Chinks in corporate governance

The full story of Satyam is yet to emerge and if past corporate failures are anything to go by, it will take some time before it does. What is already clear is that it has raised many questions about corporate governance in India—the role of boards, of independent directors, of the auditors, of investors and of analysts. Many are suggesting that this is indicative of weak corporate governance standards in India and a failure to protect minority investors.

We should be cautious before we rush to conclusions about what needs to be done. On the other side of the world, the US is going through its own corporate governance crisis in the form of the Madoff scandal. Corporate governance in financial institutions in the US, the UK and continental Europe is coming under serious scrutiny. Countries with very different types of corporate governance systems, laws for protecting minority investors and different patterns of ownership of companies are facing similar crises of confidence.

Furthermore, this comes after an extensive tightening of corporate governance standards in the US in the face of the Enron and WorldCom scandals. The Sarbanes-Oxley Act was supposed to have plugged the loopholes in accounting and governance standards that previously existed. Many thought that it went too far and undermined the competitive position of the US.

The decline in foreign listings on the US stock exchanges was attributed to the unduly onerous regulatory standards that Sarbanes-Oxley imposed. Irrespective of whether this is correct, the legislation has not prevented major failures from occurring in financial institutions across the US.

The board of directors is frequently regarded as being central to good governance, and the role of the board has featured prominently in discussions about Satyam. The board is the body charged with having oversight of the operations of the firm and setting its strategy. The board should ensure that the company is upholding high standards of probity and conduct, and provide a probing analysis of the activities of management.

In particular, non-executive directors are supposed to give an independent assessment of the quality of management. But time and time again, failures of corporate governance suggest that they do not.

There are several reasons.

First, it is difficult to appoint truly independent directors. This is particularly hard to achieve in countries such as India where family ownership is widespread and there is a close-knit group of corporate leaders. Even in countries where family ownership is less prevalent, such as the UK, there are serious doubts about the independence of directors.

Further, it is unclear whether independence is a good thing. In terms of providing oversight of the activities of management it might be, but non-executive directors are supposed to perform an equally important function in guiding and advising management. They bring a degree of expertise from other companies, industries and countries that would not otherwise exist in the firm. In many cases, they are appointed to support rather than question and criticize management.

It is difficult for non-executive directors to perform a scrutiny objective at the best of times, but it is particularly difficult to do so when faced with a dominant chief executive who expects support not criticism from the company’s board. To some extent, the dominance of the chief executive can be moderated by appointing an independent chairman and ensuring a separation of functions between the two individuals.

Many countries have sought to separate the roles of chairman and CEO. However, it can inhibit firms from implementing effective strategies, especially in companies operating with new technologies, such as Indian information technology firms, that require visionary strategies. In any event, separation (sometimes with independent deputy chairmen as well as chairmen) has not prevented some of the most prominent failures of financial institutions over the past few months.

Can the role of the board be strengthened? The answer is yes. Tighter rules regarding the appointment and rotation of independent directors can be introduced. There can be rules relating to the credentials, experience and training of members of the board. The requirements on members of the board to provide oversight can be clarified.

Reporting by the independent members to external investors can be strengthened and attention can be given to the remuneration and incentives of non-executive as well as executive directors.

All of this is important. But will it solve the problem? The answer is almost certainly not. Many countries have played around with these rules to limited effect. Boards are a focus of much discussion about corporate governance, but they are not a solution. Effective corporate governance requires the direct involvement of investors, and attention is increasingly being focused on shareholder activism as an alternative to a reliance on boards.

source: www.livemint.com