Speeches

Corporate Governance - A Road Map to Achieve Corporate Excellence

I am honoured to have been invited to deliver the Annual Oration on “Corporate Governance – A Road Map to Achieve Corporate & \”. I am conscious of the fact that I owe this honour to the magnanimity of my greatest mentor and inspiration – one of world’s finest legal brains and the most admirable human being - His Lordship Justice Venkatchaliah. Sir, my deepest gratitude to you for bestowing the honour.

The Institute of Chartered Accountants of India is a repository of India’s most exquisite financial gemstones, and therefore, there is nothing more daunting than to speak to such a distinguished audience as yourselves.

I compliment the Institute for the choice of the topic. Role of Corporate Governance has never been more vital. It is not just because of Enron or the UTI. The debate about corporate governance is taking place all over the world. During the past one month I have visited UK, US, Germany, Netherlands, Italy, Canada, Russia and the Middle East. Corporates and governments everywhere are seized with this topic and hoping this will help them attract foreign investment. In fact the issue of Corporate Governance is much more important than simply getting international investment. The need and demand for high standards of governance, ethics and environmental and social responsibility are the key aspects of globalization debate. They do not affect just the big business or institutions concerned with financial investment. They concern all of us. The Issues of transparency, accountability, equity, integrity, probity, responsibility and sustainability are instruments of not only ‘corporates excellence’ but also ‘professional excellence’. Hence, I shall be taking both the issues together.

In India we have often been blamed for having a myopic view. We believe that high profile failures are a part of only India’s system. But as you all know the amount of shareholder’s wealth that Enron succeeded in destroying is far more than the loss due to any single scam in India. When the US President uses a “State of the Nation” address to speak about accounting standards, as he did last week, the issue has got to be on top of the national agenda. Even the UK, which already has conducted half a dozen reviews on this subject, its Secretary of State announced further review of how the Boards are constituted and how they ought to operate.

I have been fortunate in being involved in a conference on Corporate Governance which World Council For Corporate Governance in association with IOD in India and the Centre for Corporate Governance organized soon after ENRONITIS, a couple of months ago under the guidance of Justice M N Venkatchaliah. We had the benefit of some of the best legal brains of the country such as Justice A M Ahmadi, P Chidambaram, Padmabhushan K K Venugopal, Kapil Sibal and Dr A M Singhvi. It came out with some very significant recommendations that can have far reaching impact on corporate governance developments worldwide.

The conference participants felt Corporations must recognize that globalization offers them both the strength and opportunity to usher in a just and conflict free world for their own security, survival and sustainability. The scope of Corporate Governance should be enlarged to encompass Good Governance in all its aspects taking cognizance of the political, administrative, economic, social and judicial environment in which they function. Board of Directors ought to balance the interests of capital providers with those of other stakeholders and aim for a long term and sustained business success. Good Corporate Governance ought to create value for all stakeholders including society at large. It was also felt that there is a need for stricter internal audit controls to ensure that debacles such as that of ENRON do not recur. There needs to be greater scrutiny of the role of Chairman & CEO by the Board of Directors. The role of Chairman and CEO must be separated. There should be clear separation of the Audit and consultancy function. These should not be done by the same organisation. There is a need for economic costs to reflect full ecological costs. Accounting practices need to ensure that environmental costs are properly internalized with business. Corporate Governance ought to cover disclosures on Environmental and Social responsibility. Sustainability ought to be the end game of business. No business activity is undertaken or permitted that jeopardizes the ability of future generations to meet their own needs.

The ‘role of non-financial capital’ such as ‘human capital’, ‘social capital’ and ‘cultural capital’ was particularly emphasized. It was felt that there needs to be a greater recognition of the importance of ‘intellectual and reputational capital’ and the tectonic shift in public values with the onset of knowledge economy.

A primary goal of good corporate governance ought to be to foster a culture of creativity, innovation and entrepreneurship to protect the business from irrelevance and obsolescence. It should aim to leverage the intellectual capital to serve the unarticulated customers and untapped markets.

To strengthen Boards of Directors and in order to induct people of eminence and ability into the Boards to discharge the functions as watch dog of other stakeholders’ interests on Audit Committee, on Remuneration Committee etc., these people should be insulated from the failings of the day – to - day management. Non-Executive Directors should be freed from accountability for failures such as a cheque bouncing or a pollution device failing. Amendments in the laws and Rules & Regulations in this regard should be made.

It is unpractical and unethical to hold non-executive Directorship or Directorship in ten and more companies. The rules for Directorships need to be amended so that the number of non-executive directorship a person can hold is less then ten.

It is vital that a Minimal Training Programme should be designed and administered for all Directors, both Executive and Non-executive, covering key aspects of good corporate governance and directorial responsibilities - statutory, environmental and social. There should be a compulsory induction programme for institutional nominees.

The most important aspect in Corporate Governance is the effectiveness of the boards. Cadbury Report was emphatic about the quality of the Board. It says,

“The country’s economy depends on the drive and efficiency of its companies. Thus the effectiveness with which their boards discharge their responsibilities determines Britain’s competitive position. They must be free to drive their companies forward, but exercise that freedom within a framework of effective accountability. This is the essence of any system of good corporate governance”.

In the UK, the Company Boards are a mix of ‘executive directors’, ‘non-executive directors’ and 'independent directors’. The difference between the latter two is that both are non-executives but the independent directors have, or represent, no financial stake in the business.

I will refer to both categories of non-executives as the "independents" for the rest of my talk for convenience. The distinction between the executive directors and the independents is two-fold: firstly the former are employed, normally on a full-time basis, to run the business, whereas the independent directors aren't; and secondly the independents get paid very much less. In a big company it’s typically about 10% of what their executive colleagues get. As far as the law is concerned, as far the Stock Exchange is concerned, they are all simply ‘directors'. They carry equal responsibility for the business, they have the same fiduciary responsibilities, carry the same obligations, and face the same personal liability.

The UK system ensures that the independent directors are closer to the action; they are present when the key decisions are made; they help shape strategy; they are able to question the top executives directly; and they can observe how well the latter function as a team.

Independent directors have certain specific roles. They invariably chair, and usually dominate, two key committees: audit and risk, and remuneration.

One characteristic you will find in almost every business that has gone off-track is the dominance of the board by a single overbearing individual. Chairing the Board and heading-up the management team are also different roles, usually calling for quite different capabilities. Therefore, the Combined Code of good governance in the UK requires the Chairman's role to be separate from that of the Chief Executive. I think that is a wholly appropriate distinction.

Aside from the structure of the Board, another aspect of good governance is the fullness and quality of its reporting. The reporting requirements for companies are, of course, both specific and in some ways quite onerous-designed to inform the world, and especially the shareholders, exactly where the company stands and how it is performing. These are even more demanding if the company is listed on the Stock Exchange.

To ensure full and accurate reporting the company is, of course, required to have its accounts audited. This adds to the pressure on the Directors rather than alleviates them. As Andersen has recently been at pains to point out, it is the Board that signs off the accounts and issues the annual report, not the auditors.

UK’s system of Corporate Governance has been progressively developed over the years, and in the last 10 years subject to a series of reviews. Cadbury, Greenbury, Hampel, the Combined Code, Turnbull and now the Myners Review. In 1998 London Stock Exchange published “The principles of Good Governance and Code of Best Practice, commonly called “the Combined Code” following consultations on the final report of the Hampel Committee published the previous January. The Hampel Committee was established in November 1995 to review the Cadbury and Greenbury Committee reports. The combined Code requires listed companies to report compliance with the following provision:

• The board must meet regularly.
• The board should have a formal schedule of matters specifically reserved to it for decision.
• There should be a procedure agreed by the board for directors in the furtherance of their duties to take independent professional advice if necessary, at the company’s expense.
• All directors should have access to the advice and services of the company secretary, who is responsible to the board for ensuring that board procedures are followed and that applicable rules and regulations are complied with. Any question of the removal of the company secretary should be a matter for the board as a whole.
• All directors should bring an independent judgement to bear on issues of strategy, performance, resources (including key appointments) and standards of conduct.
• Every director should receive appropriate training on the first occasion that he or she is appointed to the board of a listed company, and subsequently as necessary.

These issues have been dealt with in India on similar lines in Kumar Mangalam Birla’s Report which has been adopted as SEBI Guidelines. The Centre for Corporate Governance has published its own Guidelines which cover environmental reporting in addition to financial reporting. All this sounds solid. So, where is the real problem?

The issue essentially comes down to the quality of the Board, how well it is chaired, the choice of directors and how far they understand their role and how well they are able to discharge it effectively. It also depends, on how far and how well the shareholders, principally in the form of the large institutional investors, play their part.

The key role of the independents is to ensure that the Board functions well. They are not there to manage the business, but to ensure that the business is well managed.

A prerequisite for this is to get the right people on the board and train them. I know what directors feel about training. They all think they know what needs to be known. But independent directors are different. They know little about the company. Their value lies in the diversity of their viewpoint. But, they must know how it should be put across effectively. It needs special skills. It is a tragedy that we have little training on one of our most important need of communication.

There is a general belief that director appointments are all incestuous, with the directors of the big companies sitting on each others boards. Too many directors are still chosen for their name, or reputation, rather than for what they bring to the Board. I would recommend that directors are recruited through independent search firms, rather than through personal contacts.

In trying to recruit directors we ought to cast the net much more widely. Greatest value accrues from people from different disciplines, academic backgrounds, social strata, ethnic and religious beliefs, age and gender. I would look to professional bodies such as yours, apart from the business, the public sector and for all but the biggest organisations to top-level executives who are one step below board level in larger organisations.

I would also like to see far more done to education and development of directors. Here the Centre for Corporate Governance, which the World Council For Corporate Governance has helped establish with the Institute of Directors in India, has developed a 12 Module programme especially over 40 hours, which we believe should be the best for any corporate director.

Being an independent director is not as cushy as just turning up for a meeting each month, stay in 5 Star Hotels, dine at the best restaurant and collect your cheque at the end, as many imagine it to be. You need time to read valuable paper work that is prepared for each meeting and be available for consultation when things go wrong specially when a company starts projecting badly. You would not envy the job of the directors of ENRON today.

In the wake of Enron a number of ideas have been suggested, some new, some old, for improving corporate governance, both in UK and in the United States. Some are worth exploring.

The Myners review has focused on the role of the institutional investors, and suggested that an annual meeting with the independent directors would be a useful additional insight into the business.

It has also been recommeded that auditors should not be allowed to sell consultancy services to the same client, or perhaps that the former should not offer other services at all. This is also a point that the 2nd ICCG held in Mumbai in January 2002 has adopted.

It is also important that companies should spell out their risks in more details in the annual report. Here we would need to strike a balance and be very cautious. Many of those risks are a matter of commercial confidentiality and you may not like to share these with your competitors. You have to, therefore communicate your concerns effectively to your shareholders.

On the subject of pay, it has already been suggested that the remuneration policy should be explained and put to the shareholders each year.

As the Enron debacle indicates, a good corporate governance code is no guarantee of good corporate governance. There needs to be stricter monitoring and enforcement of laws on punishment for corporate scams to ensure that those who violate the public trust do not go scot-free. Along with a requirement of disclosures and accountability, laws should be amended to mete out swift and deterrent punishment to the offenders. Here one would endorse George Bush’s message in his “State of the Nation” address:

“Executives who profit from false financial statements may be required to repay bonuses or other pay if accounts are subsequently restated as a result of misconduct. Executives who abuse their position may be disqualified from holding future corporate roles”.

The cases such as Enron and many others are not just breach of codes but violations of the law. In which case, one would like to see vigorous prosecution pursued, but let’s not assume that it is the law alone which is going to bring about the high standard of governance we seek. Good governance, is not simply a matter of structures and procedures: The last thing one wants is a ‘tick in the box’ attitude to the whole subject. It depends on the ethics of the people overseeing and running the enterprise. On having a fundamental sense of what is right and what is wrong, a belief in their honesty for its own sake and a sense of personal responsibility.

Role of Ethics

Ethics tend to be something that pervades our organisation’s total culture. You don’t get unethical boards running ethical companies, or vice versa. However, barring a few villains, the question of ethics is not always straightforward. Situations are not black and white, they’re usually grey. The ethical dimension is not always apparent; or if it is, there are conflicting sides to the argument: not in terms of whether to make the right ethical decision or not, but what is the right ethical decision.

Good Governance is not simply about corporate excellence. It’s the key to economic and social transformation. The corporations of today are no longer sheer economic entities. These are the engines of economic and social transformation. Kenichi Ohmae argued in ‘The Borderless World: Power and Strategy in the Interlinked Economy’ that:

“A Corporation is a social institution whose responsibilities extend far beyond the well being of its equity owners to giving security and a good life to its employees, dealers, customers, vendors, and subcontractors. Their whole life hinges on the wellbeing of the corporation.”

Corporations are the powerhouses that generate employment, provide education and health care, and give sustenance to the society. Globalization has given multinationals overwhelming power at the expenses of democratically elected governments. Good governance needs to ensure that the corporations take in to account the interests of all constituencies in which they operate. A business entreprise’s corporate actions must be compatible with long term societal needs such as the quality of environment and welfare of local community. It has been increasingly demonstrated that the ultimate competitiveness and corporate success is dependent as much on investors, employees, customers, creditors and suppliers as on shareholders.

Morphing of industrial economy into knowledge economy has created a tectonic shift in public values. Companies can ignore this shift only at their own peril. Public hostility faced by Shell, Nike, Reebok, Ikea and Monsanto should provide lessons to corporations who violate the social license and show lack of environmental responsibility. In today’s market, successful companies will be those that recognize they have responsibilities to the society, the community and the planet that go beyond compliance with law. In a study carried out by Wheeler and Seelampaa quoted in their book called “The Stakeholder Corporation: A Blue print for Maximizing Stakeholders Values (1997)”, they asserted that during most of the 20th century in the UK and USA, stakeholder inclusive enterprises fared better than “shareholders – first” companies. Stakeholder inclusive corporations invariably lead to better long term business performance.

Harnessing the full potential of knowledge economy requires understanding of how knowledge works. Sharing of capital or physical assets does not increase the total value to society. Sharing of knowledge, on the other hand, adds value to both sides. Knowledge behaves entirely differently from capital. Capital consists of tangible assets (buildings, plant, land etc.) that are limited and can be used for only one purpose. But knowledge is a fluid, intangible asset that can be transferred at little cost. Its value increases when shared. This insight explains why collaboration between the corporation and its stakeholders can be beneficial to both sides. The end result is not one plus one equals two, but much more.

Good governance of corporations is a source of competitive advantage and critical to economic and social progress. It not only attracts long term patient foreign capital but also helps to broaden and deepen local markets.

It must be remembered that the biggest brunt of poor Corporate Governance practices is borne by the poor. Corporate scams can set back social and economic gains by as much as a generation. Similarly good governance can have a transformational effect on the life of poor, especially in developing and transition economies. A healthy growth of competitive corporate governance is fundamental for sustained and shared growth – sustained in the sense that it withstands the shocks of market volatility; shared in the sense that it delivers benefits to all of society. Poverty persists because the gains of growth are not equitably distributed.

There are many definitions of Corporate Governance. The classical view is that its main purpose is to define relationship between those who own the capital and those who control it. This is a narrow definition. The end purpose of Corporate Governance must be to maximize company’s value. Unfortunately for far too long this value has been determined only by the financial value. It has now been realized that the financial value depicts merely a small percentage of the total value. The value of human capital and natural capital is infinitely more than the value of financial capital. Admittedly there are problems in calculating the cost or value of human capital, cultural capital or natural capital. This by no means suggests we can ignore it. Specially now that we find that our progress is not being limited so much by the financial capital but the human and natural capital.

It has been estimated that the value of biological services flowing from natural capital is around $36 trillion annually. Capitalizing it on the basis of current return on capital gives a capitalized monetary value of world’s natural capital at about $500 trillion. Compared to this, the World’s gross product is only $39 trillions. Similarly the World Bank’s 1995 Wealth Index found the total value of human capital to be three times greater than all financial and manufactured capital reflected in global balance sheets. This is a conservative estimate as it counts only the market value of human employment, not uncompensated effort or cultural capital.

The true purpose of corporate governance is to maximize creation of company’s total value. The social and environmental issues, therefore, are equally important in any corporate governance debate. There is a need, therefore, for corporations to disclose their environmental & social performance.

Business has to take on the responsibility of upgrading the environment. Society will not gain if financial capital increases at the cost of natural capital. We have to create new production and distribution processes to reverse the loss of natural capital and eventually increase its supply. This will involve more than product design, more than marketing and competition. It will mean a fundamental redesign of business models, its roles and responsibilities.

We have to question how did we come to create an economic system which is so contrary to natures biological processes and is based primarily on extraction, depletion, waste and disposal. How did we create an economic system that confuses the capital liquidation with income? How is it that our pricing system tells us it is cheaper to destroy the earth than to conserve it? Is it normal to have an economic system that discounts the future and sells of the past? Wasting scarce natural resources to achieve immediate profits does not lead to value creation and wasting environment to achieve economic growth is neither economic nor growth.

Corporate governance framework has to be established on the simple proposition that all capital be valued. While it may be difficult to value a forest, a river, grassland or a mountain, it is wrong to give it no value at all. Ask how much will it cost to make a 700 year old tree or new atmosphere or a new culture? It is you who as professionals have to determine the methodology of replacement cost.

Today’s business faces multitude of challenges, increasing business pressure on all fronts, globalization, shorter product life cycles, internet, over capacity, complex regulations, currency volatility, value migration etc. Meeting these challenges will bring about economic discontinuities that are unprecedented in rate and scope, and would require highly innovative approaches. We have to leapfrog over existing technologies rather than incrementally improve them. Using Nicholas Negroponte’s expression for the times that we are living ”incrementalism is our worst enemy”. But innovation will bring tremendous resistance from vested interest. One only has to refer to Jim Utterback’s (An MIT Professor) case studies of pressures on electric companies brought by gas lighting companies in the 1880s, recorded in his book “Mastering the Dynamics of Innovation”. To understand how hard it is to resist change. This is the Board’s number one job in today’s economy which is driven by innovation.

Corporate Governance is concerned with empowering people, spurring and pursuing innovation and improving efficiency. It also addresses conflicts of interest which can impose burdens on the enterprise. Ensuring transparency and probity in corporate affairs can make a major contribution to improving business standards, public accountability and consequently increase its market capitalization.

We are on the threshold of a profound transformation. The gap between what can be imagined and what can be achieved could never have been smaller. The key constraint to achieving our ambitions is no larger the financial capital. It is the limitation of our own imagination and attitude. Our governance systems whether in public or corporate must foster innovation, nurture creativity and build trust, transparency and a sense of sharing. We must recognize that we are living today not in an economy of hands or heads but the economy of hearts. Our governance systems need to be recast in a way that they touch the hearts and not only the minds.

The greatest challenge facing the accountancy profession today is the determination of the true costs. Market economy cannot function effectively without internalizing costs of each input. Environment is a key input in the creation of wealth. Shattering of a huge ice shelf Larsen B weighing 500 million billion tonnes in Antarctica a few days ago is a sharp reminder of the cost of industrial activity on environment. Counting what is not easily countable is the greatest challenge of your profession. For globalization to succeed prices must tell the economic truth. Socialism collapsed because it concealed the economic truth. Capitalism will collapse if it does not allow prices to tell the ecological and social truth. Pursuit of good corporate governance framework therefore, has to take care of a triple bottom line approach i.e. it must look after profits, people and planet.