Corporate Governance

Concept, Evolution and India Story

Praveen B. Malla

• Publisher: Taylor & Francis
• Year: 2013
• Print ISBN: 9781138662742
• eBook ISBN: 9781317810100
• Edition: 1
• Topic: Negocios y empresa
• Subtopic: Negocios en general

With the increasing awareness that mere economic and production-based explanations do not adequately describe the motivations for governance, researchers have focused on the behavioral side of the firm performance to justify the economic rationale of their typical behaviours. This book describes the concept of corporate governance, its emergence and the contemporary thinking around it.

With emphasis on "conflicts of interests" assumed to be related to the theory of separation of ownership and control, the book delves into topics such as insider trading, excessive executive compensation, managerial, expropriation of shareholders' wealth, false reporting, accounting non-disclosures and self dealing.

PART I

Introduction

Chapter 1

CORPORATION AND GOVERNANCE

Over the last decade and a half, corporate governance has become a central issue globally, Why? Modern-day business is beset with changing operating paradigms. With corporations growing larger and larger and the need for capital multiplying manifold, the need to enter foreign capital markets and access them for their capital requirements has given rise to new challenges in the governance of international business. The pre-transition era was justified by the need to protect domestic markets, but with corporations growing in gargantuan proportions, the need to open up domestic markets for the entry of foreign business became a necessity.

After the Second World War, when economies needed to be rebuilt the world over, increased cooperation amongst countries became indispensable for international movement of goods and services. Capital lying idle in some countries had to move out to lubricate the economies of other countries. This sowed the seeds for growing internationalization of business. Prior to this, protectionist regimes seldom allowed any foreign intruder into their national business scene. The growth of corporations that led to the demand for more and more capital, prodded the protectionist regimes to open up their economies and enable more foreign investment to flow into the domestic business. Control and command-based structures had to be done away with. Instead, a new form of governance structure, which was led by market-based economic systems primarily dominated by the private sector, had to be embraced. Now most governments the world over, are relinquishing State control over industry and the private sector is given incentives to accept the new challenges of globalization. This is evident from the transition efforts made by the East European and some Asian countries, including India, following the Russian reform process (perestroika) which was initiated by the change in leadership in the mid-1980s.¹

Economies with efficient economic policies and stable political systems are a big draw amongst the investors. Countries that have opened themselves to world markets and that have good legal systems in place providing protection to investors, have attracted more capital in the process of globalization. As the demand for capital is growing in both the developed and the developing economies, the need for establishing good governance practices has gained momentum. Thus, corporate governance has become a pressing problem.

Despite the established checks and balances that protect shareholders, many a business has collapsed in the face of governance and investor confidence has been shattered. Some prominent scandals that have heated up the corporate governance discussion are Barings Bank, Enron, Adelphia, Tyco, and Parmalat. Closer home LIC-Mundhra scam as far back as in 1957, Home Trade, Ketan Parekh scandal, Securities Scam of 1992, C R Bhansali scam, debt default by Jindal Group, MESCO scam, or even as simple a governance let-down as Bombay Dyeing's failure to prevent ‘creeping’ acquisition of its shares by Arun Bajoria, have all lent voice against the growing corporate misdemeanors and a need to harness them.

Since this book's main purpose is to introduce you to the concept of corporate governance, it is imperative to take you through a chronological understanding of the subject. It is important to understand each of the words in corporate governance individually, and as we progress through the chapters, you will be exposed to a variety of terms that are woven around this concept.

CORPORATION

Origin of the Corporation

There are different versions of the exact period of the birth of the corporation. During the early Middle Age, corporations existed in the form of universities and ecclesiastical orders and were barred from making profits. While some authors believe that the early Middle Ages was the harbinger of the modern corporate form, others argue that since corporations during this period existed only to serve the society and also since economic motive that is so very ingrained in the corporation as we see today was absent, Middle Ages was certainly not the forerunner of today's corporate form.

Business history studies have been few and far between; that leaves us with scant literature to trace the exact origins of today's corporations. However, most business historians concur that not until the East India Company received a charter from Queen Elizabeth in 1600 AD to commence its trading business, was the real corporation born. Chartered corporations were semi- or quasi-governmental institutions that remained in business as long as they enjoyed the confidence of the crown. A charter was accorded to corporations by the crown with a specific purpose, especially that of bringing together individual investors in financing large-scale projects.

Prior to the formation of the East India Company, a few enterprising individuals engaged independently in trading. They would buy tea, raw silk and spices from India and sell them at a profit in their home countries. These individual traders owned their ships and deployed them in their trading business. But as business grew bigger and bigger, the need to raise more capital to shore up shipping vessels for transportation grew, necessitating individual traders to come together and form a syndicate.

A closer look at the operations of the East India Company suggests that it was truly the predecessor of the modern corporate form. It had its corporate headquarters in London at East India House which monitored its global operations in continents as diverse as Asia, Europe and North America. The Committee of Correspondence, the highest executive body within the company, headed by the Examiner of Correspondence was responsible for all the issues pertaining to policies and strategies. The day-to-day operations of the company were run by the Examiner's office along with the Corporate Secretary amongst other important functionaries.

Shareholders held quarterly meetings and one-fourth of the total number of directors were elected annually by them. Directors enjoyed a four-year term with the company and had the opportunity to rejoin the committee of directors after a one-year break.

Control was exercised by the head office at London over its territorial offices through the examination of the annual financial reports and intelligent analysis of such reports. The East India House put reporting structures and procedures in place and insisted on strict adherence to established norms. Thus in more ways than one, East India Company bears strong resemblance to today's advanced corporations. Hence, one is given to believe that the roots of the modern-day corporation lie in the incipience of the East India Company.

What is a Corporation?

Since this book focuses on corporate governance, it is important for one to understand the meaning of corporation. Throughout the book we will be discussing concepts related to the governance of corporations.

Not all forms of business organization are called corporations. Sole proprietorship, partnership and company are the best known and most widely discussed forms of businesses.

Sole Proprietorship

What comes to your mind when you see a beauty parlor, a small-sized eatery, a grocery shop or a medical shop? Most such small business ventures are funded and managed by individuals and hence the term ‘sole proprietorship.’

You will observe that most businesses around you are sole proprietorships. Why? That is mainly because of the ease in obtaining a license and minimum capital requirement to set up such sole proprietorship businesses.

Sole proprietorship businesses exist as long as the business enjoys sustainable patronage and does not need huge funding requirements. Since the equity capital of this form of business is largely limited to the personal wealth of the proprietor, sole proprietorships usually tend to remain small in size.

The best thing about sole proprietorship is that business decisions can be taken at will and are subject to the business acumen of the proprietor. Nimbleness and speed are permanent features of this form of business. Should the proprietor wish to introduce a new product line or, say, serve a new market, she can do so in a jiffy. All business decisions are subject to the volition of the proprietor. There are no shareholders to convince.

Personal income and business income are one and the same in sole proprietorships. The biggest limitation of such a form of business is that it cannot grow beyond a certain point, unless the owner is enormously wealthy and is desirous of expanding his/her scope of operations.

Partnership: When two or more than two people come together to own and manage a business entity, it is called partnership. Each partner contributes towards the total capital of the business organization. Also, each partner may bring in a unique skill or expertise to the partnership firm.

Is there a decent-sized restaurant near your residence? Go and enquire whether it is a sole proprietorship or a partnership firm. If it is a partnership firm, probe further and find out which partner brought what to the table. Partner A could have met 80% of the capital requirements, Partner B could have provided for real estate and Partner C a wealth of expertise in running restaurant operations. There could be various other forms and levels of contribution to the partnership.

Unlike sole proprietorships, partnership firms are legal entities. To set up a partnership firm, a partnership deed that details out the capital contributions, shares, rights, duties and obligations of the partners has to be executed.² Partners, as specified by the executed deed, reap the rewards of the business and also assume any resultant liabilities.

Corporation: Most medium- and large-sized businesses are organized as corporations. General Electric, Microsoft, Oracle, IBM are all examples of large corporations. In India, Reliance Industries, Bharti Enterprises, Hero Group, Wipro, TCS are examples of large private sector corporations, while Oil and Natural Gas Corporation, Bharat Petroleum, SAIL are examples of large public sector corporations. Corporations are owned by a diverse group of owners more popularly known as shareholders.

Corporations can be of many types, namely, for-profit, not-for-profit, closely held, public companies. Closely held companies are those that are owned by a small group of investors who do not trade in the shares of the company. Usually, during the initial stages of incorporation, companies are funded by a handful of investors. These investors may either manage the company on their own or entrust the management to professional managers. The company is not listed in the stock market and hence does not invite retail participation. Since the closely held company has the backing of a few individual investors, social consciousness is far stronger than in any other form of business organization. Owners and employees are one big family and during hard times, owners find it difficult to lay off their employees. Market expectations of a closely held company are nil and hence business decisions are not dictated by myopic needs. Business decisions are taken based on the collective acumen of the investors. Most closely held companies grow big, make themselves attractive to external investing entities like institutional or retail investors and list themselves in stock exchanges to raise additional capital.

You must have heard of the term Initial Public Offer, more popularly known as IPO. Meet a stock broker or a sub-broker near your place. Ask him what an IPO means and discuss with him the merits and demerits of IPO.

Most widely known corporations today are public companies. Public companies are characterized by diverse ownership groups such as promoters, institutional investors, foreign shareholders, corporations, retail shareholders. Such companies are listed entities and their shares are traded in the stock markets. Ownership is easily transferable and shares keep changing hands with every trade. Public companies are always at the mercy of the markets and their value appreciates or depreciates based on the market sentiments on a given trading day. Investors have a limited exposure to risk but enjoy substantial benefits should the stock of the company rise. A major advantage of being a public company is that it has more working capital at its disposal than any other form of organization.

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Table of contents

• Cover Page
• Half Title page
• Title Page
• Copyright Page
• Dedication
• Contents
• Preface
• Acknowledgements
• List of Abbreviations
• Part I Introduction
• Part II Governance: Four Important Players
• Part III Corporate Governance: Four Models
• Part IV Miscellaneous
• Part V Corporate Governance in India
• References and Bibliography
• Index