleast 50% of the Board be Independent directors
from Kumarmangalam Birla (SEBI) Report
Ideal board:
Directors should have:
Integrity Sense of accountability Track record of acheivements Ability to ask tough questions Financial literacy Ability to think strategically Commitment to the company Can represent maximum 10 Boards instead of 20
from Kumarmangalam Birla (SEBI) Report
Ideal board:
Nominees of Financial Institutions
Appointment on selective basis where such appointment is considered necessary to protect the interests of the institution or where it is a right under loan agreement.
from Kumarmangalam Birla (SEBI) Report
Role of Chairman
Ideal board:
To ensure Board works both as governance and as a contributor to policy and growth. Maintain relation with institutional shareholders, government, media and business Collaborates the overall design of policy, encourages growth and development. vs
Role of CEO
Developing the bottomline Maintain operational control Proposing and implementing policy Leading the operational team Can same person hold both the position ? from Kumarmangalam Birla (SEBI) Report
Creating the right structure by inducting professionally acclaimed people who can:
Evaluate and comment. (eg Orchid Chemicals) Contribute in critical areas. (eg Marico) Independent from the management (eg Hughes) Give good counsel (eg HLL) Build the brand equity (eg Goenka) Build up overall expertise (eg Mahindra and Mahindra) Complement the expertise of Board (eg Godrej) Market the company (eg Infosys) Provide right kind of diversity Provide adequate time
Creating the right structure by inducting professionally acclaimed people :
Supervisory or advisory boards Independence vs knowledge
Past CEOs even on joining as independent directors think and act like management !
From across spectrum of background to bring in new perspective
Examples
L&T : 3 insiders vs 7 outsiders ITC : 4 insiders vs 9 outsiders Hughes : 1 insider vs 10 outsiders
Important issues related to BoD
Process makes perfect :
- Process of regularly reviewing, aligning and, if needed, adding and removing talent and expertise on its Board. - Individual accountability - Fluid portfolio of roles
A survey of 200 CEOs in 2001 serving as outside directors of public firms found :
1.
2.
63% of the boards they serve have never been subjected to performance evaluation. 42% of their own companies, where they are CEOs, have never done a board evaluation.
A Korn/Ferry study of board directors in 2001 found that :
1. 2. 67% of the boards regularly evaluate the CEOs. 42% assess the Board performance.
Examples
Once every three years, every Director on the British Airways Board is expected to submit a peer group review to the Chairman. Independent Director signs KRAs to be achieved. Pepsico Board spends one full day of each Board meeting to look in depth at the strategic challenges of each business unit. Home Depot Board members are expected to visit 8 stores outside their home states between each board meeting.
Murugappa group Each Director mentors few managers out of the list of 100 fast track managers. Annual reviews Infosys and Dr Reddys Lab
Important issues related to BoD
Culture :
Culture of openness Culture of open dissent Culture of trust and candour Intellectually stimulating Training
Some examples:
Groupthink ????? In Enron, Rebecca Mark and Clifford Baxter resigned as they were not comfortable with the paths the Company had taken. Walter Hewlett was the lone dissenter in the merger of HP with Compaq. At Tyco no body questioned the millions od dollar lent to the CEO. Medtronic pharma company lone dissenter convinced the Co not to get out of angioplasty business.
ICICI Bank Middle level managers make presentatiion to the Board
Some of the most exciting times that I have had as an independent director have been on the Board S Ganguly, one of the former ICICI Bank Directors.
Independent Directors
Clarion call for independent Directors Expected to participate actively in audit committees Part of non statutory advisory or superevisory Board Proposed amendments seek to expand the scope of their responsibilities.
Eg, they have to periodically review legal compliance reports prepared by the Company and the steps taken to cure any taint. For NASDAQ/NYSE listed companies, every director of a audit committee is expected to be independent.
Examples:
Supervisory Boards :
no restriction on payment (BoD members are paid sitting fee of Rs 5000.00 per Board meeting and the Board shares upto 1% of the profit). Utilise their expertise better.
Eg, Orchid Chemicals has a scientific advisory Board.
Please go through the handout detailing Maricos BoD. Harsh Mariwala reconstituted his Board in mid 2002. He put the structure ahead of Directors. Marico identified four critical areas where Directors could contribute and spent close to 7 months in finalising the Board. FMCG strategy Entrepreneurial wisdom Technology finance
Can you identify who fits in which slot ?
BoDs role : from active to passive
Corporate governance and public enterprises
Public Sector Enterprise:
Monopoly environment for 40 years. Protected from vissitudes of market. State is the biggest shareholder. Board is beset by :
Political interference Political appointees Low expectation of performance General apathy
Is there a lack of understanding of the role that Board could play in public enterprises ?
What are some progressive Boards saying about their roles ?
ONGC: 1. Visioning 2. Strategising 3. Promote business 4. Ensure long-term growth 5. Add value in large investment decisions 6. Technology upgradation 7. Encourage creativity 8. Value-based business
Question : Can you tell us Board composition at ONGC ?
Question : How Board has helped in guiding ONGC in market driven economy.
Answer : Can you tell us ?
Transformational vs Transactional leadership
motivate performance through empowerment vs Management through command & control.
Transformational Board : creating and sustaining an environment that delivers.
Please go through the BBC report on US 64 debacle.
Do you notice that this is a extremely apt case of corporate misgovernance.
Whistleblower
What should you (a Director) do if a whistle-blower comes to you with allegations that the company, or one or more of its officers, is cooking the books or misbehaving in some other way?
Whistleblower
- Worldcom inflated its income figures since 1999 by as much as $9bn Dy Vice President of Internal Audit dept acted as the whistleblower - At Enron, Sharron Watkins of Internal Audit had raised major questions about financial irregularities.
(check out whistleblower.org. The Government Accountability Projects mission is to protect the public interest by promoting government and corporate accountability through advancing occupational free speech and ethical conduct, defending whistleblowers, and empowering citizen activists.)
We will now discuss 10 recommendations categorized into three broad areas of responsibility for improving the effectiveness of corporate governance practices in Public Enterprises: 1. stewardship of the corporation; 2. working with management; 3. and the functioning of the board.
Stewardship of Corporation
1. Board Responsibility
(i) approve the strategic direction and the corporate plan for the corporation; (ii) ensure that the principal risks of the corporations business have been identified and that appropriate systems to manage these risks have been implemented; (generally all PSUs have commercial and
public policy objectives)
(iii) approve managements succession plan including appointing, training and monitoring senior management; and (iv) ensure that the corporations information systems and management practices meet its needs and give the board confidence in the integrity of information produced.
2. Public Policy Objectives
(i) document the current public policy objectives of the corporation; (ii) appreciate the contemporary trade-offs between the often competing public policy and commercial objectives of the corporation; and (iii) assess the relevance of the corporations mandate, and, if appropriate, propose changes for the consideration of the appropriate ministry
3. Communications
The board of directors of every corporation should ensure that the corporation communicates effectively, with the Government, other stakeholders and the public. Communication responsibilities Reporting responsibilities
Working with Management
4 Board and Management Relations
Allocating responsibility Building a Relationship Establishing Accountability
5 Board Independence
The Rolesof the Chair and the CEO Meeting as a Board Public servants as Directors The use of committees Independent Advice Conflict of interest
6. The Position of the CEO
Assessing the CEOs position Evaluating the CEOs performance
Functioning of the Board
7. Renewal of the Board
Assessing the Board Renewal of the Board
8. Education of Directors
New Directors Ongoing education
9. Compensation
10. Responsibility for Corporate Governance
Business Ethics
Imagine that you are the ruler of the world. You have total power over everything on the planet. You are faced with the following dilemma:
1. You can almost completely remove hunger from the face of the planet. Unfortunately, to do so will involve you killing one million people. The reason for this is not clear you just have to andthere is no way out.
You can reduce hunger in the world by 20% from its current level. This is still clearly a desirable outcome. Again though, there is a downside. In this case you have to kill one hundred people You can leave things as they are. There is no trade off whatsoever in this case.
2.
3.
What do you do ? There are some more rules to be noted : 1. 2. Whichever decision you make, you will not kill yourself. The people you kill will all be complete strangers to you.
Did you go for Classic Compromise ?
Ethics = doing the right thing.
In truth though, there is no perfect set of ethical rules.
Two broad school of thoughts :
Teleological : Ends justify the means. Deontological : Is bothered about the means, and not just the end.
Ethics : Concerned with how individual should behave. What is right and what is wrong? Values : These are the core beliefs or desires that guide or motivate attitudes and actions. These are form early in life. They come from parents, friends, school, culture, society. Morals : Of or concerned with the judgment of the goodness or badness of human action and character
Ethical Relativitism
Ethical Relativitism
Circumstances alter cases. Everyday standards are good, but exceptions are also right and good. The judgment of good or bad is based upon the result or consequence of the act rather than the act itself. An action is right if it tends to produce the greatest good for the greatest number. Ethical relativism claim s that when two individuals or two cultures disagree on their moral views of an act, both can be right.
Business ethics : A very new old subject.
There neither is a separate ethics of business, nor is one need. For men and women do not acquire exemption from ordinary rules of personal behavior because of their work or job. Nor, however, they cease to be human beings when appointed vice-president, city manager or college dean. Peter Drucker
Corporate management would like to have a clear cut conceptualisation of business ethics so that corporate policies and programs are formulated and implemented in a way that endears business to the society at large.
Business ethics make business sense:
Ethical positioning could be your differentiator in the market. (eg Bodyshop, Shahnaz Hussain) Reduce the demand for consumerism. (eg Mclibel case of Mcdonalds) Cooperation with govt. agencies, non profit organizations, consumer groups.
Business ethics : the set/system of principles and rules of conduct applied to business.
The Electronics Company
Please read the case study.
The problem of line
A belief that the activity is within reasonable ethical and legal limits. A conviction that the activity should be done because it is in the best interest of the individual or corporation. A view that activity is safe because it will never be found out. A view that because the activity helps the company the company will support it and even protect the person who engages in it. Mass Irresponsibility
The Libby Case
Please read the case provided.
Its legal so it is OK
Morality is broader than legality. The view that laws and not morals should restrict business practice fails to recognize:
It is illegal as it is immoral !!! If morals are not policed by industry, then when laws do come along they are much mor tougher.
Business ethics has come to represent a set of fundamental beliefs about business such as : a. Employees do their best in a good work place. b. Companies do their best in healthy communities with a good quality of life. c. Companies achieve more if they respect the environment and conserve resources.
Business ethics has come to represent a set of fundamental beliefs about business such as :
d. Companies must take a long term view of their operations. e. A companys reputation will become as important as profits in the years to come. f. There is no reason why, as between various stakeholders, the interests of shareholders should prevail unconditionally over others interests.
The Ford Pinto
Please go through the case study.
Remember :
1. The car did not break any law. 2. By producing the car, Ford kept many people in work. The death of a few people was a small price to pay. Many other Americans lost their lives in car accidents during this time. It is best to benefit the majority.
Analysis:
Why ? Groupthink !!!! (This concept argues that a group of people will tend to focus on one objective and go along with the rest of the group in search of this goal, even though the gol or the means should have been questioned. Go with the flow)
Financial aspects of Corporate Governance
Financial ethics:
Creative accounting = cook the book. Insider dealing Leveraged buyout
Some ways of creative accounting :
1. Charging of private expenses to the firms accounts in an attemp to reduce the individuals tax liability.
(such allegation ultimately led to sacking of Sunil Alagh from the top position at Britannia)
Inaccurate stating of stock levels to increase or reduce profits Booking orders at quarter end/year end to boost revenue Smooth out performance of the company by holding back sales in certain periods. Manipulation of fixed assets
Changing the depreciation method from year to year. Qualification for bad debts. Cash. Stocks. Treatment of extraordinary items Off balance sheet accounting
Why is creative accounting so common ?
Pressure to produce results which look good. Market expectation. Short term outlook of investor.
Creative accounting is a short term approach to paste over the crack until long term and legitimate solutions can be found.
Some examples of selective display :
Tata Steel : Net profit is up 651%. This is not due to operational efficiences but instead a rise in steel prices from a 20 month low in Sept 2002. Grasim : Net profit grew 55%. This is due to gains on exceptional items rather than an increase in net sales which were up by mere Rs 4 crore. L&T : Operating income down by 14%; net profit up 5%. This is due to a 41% fall in interest payments from Rs 90.1 crore to Rs 53.4 crore. Bajaj Auto : Gross profit is up 50% over the last quarter but net profit is down by 8.21%
Some examples of selective display :
BPCL : Net profit grew by 78.4 %. This is due to a gain of Rs 9.2 crore on deferred taxes against a tax outgo of Rs 31.8 crore in quarter ended sept 2002. ONGC : A higher other income of of Rs 630 crore and lower interest payments of Rs 7.20 crore account for almost half of net profit increase in Sept 2002.
Insider dealing : This occurs when an individual with inside information about a company uses their particular knowledge to gain on the stock market. Refer to Tata Finance case.
Insider trading : HLL vs Tata Finance
HLL : Hindustan Lever which when charged with insider trading by the stock market regulator, could demonstrate adherence to elaborate compliance rules by the directors TFL : Tatas have no reporting requirements regarding individual trading operations. One of the Directors was asked to step down due to charges of insider trading, but the role of other Tata directors on the board of Tata Finance is also open to question.
Leveraged buyout :
Rogue trader : Nick Leeson
Analysis:
Star trader was given too much freedom. Lack of segregation og Leesons duties, so he could cover his tracks well. Lack of supervsision. No body questioned the extraordinary profit that he was making.
We can similarly discuss many more aspects of business ethics :
- marketing aspect - environment aspect - globalization aspect
Boeing sacked the CFO on Nov 24, 2003. His alleged misdeed : Negotiating to hire Air Force procurement officer Darleen A Druyun while she was in a position to influence the outcome of a defense dept contract to buy Boeing 767 tankers.Druyun, hired in Jan 2003, after leaving the Air Force job in Nov 2002, also lost her job.
CEO Philip M Condit said Boeing must and will live by the highest standards of ethical conduct.
Enron
Please go through the writeup on Enron.
Enron :
The deadly combination of : - bad business strategy, - bad investments and - desperate attempts to use accounting tricks to hide bad decisions
led Enron to free fall into the largest bankruptcy in American history.
What can Directors learn from whats happened at Enron ?
Directors should understand the operations and economics of their company, its strategy, and the key performance indicators that give them some idea of how the business is doing. Excellence in corporate governance is critical to the accountability and integrity of any company, and that requires knowledgeable, active, and independent board members. Outside board members need to be sure they dont have economic ties to the company or other possible conflicts of interest that might seem to compromise their independence.
What can Directors learn from whats happened at Enron ?
While directors should not micromanage or second-guess top management, they absolutely cannot shy away from their responsibility to ask the tough questions. And if, after asking those questions, directors are not comfortable with the answers they are getting, then they need to consider whether they should seek outside counsel and advice.
What red flags could Directors have checked out ?
Beware of all kinds of transactions between members of management and outside firms and affiliates, any one of which might provide an opportunity for self-dealing. Directors should consider whether there is a legitimate business reason for the company to enter into any such transaction. If necessary, get outside legal advice. (something similar happened at Tata Finance)
What red flags could Directors have checked out ?
Building off-balance-sheet financing, such as securing debt with leases and special-purpose entities, or SPEs. Investment bankers, lenders, auditors, and other outsiders often help put these kinds of deals together as a way to get around showing debt in the financial statements. It is often done in order to hide just how leveraged a company is. Directors have to request the CFO or treasurer to provide a quarterly summary of all debt, both on and off the balance sheet, along with information on where the cash will come from to service the debt .
What red flags could Directors have checked out ?
Directors should make sure that (1) the company has up-to-date written riskmanagement policies, procedures, and internal controls and that theyre in place; (2) the internal controls include sufficient safeguards, such as adequate segregation of duties, that prevent any one person in the company from executing improper transactions or doing improper accounting; (3) the company has established well-reasoned and supportable methodologies that consistently measure the fair values of derivatives and financial instruments. A board would be well advised to ask independent auditors or other experts to assess the companys policies and controls on this topic.
Learnings for the audit committee
Ask tough questions Insists on answers Ensure that each committee member is financially literate enough to understand the companys financial statements and disclosures. Provide training for all new inductees
Learnings for the audit committee
Ensure from both the CFO and the independent auditor if the accounting for transactions, as reported and disclosed in the financial statements, reflects the highest-quality accounting standard that could be used, and if not, why not. (eg, debt could be on or off balance sheet. Have any accounting policies changed ?) Insist on an annual statement from the CEO and CFO that the company has internal controls and that they are operating effectively.
Learnings for the audit committee
the audit committee and independent auditor have open lines of communication and a clear delineation that the auditor is working for the audit committee. ask the auditor to identify the most sensitive accounting and auditing issues and to describe the steps he is taking to test whether those transactions are properly accounted for and disclosed.
Role of Audit Firm
non-audit fees have approximated tens of millions of dollars, up to 20 times the amount paid for the actual audit. The big issue is whether any of these extra services impair an auditors independence. (remember the TFL case as well)
Role of Audit Firm
If the CEOs and CFOs play the numbers game and cook the books, and if the auditors dont stir the pot enough to figure out whats being cooked, and whether it is edible by investors and the markets, they will continue to repeat the mistakes that they did at Enron
