Chapter - 3 86 Regulatory Framework of Corporate Governance 3.1 Emergence of Corporate Governance: The seeds of modern corporate governance were sown by the Watergate scandal in the United States. Detailed investigations was conducted by the U.S. Regulatory and Legislative body. It was detected that the loopholes in the control mechanism paved way to several major corporations to make illegal political contributions and to bribe government officials. This necessitated the development of foreign and corrupt practice Act 1977. The act contained specific provisions related to establishment, maintenance and review of systems of internal control. In 1979, the Securities and Exchange Commission of the U.S.A’s proposals for mandatory reporting on internal financial controls came to be enforced. The year 1985 has witnessed a series of high profile business failures in U.S.A., the most notable one among them being the Savings and Loan collapse. Therefore, the Tread Way Commission was formed. The primary role of this commission was to identify the main causes of misrepresentations in financial reports and to recommend ways of reducing such misrepresentations. The Tread Way Report published in 1987, highlighted the need for a proper control environment, independent Audit committees and objective Internal Audit Function. It called for published reports on the effectiveness of internal control. In a way, it motivated the sponsoring organizations to come forward with an integrated set of internal control criteria to facilitate companies to improve their control systems. As a result the Committee of Sponsoring Organization (COSO) was born. In the year 1992, the committee produced a report that stipulated a control framework which has been endorsed and refined in the subsequent United Kingdom reports.
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Chapter - 3
86
Regulatory Framework of Corporate Governance
3.1 Emergence of Corporate Governance:
The seeds of modern corporate governance were sown by the Watergate scandal in the
United States. Detailed investigations was conducted by the U.S. Regulatory and
Legislative body. It was detected that the loopholes in the control mechanism paved way
to several major corporations to make illegal political contributions and to bribe
government officials. This necessitated the development of foreign and corrupt practice
Act 1977. The act contained specific provisions related to establishment, maintenance
and review of systems of internal control. In 1979, the Securities and Exchange
Commission of the U.S.A’s proposals for mandatory reporting on internal financial
controls came to be enforced. The year 1985 has witnessed a series of high profile
business failures in U.S.A., the most notable one among them being the Savings and
Loan collapse. Therefore, the Tread Way Commission was formed. The primary role of
this commission was to identify the main causes of misrepresentations in financial reports
and to recommend ways of reducing such misrepresentations.
The Tread Way Report published in 1987, highlighted the need for a proper control
environment, independent Audit committees and objective Internal Audit Function. It
called for published reports on the effectiveness of internal control. In a way, it
motivated the sponsoring organizations to come forward with an integrated set of internal
control criteria to facilitate companies to improve their control systems. As a result the
Committee of Sponsoring Organization (COSO) was born. In the year 1992, the
committee produced a report that stipulated a control framework which has been
endorsed and refined in the subsequent United Kingdom reports.
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The issue of corporate Governance became particularly significant in the context of
globalization because one special feature of the late 20th century / 21st century,
globalisation, is that in addition to the traditional three elements of the economy namely
physical capital in terms of plant and machinery, technology and labour, the volatile
elements of financial capital invested in the emerging markets and in the third world
countries is an important element of modern globalization and has become particularly
powerful. The significance and the impact of the volatility of the financial capital was
realized when in June 1997, the currency of South East Asian countries started melting
down in countries like Thailand, Indonesia and South korea. It was realized by the
world bank and all investors that it is not enough to have good corporate management but
one should have also good corporate governance because the investors want to be sure
that the decisions taken are ultimately in the interests of all stakeholders. Honesty is the
best policy is a fact that is being rediscovered.
3.2 Corporate Governance Reports across globe
1. Organization for Economic Co-operation and Development:
The Organization for Economic Co- operation and Development (OECD) in its principles
of good governance has identified requisite elements of good corporate governance. The
first requisite is that majority of directors should come from outside the company and
should not have business or personal ties with it. This would imply that shareholder
promoter directors should be in minority in the board. This requisite is not met in public
Sector and Banks where the reverse is true with outside directors being in minority. Even
in the private sector, barring a few professionally managed companies, this condition is
not met. The other conditions are that the board should protect the rights of shareholders
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including minority shareholders, provide timely and accurate disclosure of the company’s
financial performance and effectively monitored management.
2. Greenbury Committee:
Greenbury Committee was set up under the chairmanship of Sir Richard Green Bury in
July 1995. The committee, in its report recommended a code of best practice based on
the fundamental principles of accountability and transparency and linkage of rewards to
performance. The committee also gave recommendations related to Directors’
remuneration. It also recommended setting up of remuneration committee in each
company to solve remuneration related matters. Further, the above report focused on
some points like formation of a Board Remuneration Sub – Committee consisting of non-
executive Directors to settle the remuneration of their executive colleagues, reduction of
notice periods in Executive Service contracts to 12 months, improved disclosure of
directors’ remuneration in annual reports and access to the remuneration committee
chairman at annual general meetings for proper interaction. It also recommended that the
Directors need to delegate responsibility for determining executive remuneration to a
group of people with good knowledge of the company and the same group shall submit a
full report to the shareholders each year explaining the company’s approach regarding
executive remuneration and providing full disclosures of all elements in the remuneration
of individual directors.
3. Cadbury Committee:
It was set up under the chairmanship of Sir Adrain Cadbury in May 1992 by the
Financial Reporting council of London Stock Exchange and accounting profession
(United Kingdom). The committee submitted its report in December 1992 wherein it
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recommended guidelines for the Board of Directors. The Cadbury Code of Best Practices
had 19 recommendations. The guidelines specifically referred to the various components
of the boards as Non – Executive Directors, Executive Directors and Independent
Directors. The recommendations themselves were not mandatory, the companies listed on
London Stock Exchange were asked to explicitly state in their accounts whether or not
the code had been followed. The companies who did not comply were required to explain
the reasons for that. The committee recommended independent judgement for the non-
executive directors, division of responsibility, effective control over company affairs and
regular meetings of the Board of Directors. The majority of directors should be
independent directors because of their attitude of impartiality rewards other stakeholders.
4. The Hample Committee:
It was set up on Corporate Governance under the chairmanship of Sir Ronald Hample in
1998 in UK to review the impact of the Cadbury Code. Hample committee not only
focused on broad governance principles that emphasize on business performance but also
on the accountability of business towards large stakeholders. The committee suggested
that the companies should organize their own governance arrangements and disclose
them to shareholders. For example, if a company wishes to combine the roles of chairman
and Chief executive, it should do so and explain the decision to shareholders. The
committee issued a list of governance principles related to the role of directors, director
remuneration, role of shareholders accountability and audit committee. It also
acknowledged the fact that the importance of Corporate Governance lies in its
contributions both in terms of attaining business prosperity and ensuring accountability of
board.
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5. The Blue Ribbon Committee
The Blue Ribbon Committee was jointly sponsored by the New York Stock Exchange
(NYSE) and National Association of Security Dealers (NASD) for improving the
working of corporate audit committees. The Committee has given certain
recommendations specifically for the Audit Committees. The recommendations are:
1. The members of the Audit Committee should be independent directors and financial
literate.
2. External auditors being the representatives of shareholders should periodically
discuss the quality of company’s accounting principles in relation to General
Accepted Accounting Principles (GAAP) with the audit committees.
3. Statutory auditors should maintain their independence in discharging their
professional responsibilities, and
4. On an annual basis, the committee should review and discuss with the accountants
all significant relationships the accountants have with the corporation to determine
the accountants’ independence.
Blue Ribbon committee has also recommended that Audit committee should have a
formal written charter.
6. The Mevyn King Committee
The Mevyn King Committee was set up in 1994 in South Africa at the instance of the
Institute of Directors of South Africa with support from the South African Chamber of
Business and the Chartered Institute of Secretaries and Administrators. The King
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Committee’s terms of reference were much wider than those of the Cadbary Committee
as is evident from the following term of reference:
(1) To consider and make recommendations on a code of practice on the financial
aspects of corporate governance in South Africa.
(2) To recommend simpler reporting without sacrificing the quality of information.
(3) To lay down guidelines for ethical practices on business enterprises in South Africa.
(4) To keep in view the special circumstances in South Africa concerning entry of
disadvantaged communities into business.
The Committee has also given certain recommendations for improving the quality of the
governance of enterprises in South Africa. The recommendations are as follows:
(1) The Boards should be balanced between Executive and Non- Executive Directors
(2) Roles of Chairperson and Chief Executive Officer should be split and in the absence
of split there should be at least two non-executive directors
(3) The Director’s report should incorporate statements on their responsibilities in
respect of financial statements, accounting records, internal audit, adherence to the
code of corporate practice and conduct along with details of non- adherence
(4) Share-holders should properly use the meetings by asking questions on the accounts
for which form should be provided in the annual reports and
(5) Corporate should have effective internal audit committee with written terms of
reference from the board.
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Table no. 3.2 Committees across the globe
Year Name of the Committee Area/Aspects Covered
1992 Sir Adrian Cadbury Committee, UK Financial Aspects of Corporate
Governance
1994 Mervyn E. King’s Committee, South
Africa
Corporate Governance
1995 Green bury Committee, UK Independent Director’s Remuneration
1998 Hampel committee, UK Combined Code of Best Practices
1999 Blue Ribbon Committee , US Improving the Effectiveness of Corporate
Audit Committee
1999 OECD Principles of Corporate Governance
1999 CACG Principles for corporate Governance in
Common Wealth
2003 Derek Higgs Committee , UK Review of role of effectiveness of Non-
executive Directors
2003 ASX Corporate governance council,
Australia
Principles of Good Corporate governance
and Best Practice Recommendations
Source: Corporate Governance in Asia, R.K. Mishra and J.Kiranmai
3.3 Models of Corporate Governance:
In general, there are two corporate systems prevailing in the various countries to be
distinguished. They are as follows:
1. Continental
2. Anglo – Saxon model
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In the continental model (known as insider model), the interests of the management,
employees and banks are integrated. The stakeholders have a long term and intense
relationship with the company: mostly prevailing in continental European countries like
France, Germany and Italy which have relatively small equity markets and hence pay
little attention for protecting minority shareholder rights.
In the Anglo- Saxon model, the corporation is an extension of the shareholder. The
widely spread shareholding and the related conflict of interests between managers and
shareholders lead to the liberal and active market of corporate control. This model
followed in the English Speaking countries like India, U.S.A and U.K., is called as
“Outsider” model also.
From the above discussion, it is thus clear that no two countries share the same code of
corporate governance and every country formulates its own guidelines and principles of
corporate governance according to the environment prevailing in their respective regions
and the country.
Good Governance as Code of best corporate practices, ethics, a strong and responsible
Board of Directors – All these are prerequisites for survival and excellence in today’s
competitive world. These should hence be part of any organization ’s corporate strategy.
The march has already begun, the journey being long, good sense with necessary
commitment should bring about the desired rules and standards for better corporate
governance.
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3.4 Players in Corporate Governance:
Corporate Governance comprises of many players such as Board of Directors, Non-
Executive Directors, Institutional Directors, Audit Committee, Company Secretaries,
Accounting Professionals, Government and other law making agencies, Small investors,
consumers, Vendor and Strategic partners, employees, media etc.
Board of Directors: The Board of Directors is entrusted with the responsibility of overall
direction and management of the affairs of the company. They are bound to comply with
the provisions of the Companies Act 1956 and to perform the general and specific duties
imposed by the Articles of Association. They are responsible for preparing annual
accounts and also maintain proper records as per the requirement of companies Act for
preventing and detecting frauds and irregularities. The need of the hour is to select only
capable Board of Directors so that they may manage and guide the operations of the
company efficiently, effectively, and diligently and protect the interest of stakeholders.
They shall ensure that adequate information, audit and control system exist in the
company and to see that the company complies with legal and ethical standards. The
Head of board of directors is called Chairman, who should have a dynamic outlook,
professional experience, clear vision and leadership qualities..
Non – Executive Directors: The non-executive directors are other than managing
director and functional. The directors are nominated by the government from various
fields. They must have very rich professional experience. Their appointment and
reappointment should not be automatic but based on their previous performance. Today,
in the age of competition and integration with global markets, the Non-Executive
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Directors should, as eyes and ears of the chairman, convey their independent and expert
views to the chairman and maintain balance between the chairman and objectives of the
company. They should try to protect the interest of all stake holders rather than acting as
“Yes man” of the Chairman.
Institutional Director: In changing corporate environment, the role of Institutional
Director’s has changed from mere spectators to big key players. Financial Institution’s
hold major chunk of shares in company, hence their role has become very important in
transparency and accountability .In pursuit of this objective, the Financial Institution’s
have prescribed a 19 point agenda for nominees in companies. These objectives
included long-term dividend policy, depreciation, investment in unlisted companies,
merger and acquisitions, loans and advances, further issues of shares or raising loans for
companies and award of contracts. Institutional Director’s are expected to play a key role
in these areas for good governance. However the list of areas cannot be assumed as final.
Audit committee: It is a sub-committee of the Board of Directors consisting of a
minimum of three independent non-executive directors and is answerable to the Board.
The basic function of an Audit committee is like that of a watchdog. Its role is to ensure
that the auditors of the company perform their duties satisfactorily and to the best interest
of the shareholders. The presence of audit committee would improve the quality of
financial reporting, create a climate of financial discipline and control and increase public
confidence in the credibility and objectivity of financial statements besides providing a
forum to finance director and external and internal auditors to discuss their problems and
issues of concern. Although the concept of Audit Committee is new to India, its role in
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upgrading the standard of corporate governance has since long been well recognized in
the West. For instance, since 1978 the New York Stock Exchange requires all listed
companies to set up audit committees consisting of independent non-executive Directors.
Similarly in the U.K. after the Cadbury committee Report on Corporate Governance, the
setting up of audit committee has become a common feature among large corporations. In
India, the Ministry of Petroleum and Natural Gas has issued guidelines to the entire
public sector oil corporation to set up audit committees in August 1997.Oil and Natural
Gas Corporation (ONGC) was the first to establish audit committee in pursuance of these
guidelines.
Company Secretary (CS): The job of a Company Secretary is to ensure that the
company’s multifarious activities are performed smoothly and conform to the provisions
of law. According to Cadbury committee, “The CS has to play a very important role in
ensuring that Board procedures are not only scrupulously followed but also regularly
reviewed. The Chairman and the Board mostly depend on the Company Secretary for
guidance as to how they should discharge their responsibilities under the stipulated rules
and regulations. All directors should have access to the advice and services of CS and
should recognize that the Chairman is entitle to the strong and positive support of the CS
in ensuring effective functioning of the Board”. The Company Secretary has to play a
major role in Corporate Governance and to submit his professional advise to Board of
Directors.
Accounting Professional (AP): With the changing corporate environment the role of
Accounting Professional is also changing. They provide non-financial trading services
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apart from traditional auditing work. The Working Group on recently amended
Companies Act, 1997 observed, “Integrity of accounting and auditing procedures and the
quality of financial disclosures are fundamental to corporate transparency and longterm
shareholders support”. In the present day, auditor is not only responsible to management
and shareholder but also to all the stakeholders of the company. Therefore the auditors
should also try to bring out even the least matter before the stakeholders of the company
to enable them to add value to every role they play. They should also express their
expert opinion regarding product profitability, strategic planning, transparency etc.
Government and other law making agencies: Since the introduction of Companies Act
1956, the Government of India enacted many legislations such as Monopolistic and