UNIT - 3 CORPORATE GOVERNANCE

STRUCTURE

3.0 Learning Objectives

3.1 Introduction

3.2 Corporate Governance: Meaning, objectives, significance

3.2.1 towards understanding Corporate Governance

3.2.2 A Historical perspective of Corporate Governance

3.2.3 Benefits of Corporate Governance

3.3 Difference between Governance and Management

3.4 Purpose of Good Governance

3.5 Potential Consequence of Poor CG

3.6 Governance Risk and Financial Stability

3.6.1 The balancing of conflicting objectives

3.7 Indian and Global Scenario: Sarbanes Oxley Act of 2002

3.8 Overview of different models of cg reports

3.9 Narayan Murthy & Ganguli Committees

3.10 Summary

3.11 Keywords

3.12 Learning Activity

3.13 Unit End Questions

3.14 References

3.0 LEARNING OBJECTIVES

After studying this unit, you will be able to:

  State the meaning of Corporate Governance

 Explain the role of Corporate Governance in business decision making and operations

 Appreciate the growth of modern version of Corporate Governance

 Discuss Good Corporate Governance

 Describe the Potential Consequence of poor CG

 Explain why it is important for companies to good corporate governance in their

operations

 Discuss the Sarbanes Oxley Act of 2002

 Explain the Overview of Anglo-American, Japanese, German models

 Know recommendations of Narayan Murthy & Ganguli Committees

3.1 INTRODUCTION

Corporate governance is a central and dynamic aspect of business. The term ‘governance’ is
derived from the Latin word gubernare, meaning ‘to steer’, usually applying to the steering of
a ship, which implies that corporate governance involves the function of direction rather than
control. In fact, the significance of corporate governance for corporate success as well as for
social welfare cannot be overstated. Recent examples of massive corporate collapse resulting
from weak systems of corporate governance have highlighted the need to improve and reform
corporate governance at international level. In the wake of Enron and other similar cases,
countries around the world have reacted quickly by pre-empting similar events dramatically.
"Capitalism with integrity outside the government is the only way forward to create jobs and
solve the problem of poverty. We, the business leaders are the evangelists of capitalism with
integrity. If the masses have to accept this we have to become credible and trustworthy. Thus
we have to embrace the finest principles of corporate governance and walk and the talk."
(Narayan Murthy) Corporate governance has in recent years succeeded in attracting a good
deal of public interest because of its apparent importance for the economic health of
corporations and society in general. However, the concept of corporate governance is poorly
defined because it potentially covers a large number of distinct economic phenomena. As a
result, different individuals have come up with different definitions that basically reflect their
special interest in the field. It is hard to see that this 'disorder' will be any different in the
future so the best way to define the concept is perhaps to list a few of the different
definitions.

3.2 CORPORATE GOVERNANCE: MEANING, OBJECTIVES,

SIGNIFICANCE

Corporate governance comprehends the framework of rules, relationships, systems and

processes within and by which fiduciary authority is exercised and controlled in corporations.
Relevant rules include applicable laws of the land as well as internal rules of a corporation.
Relationships include those between all related parties, the most important of which are the
owners, managers, directors of the board (when such entity exists), regulatory authorities and
to a lesser extent, employees and the community at large. Systems and processes deal with
matters such as delegation of authority, performance measures, assurance mechanisms,
reporting requirements and accountabilities. Standard and Poors defined corporate
governance as “the way in which a company organizes and manages itself to ensure that all
financial stakeholders receive their fair share of a company’s earnings and assets” is
increasingly a major factor in the investment decision-making process. Poor corporate
governance is often cited as one of the main reasons why investors are reluctant, or unwilling,
to invest in companies in certain markets. Corporate Governance concerns with the exercise
of power in corporate entities. The OECDprovides a functional definition of corporate
governance as: “Corporate Governance is the system by which business corporations are
directed and controlled. The corporate governance structure specifies the distribution of rights
and responsibilities among different participants in the corporation, such as the board,
managers, shareholders and other stakeholders, and spells out the rules and procedures for
making decisions on corporate affairs. By doing this, it also provides the structure through
which the company objectives are set, and the means of attaining those objectives and
monitoring performance.” The report of SEBI Committee on Corporate Governance gives the
following definition of corporate governance. “Corporate governance is the acceptance by
management, of the inalienable rights of shareholders as the true owners of the corporation
and of their own role as trustees on behalf of the shareholders.

It is about commitment to values, about ethical business conduct and about making a
distinction between personal and corporate funds in the management of a company”. The
simplest definitions, is given by a Cadbury Report (UK). ‘Corporate Governance is the
system by which businesses are directed and controlled’.

The Cadbury Committee said, “The primary level is the company’s responsibility to meet its
Notes material obligations to shareholders, employees, customer, suppliers, creditors, to pay
its taxes and to meet its statutory duties. The next level of responsibility is the direct result of
actions of companies in carrying out their primary task including making the most of the
community’s human resources and avoiding damage to the environment. Beyond these two
levels, there is a much less well-defined area of responsibility, which involves in the
interaction between business and society in a wider sense.” The ongoing nature of corporate
governance indicates by the definition of the Commission on Global Governance (1995), ‘A
continuing process through which conflicting or diverse interests may be accommodated and
co-operative action may be taken’.

3.2.1 Need of Corporate Governance

A corporation is a congregation of various stakeholders, namely customers, employees,

investors, vendor partners, government and society. A corporation should be fair and
transparent to its stakeholders in all its transactions. This has become imperative in today’s
globalized business world where corporations need to access global pools of capital, need to
attract and retain the best human capital from various parts of the world, need to partner with
vendors on mega collaborations and need to live in harmony with the community. Unless a
corporation embraces and demonstrates ethical conduct, it will not be able to succeed.
Corporate governance is about ethical conduct in business. Ethics is concerned with the code
of values and principles that enable a person to choose between right and wrong and,
therefore, select from alternative courses of action. Further, ethical dilemmas arise from
conflicting interests of the parties involved. In this regard, managers make decisions based on
a set of principles influenced by the values, context and culture of the organization. Ethical
leadership is good for business as the organization is seen to conduct its business in line with
the expectations of all stakeholders. Corporate governance is beyond the realm of law. It
stems from the culture and mindset of management and cannot be regulated by legislation
alone. Corporate governance deals with conducting the affairs of a company such that there is
fairness to all stakeholders and that its actions benefit the greatest number of stakeholders. It
is about openness, integrity and accountability. What legislation can and should do is to lay
down a common framework – the “form” to ensure standards. The “substance” will
ultimately determine the credibility and integrity of the process. Substance is inexorably
linked to the mindset and ethical standards of management. Corporations need to recognize
that their growth requires the cooperation of all the stakeholders; and such cooperation is
enhanced by the corporation adhering to the best corporate governance practices. In this
regard, the management needs to act as trustees of the shareholders at large and prevent
asymmetry of benefits between various sections of shareholders, especially between the
owner-managers and the rest of the shareholders.

3.2.2 Scope of Corporate Governance

Corporate governance covers the following functional areas of governance:

1. Preparation of company’s financial statements: Financial disclosure is a very important and

critical component of corporate governance. The company should implement procedures to
independently verify and safeguard the integrity of the company’s financial reporting.
Disclosure of material matters concerning the organization should be timely and balanced to
ensure that all investors have access to clear, factual information.

2. Internal controls and the independence of entity’s auditors: Internal control is implemented
by the board of directors, audit committee, management, and other personnel to provide
assurance of the company achieving its objectives related to reliable financial reporting,
operating efficiency, and compliance with laws and regulations. Internal auditors, who are
given responsibility of testing the design and implementing the internal control procedures
and the reliability of its financial reporting, should be allowed to work in an independent
environment.

3. Review of compensation arrangements for chief executive officer and other senior
executives:

Performance-based remuneration is designed to relate some proportion of salary to individual

performance. It may be in the form of cash or non-cash payments such as shares and share
options, superannuation or other benefits. Such incentive schemes, however, are reactive in
the sense that they provide no mechanism for preventing mistakes or opportunistic behaviour,
and can elicit myopic behaviour.

4. The way in which individuals are nominated for the positions on the board: The Board of

Directors have the power to hire, fire and compensate the top management. The owners of a
business that have decision-making authority, voting authority, and specific responsibilities,
which in each case is separate and distinct from the authority, and responsibilities of owners
and managers of the business entity.

5. The resources made available to directors in carrying out their duties: The duties of the
directors are the fiduciary duties similar to those of an agent or trustee. They are entrusted
with adequate power to control the activities of the company.

6. Oversight and management of risk: It is important for the company to be fully aware of the
risks facing the business and the shareholders should know that how the company is going to
tackle the risks. Similarly the company should also be aware about the opportunities lying
ahead.

3.2.3 Participants to Corporate Governance

Corporate governance is concerned with the governing or regulatory body (e.g. the SEBI), the
CEO, the board of directors and management. Other stakeholders who take part include
suppliers, employees, creditors, customers, and the community at large. Shareholders
delegate decision rights to the managers. Managers are expected to act in the interest of
shareholders. This results in the loss of effective control by shareholders over managerial
decisions. Thus, a system of corporate governance controls is implemented to assist in
aligning the incentives of the managers with those of the shareholders in order to limit self
satisfying opportunities for managers. The board of directors plays a key role in corporate
governance. It is their responsibility to endorse the organisation’s strategy, develop
directional policy, appoint, supervise and remunerate senior executives and to ensure
accountability of the organisation to its owners and authorities. A key factor in an
individual’s decision to participate in an organisation (e.g. through providing financial capital
or expertise or labour) is trust that they will receive a fair share of the organisational returns.
If somebody receives more than their fair return (e.g. exorbitant executive remuneration),
then the participants may choose not to continue participating, potentially leading to an
organisational collapse (e.g. shareholders withdrawing their capital). Corporate governance is
the key mechanism through which this trust is maintained across all stakeholders.

3.2.4 Importance and Benefits of Corporate Governance

Policy makers, practitioners and theorists have adopted the general stance that corporate
governance reform is worth pursuing, supporting such initiatives as splitting the role of
chairman/ chief executive, introducing non-executive directors to boards, curbing excessive
executive performance-related remuneration, improving institutional investor relations,
increasing the quality and quantity of corporate disclosure, inter alia. However, is there really
evidence to support these initiatives? Do they really improve the effectiveness of corporations
and their accountability? There are certainly those who are opposed to the ongoing process of
corporate governance reform. Many company directors oppose the loss of individual
decision-making power, which comes from the presence of non-executive directors and
independent directors on their boards. They refute the growing pressure to communicate their
strategies and policies to their primary institutional investors. They consider that the many
initiatives aimed at ‘improving’ corporate governance in UK have simply slowed down
decision-making and added an unnecessary level of the bureaucracy and red tape The
Cadbury Report emphasized the importance of avoiding excessive control and recognized
that no system of control can completely eliminate the risk of fraud (as in the case of
Maxwell) without hindering companies’ ability to compete in a free market. This is an
important point, because human nature cannot be altered through regulation, checks and
balances. Nevertheless, there is growing perception in the financial markets that good
corporate governance is associated with prosperous companies. Institutional investment
community considered both company directors and institutional investors welcomed
corporate governance reform, viewing the reform process as a ‘help rather than a hindrance’.
Specifically, towards corporate governance reform.

The findings of (Solomon J. and Solomon A., 1999) endorsed many of the issues relating to
the Notes agenda for corporate governance reform in UK. For example, they show, that
institutional investors agreed strongly with the Hampel view that corporate governance is as
important for small companies as for larger ones. The results also indicated significant
support from the institutional investment community for the continuance of a voluntary
environment for corporate governance. The respondents’ agreement that there should be
further reform in their investee companies also added support to the ongoing reform process.
Lastly, the institutional investors perceived a role for themselves in corporate governance
reform, as they agreed that the institutional investment community should adopt a more
activist stance.

Benefits of Corporate Governance

The initiation of the process of corporate governance in PEs is likely to result into a series of
important benefits. Firstly, the flip-flop about owning of the responsibility for low
performance would perhaps come to an end. The owners will be on enterprise board.
Secondly, goal and role clarity would improve. Enterprise would be mission – vision driven.
Thirdly, opportunity for top management to create a cultural transformation from government
entities to corporate entities, and from state-financed to self-sustaining ones.

Role of Corporate Governance

The role of effective corporate governance is of immense significance to the society as a

whole.

It can be summarised as follows:

1. Corporate governance ensures the efficient use of resources.

2. It makes the resources flow to those sectors or entities where there is efficient
production of goods and services and the return is adequate enough to satisfy the
demands of stakeholders.

3. It provides for choosing the best managers to administer scarce resources.

4. It helps managers remain focused on improving performance and making sure that
they are replaced when they fail to do so.

5. It pressurises the organization to comply with the laws, regulations and expectations
of society.

6. It assists the supervisor in regulating the entire economic sector without partiality and
nepotism.

7. It increases the shareholders’ value, which attracts more investors. Thus, corporate
governance ensures easy access to capital.

8. As corporate governance leads to higher consumer satisfaction, it helps in increasing

market share and sales. It also reduces advertising and promotion costs.

9. Employees are more satisfied in organizations that follow corporate governance

policies.

10. This reduces the employee turnover, which results in the reduction in the cost of
human resource management. Only a satisfied employee can create a satisfied
customer.

11. Corporate governance reduces the procurement and inventory cost. It helps in
maintaining a good rapport with suppliers, which results in better and more
economical inventory management system.
 12. Corporate governance helps in establishi7ng good rapport with distributors providing
not only better access to the market, but also reducing the cost of production.

3.3 DIFFERENCE BETWEEN GOVERNANCE AND MANAGEMENT

Management vs. Governance

As a starting point to these guiding principles, it is useful to note the differences as to what is
considered to be governance and what management is.

Governance is the ‘what’ - the strategic planning and leadership of an organisation that is
carried out by the appointed Board. This is about planning and the overall strategy and
direction of the organisation and ensuring that this is reviewed on a regular basis.

The management is supported by the Board to deliver on those strategic plans.

Governance is about:

 Determining the mission

 Policy and strategy

 Appointing and overseeing management

 Managing governance processes

 Providing insight, wisdom and judgement

 Monitoring performance of the organisation

 Strategically identifying and managing risk?

Management is the ‘how’ - the delivery of the strategic plans and the work of the
organisation.

Management of an organisation is overseeing the day-to-day running of the organisation.

Management also plays a crucial role in the leadership of the organisation through supporting
staff and/or volunteers to understand and implement the strategic vision. This is a different
leadership role to the Board.

Management is about:

 Developing and delivering policy and strategy

  Setting and overseeing annual operational business plans

 Appointing managers and staff

 Supporting governance processes

 Implementing board decisions

 Measuring performance

 Delivering services and activities

 Managing strategic and operational risk

Some say that there is no difference between management and governance. But the fact is
that there are differences between management and governance.

Governance can be said to be representing the owners, or the interest group of people, who
represent a firm, company or any institution. Governance represents the will of these interest
groups who manage the company. Governance consists of a governing body, which directs
the management on all aspects of a company. It is the governing body that oversees the
overall function of an organization.

The governing body, on the other hand, appoints management personnel, whom are given the
power to administer the organization. Management comes only second to the governing body,
and they are bound to strive as per the wishes of the governing body.

Governance can be said to set the right policy and procedures for ensuring that things are
done in a proper way. On the contrary, management is all about doing things in the proper
way.

The responsibilities between governance and management also differ. The responsibilities of
governance include choosing top executives, evaluating their performance, authorizing
plans/commitments and evaluating the organization’s performance. On the other hand,
management has the responsibility for managing and enhancing the overall performance of
the organization. Management has the responsibility to implement the systems of governance.

While board of directors form the core of governance, managers and executives form part of
the management.
Governance relates to providing the right direction and leadership. Governance relates to
managing the operations of an organisation. The governing body has only the role to oversee
the functioning of the management, and it has no role in management.

Governance and management

The terms governance and management are common in business. So what is the difference
between governance and management? Why does it matter?

The role of governance

Every business has a governing body. This is either the business owners, or a group of
people who are accountable for organisations overall performance. For larger companies,
this is typically the board of directors. The governance role provides overall vision,
direction, and strategy. Therefore it establishes the framework or methods of working, and
what areas to focus on.

Governance is also accountable for compliance. Every business operates in an environment

where relevant laws and regulations apply. There are also increasing demands for corporate
social responsibility. This sets expectations to businesses to operate ethically and
sustainably.

The role of management

On the other hand, Management concerns focus on the day to day operations of the
business. It is therefore responsible for organising and doing the work. Senior Managers
make decisions in line with the organisation’s goals, set by governance. In other words,
Management is more involved with the details. Things like staff hiring, resourcing, budget
oversight, processes, and operational management.

When governance and management collide

In smaller organisations there is a risk of overlap between the governing board and
management functions. Boards in these organisations often involve themselves in the
business of management. It is healthy for boards to ask questions and seek information from
management. However, it is unhealthy for them to micro-manage by getting involved in
operational activities. For example, a board member questioning an operational decision
around a recent hires. This can occur if the board loses faith in the management team, or due
to role familiarity. Role familiarity is common, since most board members come from
management backgrounds.

The focus of governance

In commercial organisations the governance role comes down to fiduciary duty. That is,
their responsibility is to govern on-behalf-of the owners (usually shareholders). In other
words, they look after the owners interests by seeking to improve organisational performance,
while mitigating risks. So, a board’s focus is approving policies, developing strategy,
oversight of risk, and improving performance. They also choose the senior management
team and CEO. Lastly, the Board's role is to act in a way that supports the organisations
goals. How a director behaves can support or damage a company reputation.

The focus of management

Management on the other hand is responsible for executing the board’s strategy. They
develop operational plans in line with approved policy. While they too must act in a way
that supports organisational goals, they are closer to the action. They must manage and
respond to operational demands daily. Lastly, Management must support both functions by
ensuring the right information is available. This is key to managing operations, as well as
monitoring progress on strategic goals, and regulatory compliance.

Final thoughts

Understanding the difference between governance and management is important as the two
roles differ. Each has a distinctly different focus, but they must work in partnership. The
first provides strategy, direction, and the frameworks for the second to work in. Management
needs to know what to concentrate on within these frameworks. To such an end, suitable key
performance indications (KPIs) need reporting to both senior leadership and governing board
levels. This enables both groups to monitor and understand the overall health of the
organisation.

Summary:

1. Governance can be said to be representing the owners, or the interest group of people, who
represent a firm, company or any institution. The governing body, on the other hand, appoints
management personnel.
2. While governance pertains to the vision of an organization, and translation of the vision
into policy, management is all about making decisions for implementing the policies.

3. Management comes only second to the governing body, and they are bound to strive as per
the wishes of the governing body.

3.4 PURPOSE OF GOOD GOVERNANCE

What is Good Governance?

‘Governance’ is the process of decision-making and the process by which decisions are
implemented (or not implemented).

Governance can be used in several contexts such as corporate governance, international

governance, national governance and local governance.

In the 1992 report entitled “Governance and Development”, the World Bank set out its
definition of Good Governance. It defined Good Governance as “the manner in which
power is exercised in the management of a country’s economic and social resources for
development”.

Good governance has 8 major characteristics. It is participatory, consensus-oriented,

accountable, transparent, responsive, effective and efficient, equitable and inclusive and
follows the rule of law.

It assures that corruption is minimized, the views of minorities are taken into account and that
the voices of the most vulnerable in society are heard in decision-making.

It is also responsive to the present and future needs of society.

Principles of Good Governance by United Nations.

8 Principles of Good Governance by United Nations

 Fig 3.1 Purpose of Good Governance

Participation:

 People should be able to voice their own opinions through legitimate immediate
organizations or representatives.

 This includes men and women, vulnerable sections of society, backward classes,
minorities, etc.

 Participation also implies freedom of association and expression.

Rule of Law:

 Legal framework should be enforced impartially, especially on human rights laws.

 Without rule of law, politics will follow the principle of matsyanyayaie law of fish
which means the strong will prevail over the weak.

Consensus Oriented:

 Consensus oriented decision-making ensures that even if everyone does not achieve
what they want to the fullest, a common minimum can be achieved by everyone
which will not be detrimental to anyone.

 It mediates differing interests to meet the broad consensus on the best interests of a
community.

Equity and Inclusiveness:

 Good governance assures an equitable society.

 People should have opportunities to improve or maintain their well-being.

Effectiveness and Efficiency:

 Processes and institutions should be able to produce results that meet the needs of
their community.

 Resources of the community should be used effectively for the maximum output.

Accountability:

 Good governance aims towards betterment of people, and this cannot take place
without the government being accountable to the people.

 Governmental institutions, private sectors, and civil society organizations should be

held accountable to the public and institutional stakeholders.

Transparency:

 Information should be accessible to the public and should be understandable and

monitored.

 It also means free media and access of information to them.

Responsiveness:

 Institutions and processes should serve all stakeholders in a reasonable period of time.

References of Good Governance

 Bhagavad Gita provides numerous cues for good governance, leadership, dutifulness
and self-realization which are re-interpreted in the modern context.

 In Kautilya’sArthashastra (2nd-3rd century BC), the welfare of people was considered

paramount in the role of King. Mahatma Gandhi emphasized “su-raj'' which
essentially means good governance.

 Importance of governance is clearly inscribed in Indian Constitution which is built on-

premise of Sovereign, Socialist, Secular and Democratic Republic committing itself to
democracy, rule of law and welfare of people.
  Under Sustainable Development Goals, Goal 16 can be considered to be directly
linked as it is dedicated to improvement in governance, inclusion, participation,
rights, and security.

 According to former United Nations Secretary-General Kofi Annan, "Good

governance is ensuring respect for human rights and the rule of law; strengthening
democracy; promoting transparency and capacity in public administration." He also
said that “Good Governance is perhaps the single most important factor in eradicating
poverty and promoting development”.

Initiatives for Good Governance in India

Right to Information

 As a party to the International Covenant on Civil and Political Rights (ICCPR), India
is under an international obligation to effectively guarantee citizens the Right to
Information as per Article 19 of the ICCPR.

 RTI Act, 2005 marks a significant shift in Indian democracy. It gives greater access of
the citizen to the information which in turn improves the responsiveness of the
government to community needs.

 The right to information promotes openness, transparency and accountability in

administration by making the government more open to public scrutiny.

E-Governance

 The National e-Governance Plan envisions to make all government services

accessible to the common man in his locality, through common service delivery
outlets and ensure efficiency, transparency & reliability of such services at affordable
costs.

 E-Governance effectively delivers better programming and services in the era of

newly emerging information and communication technologies (ICTs), which herald
new opportunities for rapid social and economic transformation worldwide.

 E-Governance has a direct impact on its citizens who derive benefits through direct
transactions with the services offered by the government.
  Programs launched under e-Governance: Pro-Active Governance and Timely
Implementation (PRAGATI), Digital India Program, MCA21 (to improve the speed
and certainty in the delivery of the services of Ministry of Company Affairs), Passport
Seva Kendra (PSK), online Income tax return, etc.

 Focus on 'Minimum Government, Maximum Governance’.

Legal Reforms

 The Central Government has scrapped nearly 1,500 obsolete rules and laws with an
aim to bring about transparency and improve efficiency.

 Reform criminal justice and procedural laws with focus on pre-institution mediation.

Ease of Doing Business

 Steps were taken by the government to improve business conditions including

legislation meant to improve the country’s business environment and policy
ecosystems (such as the Bankruptcy Code, the Goods and Services Tax or GST, and
the anti-money-laundering law).

 Government has launched the ‘Make in India’ initiative.

Decentralization

 Centralised Planning Commission was abolished, replacing it with the think tank
called the National Institution for Transforming India (NITI Aayog), which would
usher in an era of “cooperative federalism”.

 14th Finance Commission increased the tax devolution of the divisible pool to states
from 32% to 42% for years 2015 to 2020. It provides more freedom to states to
initiate schemes based on local factors.

Police Reforms

 Modernizing police forces and implementing the Model Police Act of 2015.
  Reform of the First Information Report (FIR) lodging mechanism, including
introducing filing e-FIRs for minor offences.

 Launch a common nation-wide emergency number to attend to emergency security

needs of citizens.

Aspirational Districts Programme

 The Aspirational Districts Programme (ADP) was launched in January 2018 to

transform the lives of people in the under-developed areas of the county in a time
bound manner.

 Anchored in NITI Aayog, the programme is aimed at transforming 115 most

backward districts with focused interventions in the field of health and nutrition,
education, agriculture and water management, financial inclusion and skill
development.

Good Governance Index

 The Good Governance Index Was launched on the occasion of Good Governance
Day on 25 December 2019.

 The Good Governance Index is a uniform tool across States to assess the Status of
Governance and impact of various interventions taken up by the State Government
and Union Territories.

 The objectives of Good Governance Index are to provide quantifiable data to compare
the state of governance in all states and Union Territories, enable states and Union
Territories to formulate and implement suitable strategies for improving governance
and shift to result oriented approaches and administration.

Challenges to Good Governance

Criminalization of Politics

 According to the Association of Democratic Reforms, 43% of Members of

Parliaments of LokSabha 2019 are facing criminal charges. It is a 26% increase as
compared to 2014.

 The criminalisation of the political process and the unholy nexus between politicians,
civil servants, and business houses are having a baneful influence on public policy
formulation and governance.
  The political class as such is losing respect. Therefore, it is necessary to
amend Section 8 of the Representation of the People’s Act 1951 to disqualify a
person against whom the criminal charges that relate to grave and heinous offenses
and corruption are pending.

Corruption

Corruption is a major obstacle in improving the quality of governance. While human greed is
obviously a driver of corruption, it is the structural incentives and poor enforcement system
to punish the corrupt that have contributed to the rising curve of graft in India.

According to the Corruption Perception Index - 2019 (released by Transparency

International, India's ranking has slipped from 78 to 80.

Gender Disparity

According to Swami Vivekananda, “it is impossible to think about the welfare of the world
unless the condition of women is improved. It is impossible for a bird to fly on only one
wing”.

One way to assess the state of the nation is to study the status of its women. As women
comprise almost 50% of the population it is unfair that they are not adequately represented in
government institutions and other allied sectors.

Therefore, in order to ensure good governance it is essential to ensure the empowerment of

women.

Growing incidence of violence

Resorting to illegal force is considered to be a law and order problem. But when one looks at
it from the point of view of the principles of Good Governance, it becomes clear that peace
and order is the first step to development.

Delay in Justice

A citizen has the right to avail timely justice, but there are several factors, because of that a
common man doesn't get timely justice.

Centralisation of Administrative System

Governments at lower levels can only function efficiently if they are empowered to do so.
This is particularly relevant for the Panchayati Raj Institutions (PRIs), which currently suffer
from inadequate devolution of funds as well as functionaries to carry out the functions
constitutionally assigned to them.

Marginalization of Socially and Economically Backward People

The socially and economically backward sections of the society have always been
marginalised in the process of development. Although there are constitutional provisions for
their upliftment but in practice, they are lagging behind in so many areas like education,
economic wellbeing etc.

Conclusion

The effective functioning of governance is the prime concern of every citizen of the country.
The citizens are ready to pay the price for good services offered by the state, but what is
required is a transparent, accountable and intelligible governance system absolutely free from
bias and prejudices.

There is a need to reformulate our national strategy to accord primacy to the Gandhian
principle of ‘Antyodaya” to restore good governance in the country.

India should also focus on developing probity in governance, which will make the
governance more ethical.

The government should continue to work on the ideals of SabkaSaath, SabkaVikas and
SabkaVishwas which will lead to inclusive and sustainable development.

Probity in Governance

 Probity is a quality of having strong moral principles. It includes having integrity,

uprightness, and honesty. It is not just being incorruptible and honest but also includes
strict adherence to a code of ethics. For an effective system of governance and for
socio-economic development, probity is essential.

 Philosophical basis of governance and probity:

 The ethical concern of governance has been given in both eastern and western
literature like Bhagavad Gita, Arthashastra, by Confucius, Plato, Mill, etc.

 Administrators are the guardians of the Administrative State so they should honor
public trust.

 Max Weber: He said that it rationality that members of administrative staff should not
own means of production.
Objective of probity in governance:

 To ensure accountability in governance

 To maintain integrity in Public Service

 To ensure compliance with the process

 To preserve public confidence in Govt process

 To avoid the potential for misconduct, fraud, and corruption

3.5 POTENTIAL CONSEQUENCE OF POOR CG

Poor corporate governance can lead to issues such as corruption, negligence, fraud and
lack of accountability.

However, it’s not just scandals that point to governance failures. Stunted business growth,
repetitive complaints, and high levels of waste also highlight lack of control and strategic
alignment.

The question is why do so many businesses show bad corporate governance?

We share 3 reasons businesses get governance wrong and what you, as a GRC leader, can do.

1) Assuming awareness

Leadership and governance go hand-in-hand in a successful company.

It sounds crazy but most of the issues with corporate governance comes down to those in
leadership positions not being aware of what they need to do. These are really busy people, so
they hire GRC managers to make their role easier. However, they cannot delegate everything.
The role of those working in GRC is not to pass everything back to them, but to provide them
with a summary of key action points so they can effectively direct and influence the rest of
the business.

Tips:

 Use ISO 9001:2015 as a framework

 Tell leadership their roles and responsibilities- they are ultimately accountable for
good governance
  Actions from board meetings need to be active and comprehensive

 Make it as simple as possible, avoid complexity, make long text / meetings digestible
in under 30 seconds

2) Leaving it to the board agenda

Many businesses think that if there is a line on the board's agenda about governance, then that
is all they need to do. But we need to go beyond this. Good governance practices need to be
cascaded throughout the rest of the business.

Businesses need systems and processes to effectively communicate. Good governance won’t
just happen on its own and you can't leave it down to chance. Governance, risk and
compliance software- such as our integrated modules- provides a rigid framework for
recording risk, communicating, auditing, training, managing suppliers and issue management
etc. All this data is then fed through to a live dashboard which provides a picture of how the
business is performing.

Tips:

 Define KPIs and have a system to measure

 Establish strategic direction and ensure this is communicated

 Implement a system which ensures governance can be recorded and reported on

 Store procedures and processes centrally

3) Change

Many businesses see governance as a separate activity or the role of a certain department.
You need to make good governance by design and default, and not a bolt-on activity.
However, it’s not scalable or sustainable to have the GRC manager present for every business
decision. That will just slow your business down. It means providing training and systems
which encourage employees to assess risk, take responsibility and ownership, and properly
document their approach.

3.6 GOVERNANCE RISK AND FINANCIAL STABILITY

Corporate governance is the practice of shareholders exercising control over managers so that
they act in shareholders’ interests. In non-financial firms, this maximises firm efficiency.
Such efficiency effects also exist in banks. For example, banks that face more active takeover
markets are more cost-efficient (Brook et al. 1998).

Unlike non-financial firms, bank operations have another relevant dimension besides
efficiency: risk. Banks are prone to risk-taking, due to:

 Their high leverage,

 Limited creditor market discipline (a consequence of deposit insurance and too-big-

to-fail guarantees), and

 The ability to rapidly and opaquely increase the risk of assets by changing the
investment strategy.

Moreover, large-scale (‘systemic’) bank failures may negatively affect the real economy. So
we are interested whether corporate governance can not only improve bank efficiency, but
also reduce bank risk.

On this, the literature warns that better corporate governance, by itself, is unlikely to make
banks safer. In fact, the opposite may occur. Bank shareholders benefit from greater risk,
because their payoffs are protected on the downside by limited liability. Improving corporate
governance (in the Anglo-Saxon sense of giving shareholders more power) may make banks
riskier. For example, higher institutional ownership (a proxy for shareholder power) increases
bank risk according to Laeven and Levine (2009), and banks with more independent directors
on boards suffered larger losses during the crisis (Adams 2012, Erkens et al. 2012).

Then how to align bank corporate governance with financial stability?

Higher capital

Higher bank capital increases shareholders’ skin-in-the-game, making them more risk averse.
While higher capital is undoubtedly useful, it is important to realise its limitations. First,
while the cost of bank capital appears modest in steady state, the cost of building up capital
quickly may be significant. This makes bank capital scarce during and after recessions.
Second, banks often obtain new capital from passive shareholders (such as preferred equity
holders or institutional investors), who are unable to influence bank risk taking (Acharya et
al. 2012). Then, higher bank capital provides risk absorption capacity, but does not correct
risk attitudes.
Higher capital can be supplemented by CoCos (contingent capital): debt securities that
convert into capital at the early stages of bank distress (Flannery 2009, Pazarbasioglu et al.
2011, Avdijev et al. 2013). CoCos are appealing because of their lower cost (similar to that of
junior debt), ‘prepackaged’ bail-in of shareholders and CoCos holders, and the possibly of a
punishing dilution of bank shareholders upon conversion, which may give them powerful
incentives to contain risk. However, CoCos have not been tested in crises, have unsettled
design features (e.g. market-based vs. regulatory conversion triggers; Hart and Zingales
2011). Most critically, it is unclear whether the market for CoCos is deep enough to
accommodate their wide use.

Better risk management

The literature indicates that better risk management (measured by the ratio of CRO to CEO
compensation, but understood broadly as appropriate budgeting and organisational centrality
of the risk management function) reduces bank risk. However, the strength of risk
management differs substantially and persistently across banks (Ellul and Yerramilli 2013).
This prompts the question of how to improve bank risk management.

Unfortunately, it is notoriously difficult to ‘impose’ better risk management through

regulation. Direct tools, such as requiring banks to spend a given fraction of assets on risk
management, may only lead to box-checking. A better approach may be to strengthen market
discipline by requiring banks to undertake enhanced and timely disclosure of risk strategies
and positions, including assessments of tail risk. This should include clearer risk
communication within the bank and to the regulators, and to the public and the counterparties
(Basel Committee 2014). Still, given the complexity of modern banks, one can be skeptical
whether it is possible to design binding disclosure structures that would be sufficiently
comprehensive and meaningful to have a material impact on market discipline.

Another avenue to improve risk management is to make banks risks ‘simpler’ by restricting
types of risk that banks can take. For example, imposing loan-to-value (LTV) limits on
mortgages would remove hard-to-measure risks related to tail events in housing markets.
Similarly, narrowing down banks’ financial market activities alleviates the challenges of
responding to boom-bust dynamics in financial markets (see Laeven et al. 2014 for a
discussion of how bank complexity and activities relate to risk.)

Regulating managerial pay

High-powered remuneration aligns the incentives of shareholders and managers, but may
have unintended effects in banks. It may transmit shareholders’ high risk preferences to
managers, and give managers incentives to take ‘tail risk’ to boost short-term return, or to
herd to ensure on-par performance with peers. The literature confirms that high-powered
remuneration led banks to take more risk and then suffer losses during the recent crisis
(Mehran and Rosenberg 2007, Cheng et al. 2010, Fahlenbrach and Stulz 2011, DeYoung et
al. 2013).

The regulation of pay within firms is a contentious issue. The traditional policy approach is
not to meddle within firms, but to ensure conservative shareholder incentives, allowing
shareholders to put in place appropriate internal incentives themselves. However, for banks, it
may be impossible to make shareholders sufficiently conservative. Moreover, even when
shareholders are conservative, additional distortions may prevent them from putting in place
low-risk internal incentives.

The literature points to two reasons for such a failure of internal governance. The first is
externalities across banks (Acharya et al. 2010, Glode et al. 2012). Hiring talent is like an
arms race, where each bank has to outbid others, including by offering employees more
capacity to take risk. In equilibrium, employees may be given too much scope to take risk.
The second reason is time inconsistency problems (Bolton et al. 2011, Boot and Ratnovski
2013). When everyone expects shareholders to be conservative, a bank can attract cheap debt
and capture its customers in long-term banking relationships. But this capture of creditors and
customers is self-defeating, as it may give banks irresistible incentives to renege on them and
increase risk.

In designing the regulation for managerial pay, some have proposed linking compensation to
measures of bank risk (e.g. CDS spreads, Bolton et al. 2011). But such schemes are complex
and open to the ‘Lucas critique’ that they may distort the pricing of risk, making banks
appear safer than they are. Others have proposed pay claw-backs from managers that took too
much risk. But claw-backs are hard to implement. When risk cannot be measured objectively,
a manager can always claim that, at the time, the risk appeared not as acute as it has turned
out to be. A blunt tool to regulate managerial pay would be to restrict performance-related
elements of bank compensation (especially short-term performance-related elements, such as
bonuses). Beyond affecting incentives within banks, such a restriction may also direct risk-
loving talent away from banks to employers that have lower systemic importance and can
better absorb losses (e.g. hedge funds). However, such regulation risks reducing risk to
suboptimal levels.

Alternatively, one can increase the penalty for misbehaving managers by forcing bank
managers to invest a stake in the bank without the protection of limited liability, putting the
manager’s personal wealth at stake in the case of bank failure.

While such a stake is unlikely large enough to prevent the bank failure (many CEOs of failed
banks had significant stakes in their banks prior to the crisis), it would – to some extent –
increase managerial risk aversion.

Stakeholder control

Besides shareholders, bank stakeholders include creditors and taxpayers (who may need to
fund a bailout, or suffer from the impact of a financial crisis on the real economy). Bank
shareholders are relatively minor (in terms of notional exposure) stakeholders, who
nevertheless exercise most control over the bank, and can impose on a bank their high risk
preferences that are at odds with the interests of other stakeholders.

To deal with this disparity, Dewatripont and Tirole (1994, Ch. 8) suggest extending bank
directors’ and managers’ fiduciary duty beyond shareholders. To some extent, stakeholder
control of banks is already used in the real world:

 The transfer of control to the deposit insurer underpins the prompt corrective action
regime of bank intervention in the US and similar bank resolution regimes in other
jurisdictions. The limitation of such schemes is that the transfer of control may occur
too late – when the bank is already in distress – making it difficult to apply corrective
action to large, systemically important institutions, when too big to fail considerations
get in the way.

 In Europe, supervisory boards of banks often include employee representatives (such

as in Germany’s co-determination system), or bank managers may have fiduciary
duties to stakeholders other than shareholders (Macey and O’Hara 2003). Such
arrangements are often ineffective in reducing bank risk, because creditors and other
stakeholders may lack the grasp of the operations of a complex modern bank, while
fiduciary duties may be insufficiently well defined to hold up in court.

A way to make stakeholder control more effective may be to make it state-dependent:

increasing as the bank approaches distress, but becoming substantial well ahead of distress.
This would focus stakeholder control on situations when a de-risking of bank strategy is both
needed and still possible. To avoid government ownership of banks (which is associated with
inefficiencies such as directed lending), the control may primarily be exercised by bank
creditors.

Clearly, implementing creditor control of distressed banks has challenges. Bank creditors
may experience a collective action problem. A divided board (shareholders vs. other
stakeholders) may be indecisive. Bank creditors may reduce risk too rapidly, damaging the
bank’s long-term value, or be over cautious in lending, compromising the provision of credit
to the real economy. Still, creditor control may be preferred over a situation where
shareholders ‘gamble for resurrection’ to extract value out of a distressed bank.

Concluding thoughts: Supervision remains key

This column highlighted that traditional Anglo-Saxon corporate governance mechanisms

make banks more efficient, but not necessarily safer. Higher bank capital, better risk
management and pay regulation, and some stakeholder control may help steer corporate
governance towards financial stability objectives. But as our analysis has indicated, the
design of policies that affect bank governance leaves many open questions: there are possible
unintended effects and the ultimate effectiveness of such policies remains uncertain.
Moreover, the power of corporate governance in reducing bank risk may depend greatly on
the strength of supervision.

Sound corporate governance, by improving market discipline, can send informative signals to
supervisors that can speed up and improve the precision of regulatory intervention. However,
ultimately such action depends on the resoluteness of the supervisor. Risk control in banks
helps improve financial stability. But it cannot depend on market signals alone, because of
the existence of market failures, which often cannot be foreseen, and can be especially large
during financial crises when corrective action is needed the most. For these reasons,
corporate governance cannot substitute for strong supervision. It can at best provide a helping
hand.

3.6.1 The balancing of conflicting objectives

To examine how organizational routines serve as a source for balancing conflicting

organizational goals, we use an inductive study of Alessi, an Italian design company, to trace
how organizational members simultaneously achieved the conflicting organizational goals of
design and efficiency in the new product development routine. Our analysis identified three
types of regulatory actions (splicing, activating, and repressing) that participants took to
flexibly enact these conflicting organizational goals through the same routine. We observed
that the three regulatory actions facilitated new connections between new product
development participants, allowing them to create a dynamic truce and accomplish the two
conflicting goals in a new product’s origination, evaluation, and development phases. Routine
regulation shifts our focus away from the routine as a stable truce to the truce as process,
highlighting the role of actions performed by individuals throughout the organizational
hierarchy, and moves the conversation away from eliminating goal conflict to elaborating the
ongoing actions that people take to manage conflicting organizational goals. Our findings and
theoretical insights produce a deeper conceptualization of routines as generative systems by
demonstrating how action taken to enact a routine also has the capacity to regulate conflicting
organizational goals.

3.7 INDIAN AND GLOBAL SCENARIO: SARBANES OXLEY ACT OF

2002

In 2002 Paul Sarbanes, a Democrat Senator, and Michael Oxley, a Republican Congressman,
were responsible for a radical piece of corporate legislation, the Sarbanes-Oxley Act. The
Sarbanes Oxley Act introduced sweeping corporate law changes relating to financial
reporting, internal accounting controls, and personal loans from companies to their directors,
whistle blowing and destruction of documents. In addition, Sarbanes-Oxley severely restricts
the range of additional services that an audit firm can provide to a client. There are increased
penalties for directors and professionals who have conspired to commit fraud. Some
examples follow of its provisions. Section 906 of the Act requires that all periodic reports
containing financial statements by the Chief Executive Officer (CEO) and Chief Financial
Officer (CFO) of the company, certifying that the report fully complies with the Securities
Exchange Act and fairly present, in all material respects, the financial condition and results of
operations. The penalties for knowingly certifying a statement, which does not comply with
the requirements, can be severe: up to $1 million in fines and/or up to ten years’
imprisonment. Section 1102 provides that ‘knowing and wilful’ destruction of any record or
document with intent to impair an official proceeding carries fines and/or imprisonment up to
20 years. Section 806 provides protection for employees who provide evidence of fraud.
There is also protection for ‘whistle-blowers’ in publicly traded corporations. No company,
officer or employee may threaten or harass an employee who reasonably believes that a
criminal offence has been committed. Section 501 of the legislation also aimed to promote
rules to address conflicts of interest where analysts recommend securities when their
companies are involved in investment banking activities. The Sarbanes-Oxley legislation also
established a Public Company Accounting Oversight Board (PCAOB) to be responsible to
the Securities and Exchange Commission (SEC) for the regulation of auditing in US
companies, inspection of accounting firms and disciplinary proceedings. As a result of the
Sarbanes-Oxley legislation, some companies felt that the burden of compliance was too high
in relation to the perceived benefits.

The Unexpected Benefits of Sarbanes-Oxley

When Congress hurriedly passed the Sarbanes-Oxley Act of 2002, it had in mind combating
fraud, improving the reliability of financial reporting, and restoring investor confidence.
Understandably, most executives wondered why they should be subjected to the same
compliance burdens as those who had been negligent or dishonest. Smaller companies in
particular complained about the monopolization of executives’ time and costs running into
the millions of dollars.

Perhaps SOX’s most burdensome element was Section 404, which says that it is
management’s responsibility to maintain a sound internal-control structure for financial
reporting and to assess its own effectiveness, and that it is the auditors’ responsibility to attest
to the soundness of management’s assessment and report on the state of the overall financial
control system.

Yet in the course of providing compliance advice to executives, we discovered a small subset
who approached the new law with something like gratitude. For years, and especially when
financial reporting had become fast and loose and criminal conduct entrenched at places like
WorldCom and Enron, these executives had secretly wished that some of the resources
absorbed by their companies’ profit centers could have been diverted to improving financial
management processes and capabilities. They were thinking not only of protecting
stakeholders and shielding their companies from lawsuits but of developing better
information about company operations in order to avoid making bad decisions.

However, the burdens of implementing SOX for the first time, in 2004, were so great that this
more forward-thinking group could give little time to developing and adopting policies and
practices that went beyond literal compliance. Some spoke of putting their planned initiatives
in a “parking lot,’’ with the hope of pursuing them the following year. As SOX went into
effect, more and more executives began to see the need for internal reforms; indeed, many
were startled by the weaknesses and gaps that compliance reviews and assessments had
exposed, such as lack of enforcement of existing policies, unnecessary complexity, clogged
communications, and a feeble compliance culture.

In any era, the enactment of a law like SOX would probably have prompted a similar
stocktaking. But factors in the business world independent of recent abuses had rendered
some companies’ operations and reporting opaque even to the people in charge, making the
timing of SOX’s enactment particularly fortunate. These factors included a frantic pace of
mergers and acquisitions and less-than-seamless integration of the combined entities; the
rapid implementation of new information technologies and their incompatibility with legacy
systems, as well as flawed electronic security and Y2K’s jury-rigged patches and fixes;
foreign expansion, which produced disorienting encounters with unfamiliar languages,
cultures, laws, and ways of doing business; the proliferation of business alliances and
outsourcing; and the stringing together of supply chains. It is no wonder that actual and
reported performance at a number of companies diverged.

Year two of compliance is now complete at most large U.S. companies. Is the parking lot still
full of unimplemented change plans? At many organizations, it is. Their executives want to
simplify and standardize processes and systems but can’t seem to find the time or the
resources to do so. But some executives, particularly those who recognized SOX’s
advantages from the beginning, have figured out how to leverage the new law so that those
plans for improvement can be realized.

In year two, a number of companies have begun to standardize and consolidate key financial
processes (often in shared service centers); eliminate redundant information systems and
unify multiple platforms; minimize inconsistencies in data definitions; automate manual
processes; reduce the number of handoffs; better integrate far-flung offices and acquisitions;
bring new employees up to speed faster; broaden responsibility for controls; and eliminate
unnecessary controls. Moreover, SOX-inspired procedures are beginning to serve as a
template for compliance with other statutory regimes. In this article, we describe the broad
areas in which SOX compliance has benefited firms’ governance, management, and
investors.

Strengthening the Control Environment

Good governance is a mixture of the enforceable and the intangible. Organizations with
strong governance provide discipline and structure; instill ethical values in employees and
train them in the proper procedures; and exhibit behavior at the board and executive levels
that the rest of the organization will want to emulate.

These are all components of the control environment, which forms the foundation of internal
control. Popularized by the Committee of Sponsoring Organizations of the Treadway
Commission in its 1994 report “Internal Control—Integrated Framework,” the term “control
environment” encompasses the attitudes and values of executives and directors and the
degree to which they recognize the importance of method, transparency, and care in the
creation and execution of their company’s policies and procedures.

A proper control environment is one factor an external auditor considers when called upon to
evaluate internal control over financial reporting pursuant to Section 404. Bob Murray, the
director of internal audit at Yankee Candle, a $600 million purveyor of scented candles and
other household items, regularly sends to the auditing firm copies of internal correspondence
emphasizing fraud prevention, internal control, and regulatory compliance. “We hope to
score major points with our auditor for doing this,” he says (though hastening to add that
strengthening the control environment is the company’s primary concern).

These “points” are not tallied in any literal sense. Rather, they contribute to the mass of
evidence weighed by the external auditor. If a company can demonstrate a strong control
environment, then it can reduce the overall scope of its internal-control evaluation. Reduced
scope can mean the company need not carry out as many internal tests and the auditor may do
less corroborating, resulting in lower compliance costs. (Testing scope is a matter of
judgment and perhaps negotiation between the auditor and the company. Indeed, the Public
Company Accounting Oversight Board [PCAOB] and the Securities and Exchange
Commission encourage auditors to exercise judgment when evaluating financial-reporting
controls.)

PepsiCo uses an annual survey of about 100 senior executives to demonstrate the condition of
its control culture. Conducted by the company’s internal auditors, the questionnaire probes
hiring practices, employee evaluation, contract solicitation, incident reporting, objective
setting, and other areas. According to Thomas Lardieri, general auditor and vice president for
risk management, PepsiCo also tests financial employees’ understanding of their
responsibilities as part of its annual ethics training. The training is administered via an
interactive package that includes scenarios of ethical dilemmas one might encounter dealing
with customers, suppliers, and colleagues and suggests possible solutions. About 25,000
managers receive the training. The company’s remaining 135,000 employees receive a code
of ethics manual and some level of reinforcement and training, which varies according to
business unit, says Lardieri. Records of this training may be reviewed by the auditors.

In our presentations at business seminars and conferences, we are often asked why we
emphasize the control environment so heavily. Our questioners seem to believe that good
internal control is predicated on the controls themselves—the cross-checking, the
reconciliations, the data verification. We reply that without a strong control environment, a
company will never attain good governance. A focus on the control environment helps ensure
that the controls themselves are the second and third lines of defence, not the first. Employees
who have been made to understand that it’s not all right to strike side deals with customers, to
recognize revenue prematurely, to conceal possible conflicts of interest, or to look the other
way when these types of activities are going on won’t be busy circumventing the control
system at every turn.

Some executives feel they need to tie every action back to the bottom line. To them we say:
Most investor rating services include an assessment of the control environment as part of
their overall evaluation of the company. Scores from these services can have a significant
impact—either positive or negative—on investor sentiment and the company’s cost of
capital.

Improving Documentation

Documentation activities consumed countless employee hours during the first year of
Sarbanes-Oxley, as companies updated operations manuals, revised personnel policies, and
recorded control processes. Some minds equate paperwork with busywork, but this labour-
intensive effort, to our surprise, received gradually increasing support from the executive
suite. The spur was Sections 302 and 404, which require CEOs and CFOs to attest personally
to the effectiveness of internal control over financial reporting, and Section 906, which makes
“wilful failure” to portray the true condition of the company’s operations and finances a
crime. Section 404 also requires the independent auditor to attest each year to the company’s
evaluation of its controls. The auditor is expected to assess the documentation of controls and
procedures as well as how competently employees perform the control activities for which
they are responsible.

With the advent of Sarbanes-Oxley, Audet saw an opportunity to overhaul the job-description
documentation. The benefits of doing so have been especially noticeable during employee
absences and periods of high turnover, because the revised documentation has helped new
recruits become acclimated more quickly. Clearly defining who’s responsible for which
business processes is a key element of an internal-control program and facilitates training,
oversight, and performance evaluation.

BlackRock’s documentation efforts have also increased employees’ understanding of

operations. Having to commit information to paper (or hard drives) has sent internal auditors
and other employees into the field to see firsthand how tasks are accomplished and how they
might be improved.

PepsiCo has also benefited from updating its documentation processes. In the course of
making these updates, the company determined that inadequate controls existed for pension
accounting, a complex process that depends not only on the internal compensation and
benefits group but on external actuaries and asset custodians.

Lardieri says with dismay, “A lot of steps we assumed were being taken—account
reconciliations and interest calculations and data integrity checks—actually weren’t.”

As soon as the lapses were revealed, the company assigned a controller to its compensation
and benefits group, and an internal team identified, documented, and implemented the
missing control activities. PepsiCo also started demanding written assurances from its asset
custodians that companies with which it did business were adhering to strong internal
controls. (Many other companies obtain similar assurances by requiring SAS 70 Type II
reports, which certify that an independent auditing firm has examined a service provider’s
internal controls.) These measures clarified the control responsibilities of the treasury and
finance departments and the compensation and benefits group. They also improved data
transfers among these functions and with third parties.

A CFO of a Fortune 1000 real estate company informed us of another documentation benefit
from Sarbanes-Oxley. This executive approached Section 404 documentation confident that
his company’s sign-offs had been unfailingly executed, only to make what he referred to as a
“humbling” discovery: The people signing off on the documents apparently had been merely
glancing at the contracts and leases in question. That lack of attention left the company
susceptible to unenforceable contract provisions, miscalculated rent escalations, and
unexecuted underlying agreements. After disciplining the negligent parties, the company
instituted far more rigorous cross-checks of contracts and leases.

Increasing Audit Committee Involvement

Not long ago, board seats were considered by some to be plum assignments, bringing stature
and financial rewards but requiring only limited effort. Today, by contrast, directors face
increased legal liability for inattention and, thus, a heavier workload. In addition, all members
of the audit committee must be free of most financial and personal ties to the company, and at
least one committee member should be a “financial expert,” according to Sarbanes-Oxley. If
not, the company must say so. Thus, it should come as no surprise that board membership has
changed substantially. It appears that both recruits and veterans are taking their new
responsibilities very seriously, as evidenced by longer and more frequent committee meetings
and the more pointed questions members pose.

For many CFOs we’ve worked with, the transformation has been dramatic: “At the very next
meeting of our audit committee, it was a different world in terms of members’ engagement
level,” says one executive. “Some would argue that this intensity should have been there all
along, but the fact is, it wasn’t.”

Yankee Candle CFO Bruce Besanko, who was working at another consumer products
company when Sarbanes-Oxley was enacted, says that the Act changed the atmosphere on
that company’s audit committee. Besanko explains that before Sarbanes-Oxley, many
companies used the same Big Four accounting firm for both auditing and consulting, often
with the preponderance of fees going to consultants. While SEC rules forbid independent
auditors to assist in the design of internal financial information systems, other types of
consulting services are permissible. Nevertheless, a number of audit committees, including
Yankee Candle’s, have asked their independent auditors to stop providing certain consulting
services to the company, except under limited and tightly controlled circumstances. (It should
be noted that Sarbanes-Oxley states that any additional services to be provided by the
external auditor are subject to the audit committee’s explicit approval.)

Exploiting Convergence Opportunities

Two approaches to Sarbanes-Oxley predominate. Some executives dutifully meet SOX
requirements, but at minimum cost and utilizing the fewest possible resources. Others
leverage the resources expended on compliance to obtain a return on their investment.

RSA Security, a $300 million technology company that helps organizations protect online
identities and digital assets, decided to straddle those approaches, combining Sarbanes-Oxley
compliance with other regulatory obligations to gain efficiencies and reduce overall costs.
The company convened a team to identify commonalities among the statutory regimes with
which it had to comply, including the Health Insurance Portability and Accountability Act of
1996 (HIPAA), the Gramm-Leach-Bliley (GLB) Act, California’s Security Breach
Information Act, and other laws to protect privacy and combat identity theft.

One area of convergence was employee record keeping. Like most companies, RSA Security
maintains computerized HR files that contain personal data relating to pay, health benefits,
and Social Security. Various laws and regulations govern the handling of these records:
Financial information is protected under Sarbanes-Oxley, health benefits under HIPAA, and
Social Security and other personal information under various federal and state privacy
statutes.

John Parsons, RSA Security’s vice president of finance and chief accounting officer, says the
executive team realized that a single set of controls could be used for compliance with the
various acts, given the similar way the data were organized and the acts’ common interest in
protecting the data’s integrity and security. In response, functions such as IT and HR adopted
a single set of controls that determined employee level of access to the computer system. An
example of this consolidation was a single log-on for benefits, payroll, and other data.
“Depending on their level and role, some employees get ‘read only’ rights to the files; some
have the ability to change the data; and some, of course, are denied access,” Parsons explains.

RSA Security adopted a similar convergence approach for its International Organization for
Standardization (ISO) 9000 project, an international certification program administered by a
Geneva-based NGO representing hundreds of national standard-setting bodies. ISO sets
standards for quality management and quality assurance in such areas as production
processes, record keeping, equipment maintenance, employee training, and customer
relations.

The commonalities between the ISO and SOX projects weren’t readily apparent to the two
teams working on them (an operations team for the former and a finance team for the latter)
because the two groups worked in separate buildings, with little awareness of each other’s
activities.

Both teams were charged with documenting dozens of business processes and determining
how efficiently they were designed and operated. The ISO team, for example, examined
processes established to ensure that only high-quality, fully debugged software reached the
marketplace, while the SOX team, for example, scrutinized the account reconciliation
process. When Parsons examined a detailed flowchart of the revenue cycle that his SOX team
had prepared, it occurred to him that the ISO team was mapping exactly the same process.
“Why,” he asks, “would we have two different maps for the same business process? We
certainly didn’t need two process maps, two risk assessments, and two sets of controls over
the revenue cycle from generation of the invoice to receipt of payment. So we drove what
were completely parallel ISO and SOX processes into one converged process map and
operational approach.”

The benefits have gone beyond cost savings. “We were also able to free up people and
reallocate their time to higher-value activities,” he says. Instead of tying up so many
employees in the revenue-draining chores of compliance and certification, RSA Security
rededicated some of them to operational improvements, such as streamlining the customer
order process and expanding supply chain capabilities.

Standardizing Processes

While process standardization will never be mistaken for low-hanging fruit, many believe it’s
worth the climb. The work of identifying and addressing inconsistencies across operating
units and locations can be substantial, but so can the yield.

Consider the case of a large clothing manufacturer that operates retail outlets nationwide
under several well-known brand names. During the company’s first stage of Sarbanes-Oxley
compliance, Deloitte & Touche partners met with the CFO and his staff to review the
processes in place for recording basic financial transactions. We started with accounts
receivable and learned that each division of the company imposed different due and dunning
dates, late fees, and interest rates on customers. If the divisions had been independent
companies, these inconsistencies would have been innocuous, but each of these units fed its
financial data into consolidated financial statements, and these non-standardized processes
made a mess of the aged-receivable and bad-debt accounts.
An analogous situation existed at Sunoco. In documenting its procedures for Section 404,
CFO Tom Hofmann was reminded that the company “had three or four different ways to get
an invoice into the system.” Sunoco’s refining business varied the billing process by product
category, be it aircraft fuel, lubricants, or wholesale heating oil.

“These transactions aren’t that different,” Hofmann says. “Why would we have different
billing methods?” He chalked up the discrepancy to the historical independence of the
various business groups and the lack of pressure to standardize. So, on his team’s advice, he
commissioned a single form that could capture all the information required to process a
customer order. This consistency, Hofmann says, reduces the chances for error in data entry
and consolidation.

Having to rebill customers to correct invoicing mistakes can have a cascading effect on
operations: Every invoicing discrepancy, whether caught internally or flagged by a customer,
must be investigated and reconciled, and the invoice must then be cancelled, redone, and
redelivered. As a consequence, the cash flow cycle is interrupted, and customer relations may
become strained. At Sunoco, creating a single, standardized form for every type of product
reduced these problems to a minimum.

The potential benefits of standardization also caught the attention of executives at Kimberly-
Clark, the consumer products manufacturer. Mark Buthman, senior vice president and CFO,
says his company’s Sarbanes-Oxley work spotlighted an area rife with inconsistency: manual
journal entries. “It may not seem that journal entries would be such a big deal, but we have
hundreds of people around the world generating them,” says Buthman, whose company
employs more than 60,000 workers in 38 countries.

Before Sarbanes-Oxley, the company’s journal-entry process varied widely by division and
location, with some employees creating entries by hand, others keying them into Excel
spreadsheets, and still others logging them into the company’s SAP financial software
program. The process for reviewing the entries was also fragmented, with some reviews
conducted by people not senior enough. The management at Kimberly-Clark decided to have
staff log all journal entries into the company’s SAP system. “Instead of having hundreds of
ad hoc procedures for journal entries, we now have just three,” Buthman says. Data are now
more consistent and reliable, and fewer employees and man-hours are required to accomplish
the same task, he says.
Standardization is also a bottom-line issue for Manpower, a $16 billion provider of
employment services operating in 72 countries. With more than 2 million temporary and
permanent employees on the company’s payroll, the need to maintain rigorous checks and
balances is significant. “Even minor decimal or application coding errors can have a huge
impact,” says Nancy Creuziger, a vice president and the company’s controller.

To guard against these types of errors, Manpower standardized its change-management

process for software development. Any code alterations are now subjected to a series of
reviews, tests, analyses, and approvals before going live. A regression test is introduced near
the end of the development process to validate the new code. During the test, technicians
operate two machines concurrently, one running the old code and the other the new. The
same data are put into each, and the output is compared in order to identify coding errors. The
exercise is designed to reveal any programming changes that don’t fall within the scope of
the development plan.

Besides averting financial losses, standardizing the software coding processes also helps
streamline the development cycle. “You standardize a process only after defining the most
efficient way of doing it,” Creuziger notes. For a company that develops global software
applications for its business units, development and support costs can be cut substantially.
Further benefits accrue when internal and external auditors come knocking, since
standardized processes can be evaluated more quickly and thus more cheaply.

Reducing Complexity

Some tasks are inherently complex—designing computer chips, tracking weather patterns,
mapping the human genome. Others are needlessly so. In the case of Iron Mountain, a $1.8
billion records and information management company, merger and acquisition activity
contributed to an increasingly cumbersome organizational structure. Over a ten-year period,
the company had acquired more than 150 competitors and complementary businesses. It
acquired another 50 companies indirectly when it purchased its largest competitor, Pierce
Leahy, which had just completed an acquisition spree of its own.

Simplification was always the game plan at Iron Mountain, says John F. Kenny, Jr., executive
vice president and CFO, but the extensive testing requirements of Sarbanes-Oxley accelerated
these efforts. Each acquired company came with its own organizational chart; Iron Mountain
integrated and streamlined the reporting structure. Each acquisition brought its own
accounting practices; Iron Mountain centralized all accounting activities. Some of the
companies ran Unix while others ran Linux, Novell NetWare, or Windows; Iron Mountain
opted for a single platform. Many of the companies calculated taxes by hand or on
spreadsheets; Iron Mountain automated tax estimation and payments.

“We can’t say with certainty that such-and-such improvement has led to, say, a 5% reduction
in costs,” says Kenny. Nonetheless, he and other executives believe that the company has
made significant gains in efficiency.

Strengthening Weak Links

Another source of complexity arises from outsourcing, partnerships, and shared-services

arrangements, known collectively as the “extended enterprise.” Although businesses have
long outsourced such tasks as manufacturing, order fulfillment, payroll, accounting, human
resources, shipping, tax reporting, and coupon and warranty processing, SOX has recast these
relationships.

One SOX-related complication arises when the partner company engages in activities that
materially affect the primary company’s financials. These can include hosting IT
applications, managing IT infrastructure, providing services in accounts receivable or
accounts payable, processing payroll, managing benefits, and maintaining warehouse
inventories. In such cases, the primary company must obtain evidence of effective internal
control at the partner company, ideally in the form of an SAS 70 Type II report that the
partner provides. If, however, the service provider is unwilling or unable to do so, the
primary company must conduct its own audit.

In view of the difficulties companies have experienced conducting their own internal-control
assessments, most blanch at the thought of verifying third parties’ internal controls. As a
result, many of our respective firms’ clients are revaluating their outsourcing arrangements
and partnerships. Yankee Candle’s CFO, for one, plans to take a hard line if he can’t obtain
an SAS 70 report. “If it is a major partner that impacts our financials, we will terminate the
relationship,” Besanko says.

Minimizing Human Error

Ask most auditors what they consider to be the weakest aspect of internal control, and they’ll
tell you, “Manual processes.” The human beings charged with carrying them out may be
fatigued, distracted, stressed, malicious, or absent. Michael Hammer, the originator of
reengineering, was fond of saying that it is “the ‘biological work units’ that cause most of
your problems.” Automated controls, if properly designed and implemented, aren’t
susceptible to such pitfalls. Yet in our experience, most controls are still manual.

Because automated controls are more reliable, only a single sample of an activity may need to
be tested. (A manual control of the same activity could require dozens of tests.) Also,
according to recent PCAOB guidance, some automated controls can be tested every three
years instead of every year, as long as the company can demonstrate that the control has not
been changed. Some companies step up their security measures to ensure that unauthorized
software modifications can’t be made. For example, many firms now require passwords of at
least eight characters consisting of numbers, symbols, and both lowercase and uppercase
letters. Users must change passwords at least every three months and are locked out after
several consecutive incorrect entries.

Still, some situations call for human judgment. Manpower strives to find a balance between
automated and manual controls. For example, its automated monitoring system flags sales
adjustments exceeding $10,000. But sometimes such adjustments are permissible. “You need
human judgment to determine whether the override is reasonable or whether it needs to be
investigated further,” says Creuziger. “Even highly automated systems need the possibility of
human override in special circumstances.”• •

Whether companies saw the need for internal reform before SOX or have made plans only
recently, too few have actually implemented business improvements. The reasons for this are
several: Audit committees have not insisted that their companies go beyond protecting their
assets and reputation; CEOs haven’t deployed sufficient resources to handle the burden of
doing so; CFOs haven’t been ingenious enough at devising ways SOX can contribute real
value; and CEOs, CFOs, and internal audit departments haven’t collaborated to identify areas
where gains in value could be used to offset the costs of compliance.

More than a year since the first Section 404 deadline arrived, Sarbanes-Oxley still inspires
fear in boards and top executives—of enforcement actions, of the stock market’s reaction to a
deficiency, and of personal liability. Fear can be a powerful generator of upstanding conduct.
But business runs on discovering and creating value. The procrastinators need to start
viewing the Sarbanes-Oxley Act of 2002 as an ally in that effort.
3.8 OVERVIEW OF DIFFERENT MODELS OF CG REPORTS

This article throws light upon the seven important models of corporate governance. The
models are: 1. Canadian Model 2. UK and American Model 3. German Model 4. Italian
Model 5. France Model 6. Japanese Model 7. Indian Model.

1. Canadian Model:

Canada has a history of French and British colonisation. The industries inherited those
cultures. The cultural background in these industries affected subsequent developments. The
country has large influence of French merchantism.

In 19th century the Canadian industries were controlled by rich families. Since last five
decades wealthy Canadian families sold their stocks during stock boom periods. Canada now
resembles United States in industry structure.

Since last four decades there is change in industries in Canada in the areas:

i. Family owned companies are on the increase

ii. Use of new technologies

iii. More entrepreneurial activities

2. UK and American Model:

Sarbanes Oxley Act:

In July 2002, the U.S. Congress passed the Sarbanes Oxley Act (SOX), particularly designed
to make US corporations more transparent and accountable to their stakeholders.

The Act seeks to re-establish investor confidence by providing good corporate governance
practice to prevent corporate scams and frauds in business corporations, to improve accuracy
and transparency in financial reporting, accounting service of listed companies, enhance
corporate responsibility and independent auditing.

The applicability of the Act is not confined only to publicly owned US companies, but also
extends to other units registered with the Securities Exchange Commission. However, there is
a common thread running between them, i.e., that governance matters. Unless corporate
governance is integrated with strategic planning and shareholders are willing to bear the
additional required expenses, effective governance cannot be achieved.
The above events encouraged the development of the present situation where different
aspects of the Sarbanes Oxley Act are discusses, and its effects, limitations and internal
control after the act were passed and what lies beyond its compliance.

Also discussed are the varied applications of the act in areas such as IT, the fee structure of
the Big Four Accounting Firms, the mid-size accounting firms, supply chain management and
insurance.

The Anglo-American Model of industry structure and corporate governance is detailed

in Fig. 2.1:

3. German Model:

Germany is known for industrialisation since beginning of 19th century. Germany exports
sophisticated machinery in a large way since last five decades.

The industries are financed by wealthy German families, small shareholders, banks and
foreign investors. The large private bankers who invested in industry had a bigger say in
running those industries and hence performance was not up to the mark.

Germany is considering proper steps towards corporate governance since second half of
19th century. The company law in Germany of 1870 created dual board structure to care of
small investors and the public. The company law in 1884 made information and openness as
the key theme. The law also mandated minimum attendance at the first shareholders meeting
of any company.

World War I saw considerable changes in industries in Germany by dismantling the rich. As
on date Germany has large number of family controlled companies. The smaller companies
are controlled by banks. The proxy voting by small investors was introduced in Germany in
year 1884.

The German Model of industry and corporate governance is shown in Fig. 2.2:

4. Italian Model:

The Italian business was also controlled by family holdings. The business groups and the
families were powerful by mid of 20th century. Slowly the stock market gained importance
during the second half of the 20th century. The Italian government did not intervene in the
company management or their working.

When the Italian all the investment banks collapsed in 1931 the Fascist government in Italy
took over the industrial shares and imposed a legal separation of investment from commercial
banking. The Second World War brought a change from the government side to have a direct
role in the economy, helping the weak companies and using corporate governance to improve
these companies. This helped the economic growth of Italy particularly in capital intensive
industries.

Since World War II the industrial policy was introduced. The policy had no need for investor
protection. It led the investors to buy a government bonds and not invest in company shares.
The growth of Italian industry came from the small specialised industries which remained
unlisted in stock markets.

The small firms were controlled by families. The corporate governance was in the hands of
bureaucrats or wealthy families. The corporate governance activities and confidence in stock
markets started developing since last two decades. The Italian investors are aware of the
importance of the corporate governance and protection of the rights.

5. France Model:

The French financial system traditionally was regulated by the religion. The controlling
methods, borrowing and lending with the state constituting the main borrower. Religion had
prohibited the interest to some extent. The lending was based on mainly mortgages of real
estates. In early 19th century the French public took to hoarding gold and silver.

Coins composed measure part of money transactions in that period. The French industry was
conservative in its outlook. The business used the retained earnings of one company to build
other areas of business and companies.

The business was controlled by wealthy families who funded these business groups. The
control of the company continued from generation to generation. Stage wise the corporate
government was introduced in France along with economic development activities. This led
to wealthy families controlling corporate sector to come under the watchful guidance of the
state.

6. Japanese Model:

Japan was a deeply conservative country were the hereditary caste system was important.
Business families where at the bottom of the period i.e., beneath priests, warriors, peasants
and craftsmen. Due to lack of funds at the lowest level of the pyramid led to the stagnation of
the business.

The large population of the country needed goods and services and the importance was given
to prominent mercantile families like Mitsui and Sumitomo. The World War II brought a sea
change in the business, commerce and industry and opened the Japanese markets to the
American traders. The young Japanese started taking higher education in Europe and
America and learnt foreign technology, business management.

These led to building of new culture in industry, commerce and economic outlook in Japan.
The government also started establishing stated owned companies. These companies ended
up in losses and huge debts. To come out of the problem the government made mass
privatization of most of these companies. Many of these were sold to Mitsui and Sumitomo
families.

In the mean while Mitsubishi gained prominence. The three companies groups were called
Zaibatsu “meaning controlled by pyramids of listed corporations”. The growth of Japanese
industry is a mix of private and state capitalism. Meanwhile large companies developed in the
auto area like Nissan and Suzuki. The Suzuki company was owned by the Suzuki family.

The depression period of 1930’s brought economic stagnation and eroded the appreciation of
the Japanese public for the family companies. The family companies always kept their family
rights ahead of their shareholders and public interest. The private company resorted to short-
term gains and did not care for long-term investments or projects of long gestation.

The large companies in Japan also had their own banks. In 1945’s the American occupied and
took charge of the Japanese economy that changed the face of Japanese industry and
economy. By the beginning of 1950’s the Japanese large companies were free standing and
widely held similar to United Kingdom and United States.

The companies which were poorly governed were the targets for takeover by the large
companies. The banks controlled the large groups of industry which are called as Keiretsu.
The Keiretsu system is in place even today. The large companies also influence government
in a big way. The corporate governance has evolved in Japan since last 2 decades.

The Japanese Model of industry and corporate governance is shown in Fig. 2.3:
7. Indian Model:

East India Co. (EIC) in its trade had malpractices.

Current practice since 400 years since industrialisation in companies.

Environmental and world commercial are classic cases.

Family owned cos.

India has long history of commercial activities 2500 years old.

(a) The Managing Agency system 1850-1955

(b) The Promoter System 1956-1991

(c) The Anglo American System 1992 onwards

The Securities and Exchange Board of India (SEBI):

Established SEBI Act in Jan. 1992 gave statutory powers and introduced had 2 issues.

(a) Investor protection and

(b) Market Development.

SEBI is part of department of Company Affairs Govt. of India.

SEBI has moved from control regime to prudential regulation.

It is empowered to regulate working of stock exchanges and its players including all listed us.

SEBI is playing a key role in corporate governance in India.

These developments in U.K. had significant influence on India. Confederation of Indian

Industries (CII) appointed a National Task Force headed by Rahul Bajaj, who submitted a
‘Desirable Corporate Governance in India – a Code’ in April 1998 containing 17
recommendations.

Thereafter Securities and Exchange Board of India (SEBI) appointed a Committee under the
Chairmanship of Kumar Mangalam Birla. This committee submitted its report on 7 May
1999, Containing 19 Mandatory and 6 non-mandatory recommendations. SEBI implemented
the report by requiring the Stock Exchanges to introduce a separate clause 49 in the Listing
Agreements.

In April 2002 Ganguly Committee report was made for improving corporate governance in
Banks and Financial Institutions. The Central Government (Ministry of Finance and
Company Affairs) appointed a Committee under the Chairmanship of Mr. Naresh Chandra on
Corporate Audit and Governance. This committee submitted its report on 23 December 2002.

Finally SEBI appointed another committee on Corporate Governance under the Chairmanship
of N.R. Narayan Murthy. The committee submitted its report to SEBI on 8 Feb. 2003. SEBI
thereafter revised clause 49 of the Listing Agreement, which has come into force with effect
from 01 January 2006.

Some of the recommendations of these various committees were given legal recognition by
amending the Companies Act in 1999, 2000 and twice in 2002. With a view to gear company
law for competition with business in developed countries, the Central Government (Ministry
of Company Affairs) appointed an expert committee under the Chairmanship of Dr. Jamshed
J. Irani in December 2004.
The Committee submitted its report to the Central Government on 31 May 2005. The Central
Government had announced that the company law would be extensively revised based on Dr.
Irani’s Committee Report.

Corporate world is awaiting the changes to be made in company law. Parliament on 15 May
2006 had approved the Companies (Amendment) Bill, 2006 which envisages implementation
of a comprehensive e-governance system through the well-known MCA-21 project.

Corporate governance has once again become the focus of media/public attention in India
following the debacles of Enron, Xerox and WorldCom abroad, and Tata Finance/Ferguson,
Satyam, telecom scams by few companies and black money laundering, employed by few at
home.

With the opening of the markets post liberalisation in early 1990’s and as India get integrated
into world economy, the Indian companies can no longer afford to ignore better corporate
practices which are essential to enhance efficiency to survive international competition.

The question that comes to the minds of Indian investors now is, whether our institutions and
procedures are strong enough to ensure that such incidents will not happen again, or has the
Indian corporate sector matured enough to practice effective self-regulation? These
developments tempt us to re-evaluate the effectiveness of corporate governance structures
and systems in India.

Economic liberalisation and globalisation have brought about a manifold increase in the
foreign direct investment (FDI) and foreign institutional investment (FII) into India. More
and more Indian companies are getting themselves listed on stock exchanges abroad. Indian
companies are also tapping world financial markets for low cost funds with ADR/GDR
issues.

Companies now have to deal with newer and more demanding Indian and global shareholders
and stakeholder groups who seek greater disclosure, more transparent explanation for major
decisions, and, above all, a better return for their stake. There is, thus, an increased need for
Indian boards to ensure that the corporations are run in the best interests of these highly
demanding international stakeholders.

Initiatives by some Indian companies and the CII have brought corporate governance to a
regulatory form with the introduction of Clause-49 in the Listing Agreement of companies
with the stock exchanges from January 2000. The first to comply with the requirements of
Clause-49 were the Group-A companies, which were required to report compliance by March
31, 2001.

However, the code draws heavily from the UK’s Cadbury committee, which is based on the
assumption of a dispersed share ownership – more common in the UK – than the
concentrated and family-dominated pattern of share ownership in India. In addition in regard
to corporate governance the Indian corporate have also overhauled them.

3.9 NARAYAN MURTHY AND GANGULY COMMITTEES

With a view to improving the financial health of the banks further, and make the Indian
banking system world class, the Reserve Bank of India, in consultation with Indian Banks
Association (IBA), appointed a committee known as the consultative Group of Directors of
banks and financial institutions, with the following terms of reference: 1. To review the
supervisory role of Boards of banks and financial institutions and to get feedback on the
functioning of the Board vis-à-vis compliance, transparency’ disclosures, audit committees
etc. 2. To study the system prevalent in banks/financial institutions for monitoring by the
Board, the implementation of the policies laid down by it.

1. To make recommendations for making the role of Board of Directors more effective with
Notes a view to minimising risks and over-exposure. 4. To consider any other matter relevant
to the subject. With a view to getting certain expert opinion in the area of its study, the Group
discussed various issues with known specialists in the field.

The following experts and professional bodies held discussions/made presentation before the
Group:

1. Institute of Company Secretaries of India, New Delhi

2. Dr. Y.R.K. Reddy of Yoga Consulting Pvt. Ltd, Hyderabad.

3. Cons India HR Services Pvt. Ltd., Mumbai The Group held four meetings, including the
presentations by the expert Groups. It also met a representative group of banks in a separate
meeting on 8th March 2002 to elicit feedback on the draft recommendations of the Group.
The recommendations of the group concern the areas, as discussed in following subsections.

Constitution of the Board of Directors

The Board of Directors has important fiduciary responsibilities to the shareholders of the
company. The Board is responsible for the overall management and effective functioning of
the bank. As Banks are corporate entities, the Board of a bank is responsible to the
shareholders. Further, banks being important participants in the payment systems, it is
enjoined upon the Boards to safeguard the interests of the depositors and other stakeholders.
The Board, however, cannot be expected to supervise the day-to-day operations of the bank
and it, therefore, delegates and entrusts appropriate authority to the various functionaries, via
the whole-time directors of the Board such as Chairman, Managing Director and Executive
Directors. This makes each whole-time director, individually, and the Board, collectively,
responsible for the performance of the bank. The challenge facing Indian banking has been
getting the board of directors to shape strategy and monitor performance without encroaching
on management terrain or becoming too involved in the bank’s day-to-day operations. The
Group notes that the statutes governing public sector banks vest powers with the Central
Government to appoint whole-time directors as also majority of the independent/non-
executive directors. The Boards of public sector banks (barring State Bank of India) comprise
presently, two whole-time directors (one Chairman & Managing Director and one Executive
Director). Considering the fact that banking is becoming more complex, the Group is of the
view that one more whole-time director should be appointed on the Boards of large-sized
nationalised banks, who could provide undivided attention to critical areas like risk
management systems, human resource management, etc.

The eligibility criteria normally followed for nomination of independent directors to the
Boards of public sector banks are the following:

1. The candidate should normally be a graduate (which can be relaxed while selecting
directors for the categories of farmers, depositors, artisans, etc.)

2. He/She would be between 35 and 65 years of age.

3. He/She should not be a Member of Parliament/Member of Legislative

Assembly/Member of Legislative Council

The Group is of the view that the above criteria needs to be revised in view of challenges
facing the banking sector. Presently, the due diligence is done, to a limited extent, by the
Reserve Bank of India for the candidates considered for independent/non-executive
directorship in public sector banks. The due diligence by RBI is, however, confined to
verifying whether the names forwarded by the Government of India figure in the Defaulters’
List or not. This due diligence process does not assess either the ability, professional
qualification or the technical competence of the candidates being considered for directorship
to fulfil the fiduciary responsibilities expected of them. In the case of independent/non-
executive directors of private sector banks, since they are appointed by the Board, the due
diligence exercise is not done by RBI. Such directors are appointed by the Board keeping in
view the requirement of giving representation to the specified sectors, as enshrined in the
Banking Regulation Act, 1949. The Group recommends that the criteria followed by the
Government of India for nominating directors to the Boards of public sector banks and the
due diligence followed for them should be made applicable to independent/non-executive
directors of other banks as well. The Group is of the view that due diligence of the directors
of all banks - be they in public sector or private sector should be done in regard to their
suitability for the post by way of qualifications and technical expertise. The Group strongly
feels that involvement of Nomination Committee of the Board in such an exercise should be
seriously considered as a formal process. The final decision in respect of appointment of
independent/non-executive directors should be that of the Board with the Nomination
Committee presenting its recommendations highlighting both positive and negative aspects of
each recommended candidate, for consideration of the Board. While the desirable
international practice of the Board members being nominated by the Nomination Committee
from a list of qualified, experienced professionals would require amendments to the banking
laws, the Group recommends that the Government while nominating directors on the Boards
of public sector banks should be guided by certain broad “fit and proper” norms for the
directors. The Group recommends the criteria suggested by the BIS to consider “fit and
proper” for bank directors: 1. Competence of the individual directors as assessed in terms of
formal qualifications, previous experience and track record. 2. Integrity of the candidates. For
assessing integrity and suitability, features like criminal records, financial position, civil
actions undertaken to pursue personal debts, refusal of admission to, or expulsion from
professional bodies, sanctions applied by regulators or similar bodies, and previous
questionable business practices, etc. should be considered. (of, “Supervision of Financial
Conglomerates”, 1998, BCBS). The Group recommends that these criteria should also be
made applicable to nomination of independent directors of private sector banks. The Group
recommends that a pool of professional and talented people should be built up for
consideration of nomination as independent/non-executive directors to the Boards of banks
and financial institutions. The list of such eligible directors should be assembled by RBI from
independent sources after proper due diligence and such a list should be put on the RBI’s
website for access by all concerned. The Group is of the view that appointment/nomination of
independent/non-executive directors to the Boards of banks (both public sector and private
sector) should be from this list. Any deviation from this procedure by any bank, according to
the Group, should be with the prior approval of RBI. RBI may also establish procedures for
regularly updating the list through additions and deletions from time to time.

Composition of the Board Notes

The Group examined the structure and the composition of the Boards of banks. It is noted
that composition of the Boards of banks is more regulation-based rather than need-based. As
per the regulation applicable to banks, the Board of Directors of a bank is required to have
representation from specific sectors like agriculture and rural economy, co-operation, SSI,
law, etc., The Group is of the view that in the context of banking becoming more complex
and competitive, the composition of the Board should be left to the business needs of banks.
Composition of the Board (by way of representation of various sectors) should be so as to
reflect the business strategy and its vision for the future. The Group is of the view that in the
present context when banking is becoming more complex and knowledge-based, there is an
urgent need for making the Boards of banks more contemporarily professional, by inducting
technical and specially qualified personnel. The earlier requirement of ensuring
representation on the Boards of banks for areas like agricultural sector, law, co-operation,
small-scale industry, etc. which were relevant in the immediate post nationalisation era, in the
Group’s view, have not to be supplemented by other emerging priorities. The Group feels that
instead of attempting to wholly change sectional representation, efforts should be aimed at
bringing about a blend of ‘historical skills’ set (that is, regulation based representation of
sectors like agriculture, SSI, co-operation, etc.) and the ‘new skills’ set (that is, need-based
representation of skills such as, marketing, technology, and systems, risk management,
strategic planning, treasury operations, credit recovery, etc.). It recognised that agriculture
still contributes a significant share of GDP and representation to agriculture and SSI, etc.,
sectors have to be continued.

With increased de-regulation and the structural changes that have taken place in the economy
and in the banking sector, the Group is of the view that the Boards of banks should have
representation in the following areas:

1. Finance
 2. Information Technology

3. Human Resources Development

4. Persons with good track record of experience in managing/advising industrial

enterprises

5. Economics

Independent/Non-executive Directors

The independent/non-executive directors in any organisation have a constructive role to play

both on-and-off-the Board because of their knowledge and professional objectivity. Within
the existing legal framework, the Group is of the view that independent/non- executive
directors must play a more pro-active role by exercising their independence of judgement,
practical experience, specialised knowledge, etc., to the deliberations of the Board. The
independent/ non-executive directors have a prominent role in introducing and sustaining a
pro-active governance framework in banks and financial institutions. The independent/non-
executive directors, according to the Group, should provide constructive inputs regarding the
business strategy, performance of the bank, etc. They should act as the catalyst for focused
discussions on issues brought to the Board and subjects of critical importance to the bank
during the meetings of the Board. These directors, being independent, are expected to be free
from any organisational affiliation and should seek all information which are relevant to
monitor the performance of the bank, the overall risk profile of its credit and investment
portfolios, cases of over-exposure to one or a particular group of borrowers or entities
related/associated with the promoter directors, etc. According to the Group, the
independent/non-executive directors should raise in the meetings of the Board, critical
questions relating to:

1. Business strategy, including loans and recovery policy

2. Housekeeping and internal control system

3. Record of exposure to various sectors/industries by way of both credit and

investments, etc.

4. Risk management systems

5. Internal audit

6. Accounting policy
 7. Senior management development

8. Other aspects of the functioning of the bank, and

9. Investor relations.

The independent/non-executive directors need to ensure that the vital issues raised by them
are addressed by the bank to the full satisfaction of the Board. While making the above
recommendations, the Group is guided by the fact that good corporate governance in banks
will be sustained by a knowledgeable, skilful and well informed Board of Directors with a
correct blend of expertise/professionalism, independence and involvement. In the case of
private sector banks where promoter directors may act in concert, the independent /non-
executive directors should provide effective checks and balances ensuring that the bank does
not build up exposures to entities connected with the promoters or their associates. They
should also seek through the Board, all information relating to critical areas like connected
lending, investments, exposure to entities/associates related to the promoters/large
shareholders. The independent/non-executive directors should provide effective checks and
balances, particularly in widely held and closely controlled banking organisations.

Commonality of Directors of Banks and NBFCs

In regard to the existing regulatory prohibition on directors of NBFCs becoming independent/

non-executive directors on the boards of banks, the Group is of the view that it would not be
proper to debar a professional director on the board of an NBFC from becoming a director on
the board of a bank. It needs to be noted that as per the existing policy, NBFCs satisfying
certain criteria (such as, AAA rating, minimum net worth of 200 crore, CRR of not less than
12%, net NPA not more than 5%, etc) are allowed to be converted to a bank. In view of the
above policy stance, the Group feels that it would not be fair to debar directors on the boards
of NBFCs becoming independent/non-executive directors on the boards of banks.

1. He/She is not the owner of the NBFC, [holdings (single or jointly with relatives,

Associates, etc.) Exceeding 50%] or

2. He/She is not related to the promoter of the NBFC, or

3. He/She is not full-time employee in the NBFC

In regard to full-time employees of NBFCs, the Group feels that the Reserve Bank of India as
the Notes regulator, should have the discretion for considering such person for directorship in
a bank, keeping in view the specific circumstances, merits, etc., of each case.

Responsibilities of Directors

A strong corporate board performs four major roles: over-seeing the risk profile of a
company, monitoring the integrity of its business and control mechanisms, ensuring that
expert management is in place and maximising the interests of its stakeholders. Such a board
has regular and close contact with the organisation and can detect and correct any abnormal
behaviour quickly. Such a board is also able to play a crucial role in hiring and retaining
sound managers. The Group is of the view that banks being pivotal for the country’s financial
system, the boards of banks should fulfil all these four roles. The Board of Directors of banks
and financial institutions have, besides fiduciary obligations, as above, important social
responsibilities, and the responsibilities to ensure compliance with the regulatory framework.
These would include compliance with the directions/policy of the Government etc. In their
fiduciary capacity, the Boards of directors should receive regular reports from their
management committees, auditors and audit committee, formulate clear written policies in
regard to various business strategies and policies (credit, investments, etc.), performance
parameters for the bank and ensure that the bank’s affairs are conducted in accordance with
the stated policies/regulatory requirements. The Board should formulate policies relating to
credit dispensation particularly in regard to exposures to various productive sectors,
geographical areas, investments, exposures to sensitive sectors such as capital market,
strategies for recovery of loans and status of progress with respect to investments, risk
management, etc. The need for clear lines of responsibilities in any organisation cannot be
over emphasised. In the case of banks, the Group notes that the responsibilities are well
defined for the managerial functionaries. Powers are delegated to the various functionaries of
the bank for sanctioning of loans and advances, investments, incurring authorised level of
expenditure, etc.

The managerial functionaries are also made accountable and their performance is monitored
vis-à-vis the performance targets agreed to by the Board, judicious exercise of discretionary
powers, etc. The Group recommends that every director should be given a brief on the
functioning of the bank, before his appointment/induction, covering the following:

1. Delegation of various authorities by the Board

 2. Strategic Plan of the bank

3. Organisational Structure

4. Financial and other controls and systems

5. Economic features of the market and competitive environment, and

6. Meeting with key management team after briefing

Training of Directors

The Group is of the view that the directors could be made more responsible to their
organisations by exposing them to need-based training programmes/seminars/workshops to
acquaint them with the emerging developments/challenges facing the banking sector. The
directors should be exposed to the latest management techniques, technological
developments, innovations in financial markets, risk management and other areas of interest
to the organisation to discharge their duties to the best of their abilities. The Group is of the
view that such investment would be the Regulator, could take the initiative in organising such
seminars for the directors of banks and financial institutions. The Group notes that broad
guidelines have been issued both by the Government of India and the Reserve Bank in regard
to the role expected of their nominees on the Boards of banks. These guidelines emphasise
the following points:

1. The director is expected to regularly attend board meetings and take an active part in
its deliberations.

2. Members of the Board do not exercise any executive authority individually, but are
collectively responsible for the superintendence, direction and management of the
bank.

3. While directors can delegate certain powers to any committees, executives or other
officers, they cannot absolve themselves of their responsibility of ensuring that the
bank operates on sound and prudent lines.

4. They are responsible for safeguarding the interests of the depositors and owners
through efficient and well informed administration of the bank.

5. Directors are expected to critically and thoroughly go through the agenda papers well
before the Board meeting.
 6. They should pay adequate attention to the state of non-performing assets, recovery
performance and write—off large debts (say 1 crore or more)

Based on the meetings attended by them, the nominee directors are required to submit reports
to the Government (in the case of its nominees on the Boards of public sector banks) and to
Reserve Bank of India (in respect of its nominees on the Boards of all banks). Presently, there
is no mechanism to make the directors on the Boards of banks and financial institutions
accountable for the performance of their organisation. The Group is of the view that the lack
of clearly documented responsibility and accountability of directors on the Board stems from
the manner in which the Board is constituted. In the case of public sector banks, majority of
the Board comprises nominees of the Central Government and the individual directors are,
therefore, mainly accountable to the political institution of the land. The Group is of the view
that while a change in the manner in which the Boards are constituted is essential in order to
make the Board and its individual members more accountable, this would necessitate a
change in the statutes governing the banking sector. According to the Group, the role of
CEOs–their track record, competence and leadership qualities–provides the pivot for good
governance practices in a banking company. The process of selection of the CEO, therefore,
assumes crucial importance in the endeavour to introduce modern corporate governance
standards in banks. The Group is of the view that it would be desirable to separate the office
of Chairman and Managing Director in respect of large sized banks. Keeping in view the
balance sheet size, sophistication of business transactions and complexity of the bank, the
office of Chairman and Managing Director could be bifurcated into two: The Chairman who
is the Chairman of the board and the Managing Director who could function as the Chief
Executive responsible for day-to-day management of the bank. The Group is of the view that
this functional separation will bring about more focus and vision as also the needed thrust in
the functioning of the top management of the bank. The Group notes that many Expert
Committees (including the Committee on Banking Sector Reforms under Chairmanship of
Shri M. Narasimhan) had recommended in favour of a reasonably long tenure of services for
the whole-time directors.

The Group recommends that the whole-time directors should have sufficiently long tenure so
as to enable them to leave a mark of their leadership and business acumen on the bank’s
performance.

While the responsibilities of nominee directors have been clearly laid down, the
responsibilities Notes of the Board of Directors as a whole has not been delineated.
Furthermore, there is no practice of advising the directors (other than nominee directors) of
banks their responsibilities, role, etc. in the organisation. The Reserve Bank of India had
circulated in 1984 among the private sector banks, guidelines on the role and functions of
independent/non-executive directors on the Boards of private sector banks. These guidelines
were in the nature of operational guidelines bringing home to them the fact that the directors
should not interfere in day-to-day affairs of the bank or otherwise intervene in
credit/investment/personnel/other operational matters. The guidelines highlight the need for
the independent/non-executive directors to take interest in the bank’s work concerning their
own fields of specialisation/activity and also deliberate on all matters of general policy
affecting the bank’s functioning. The guidelines exhort that every director should function in
a manner most conducive to the interests of the depositors, of the shareholders and of the
nation as a whole. The Reserve Bank of India had also circulated in 1992 a list of “do’s” and
“don’ts” to the private sector banks, with a view to sensitising the directors on their role and
responsibilities. A similar list had also been given by the Government to the directors of
public sector banks. The Group recommends that these instructions may be reviewed and
updated where required, and the roles and responsibilities of independent/non-executive
directors be clearly stated. Keeping in view the recent developments and the changes
witnessed in the banks’ operations, as also the technical developments, the Group suggests
that Reserve Bank may bring out an updated charter indicating clear-cut, specific guidelines
on the role expected and the responsibilities of the individual directors. The responsibilities of
the directors according to the Group should illustratively include the following:

1. Deliberating and approving the objectives, business strategies and annual business plans

2. Deliberating and approving the management succession policy of the institution, and
assessing senior management’s performance on an on-going basis

3. Clearly defining the authorities and responsibilities of both executive directors and relevant
senior management

4. Developing and providing a list of checks and balances for use by senior management

5. Formulating policies on vital areas of bank’s functioning (viz., loan and recovery policy,
investment policy, risk management policy exposure to sensitive sector including capital
market, etc.)

6. Guidance on risk management particularly investment assessment, the fixation of risk

limits, exposure ceiling both individual and group - borrower ceilings, etc.,
7. Approve the policy on introduction of technology to the bank’s various facets of working
with a view to provide better service in a most cost-effective manner as measured by targets
of productivity and profitability.

8. Maintaining and recording appropriate levels of checks and balances with regard to the
influence of the management and/or large shareholder (s)

9. Monitoring on an on-going basis the bank’s performance, build-up of exposure to various

categories of borrowers, industries, sectors, etc against targets of the annual operating plan.

10. Discussing the reports submitted by the Audit Committee, monitoring the follow-up
action taken to rectify the deficiencies observed, etc.

1. Ensuring compliance with all legal/regulatory requirements, etc.

As a step towards effective corporate governance, the Group is of the view that it would be
desirable to take an undertaking from every director to the effect that they have gone through
the guidelines defining the role and responsibilities of directors, and understood what is
expected of them and enter into a covenant to discharge their responsibilities to the best of
their abilities, individually and collectively. In this connection the Group would recommend
that before appointment of a director, a questionnaire on the lines of the one used by the FSA
of UK, modified keeping in view of our requirements could be used as a model Annexure 2
for obtaining relevant information regarding background of the potential appointee. The
Group is of view that in consonance with transparency in regard to responsibility of directors,
an appropriate covenant should be obtained from each of the directors, whether they are
independent/non-executive directors/nominees of Government/RBI/other institutions having
sizable shareholding in banking organisations. The Group accordingly has devised a covenant
for adoption by all the banks.

Remuneration to Directors

The Group is of the view that the existing level of remuneration paid (by way of sitting fees
etc.) to directors of banks and financial institutions is grossly inadequate, by contemporary
standards, to attract qualified professional people to their Boards, and expect them to
discharge their duties as per the mutually agreed covenants. A few of the banks/FIs have
modified their compensation plans to include a base salary, performance bonus and options to
their directors. In order to get quality professional people, the level of remuneration payable
to the directors should be commensurate with the time required to be devoted to the bank’s
work and also to signal the appropriateness of remuneration to the quality of inputs expected
from a member. The remuneration of the directors may also include the form of stock option.

Prohibitions Flowing from Section 20 of the BR Act, 1949

The Group is of the view that the statutory prohibition under section 20 of the Banking
Regulation Act, 1949 on lending to companies in which a director is interested, severely
constricts availability of quality professional directors on to the Boards of banks. The Group
notes that internationally, however, banks are permitted to extend credit facilities to
companies in which the directors are interested subject to full disclosure and appropriate
covenants. The Group is aware that any change in the existing legal framework would require
an amendment to the Banking Regulation Act. The Group recommends that we move towards
that goal.

Information Flow to/from the Board

The Group notes that the effectiveness of the Board largely depends upon the flow of
information to and from the Board. The information furnished to the Board should be
wholesome and complete and should be adequate to take meaningful decisions. A distinction
needs to be made between statutory items and strategic issues in order to make the material
for directors ‘manageable’. In this context, the Group reviewed the practices of banks and
financial institutions in regard to preparation of the agenda notes, recording of the
proceedings of the meeting of the Board, follow up of various action points arising from the
decision taken at the meetings, etc. The Group noted that the manner in which the
proceedings are recorded and followed up in public sector banks leave much scope for
improvement. An issue that was brought to the notice of the Group was the number of
reviews put up to the Board as per the Calendar of Reviews prescribed by the Reserve Bank
of India. It was pointed out that the large number of reviews put up to the Board leaves little
time to the Board for fruitful discussions on future business strategies and policies. The
Group recommends that the Reviews dealing with various performance areas could be put to
the Supervisory Committee of Board Notes and a summary on each of the reviews could be
put up to the Board itself, for scrutiny and further action. The Board’s focus should be more
on strategy issues, risk profile, internal control systems, overall performance of the bank, etc.
The Group is of the view that procedure followed for recording of the minutes of the Board
meetings in banks and financial institutions should be uniform and formalised. The Group
would suggest that banks and financial institutions may adopt two methods for recording the
proceedings. A summary of key observations made which should be submitted to the next
Board meeting and a more detailed recording of the proceedings which will clearly bring out
the observations, dissents, etc. made by the individual directors which could be forwarded to
them for their confirmation. The Group is of the view that the draft minutes of the meeting
should be forwarded to the directors, preferably via the electronic media, within 48 hours of
the meeting and ratification obtained from the directors within a definite time frame. If a
director fails to respond within the time specified, it should be taken that he/she has no
comments to offer. In every Board meeting, the Board should review the status of the action
taken on the points arising from the earlier meetings and till action is completed to the
satisfaction of the Board, any pending item should continue to be put up before the Board.

Company Secretary

The Group noted that the public sector banks do not have a qualified Company Secretary on
their rolls. A Company Secretary has important fiduciary and Company Law responsibilities.
The Company Secretary is the nodal point for the Board to get feedback on the status of
compliance by the organisation in regard to provisions of the Company Law, Listing
Agreements, SEBI Regulations, Shareholder grievances, etc. Did u know? The Public Sector
banks historically had no qualified Company Secretary. In the context of a number of banks
in the public sector accessing the capital market, the Group is of the view that there is now a
need to have a qualified Company Secretary in order to ensure that the bank is in compliance
at all times with the company law related issues as also to be instrumental in redressing
grievances of the investors. A qualified Company Secretary, according to the Group, would
also fulfil the earlier recommendation in regard to recordings of the proceedings of the
meetings of the Board and its Committees. The Group recommends that all banks should
consider appointing qualified Company Secretary as the Secretary to the Board and have a
Compliance Officer (reporting to the Secretary) for ensuring compliance with various
regulatory/accounting requirements. Further, the Institute of Company Secretaries of India
may be required to include appropriate inputs in their curriculum in order to accommodate
banking provisions, technical teams etc., as part of the professional examination.

Committees of the Board Supervisory Committee

An issue raised during the deliberations of the Group was whether an additional tier by way
of Supervisory Board could be considered for banks, a practice which is followed by banks in
Germany. The Supervisory Boards of banks in Germany mainly function as “Executive
Committees” of the Board. The public sector banks in India have constituted “Executive

Committee” or “Management Committee” which meet more frequently than the full Board
do. The Group is of the view that instead of creating another tier by way of a Supervisory
Board, there could be a Supervisory Committee of the Board in all banks – be they public or
private sector, which will work on collective trust concurrently, without diluting the overall
responsibility of the Board. The role and responsibilities of the Supervisory Committee of the
Board could include monitoring of the exposures (both credit and investment) by the banks,
review of the adequacy of the risk management process and upgradation thereof, internal
control systems and ensuring compliance with the statutory/regulatory framework. Audit
Committee of the Board The Group notes that banks have set up–as required in terms of the
R.BI guidelines–independent Audit Committees. The Audit Committee comprises a majority
of the independent/non-executive directors with the Executive Director of the bank as one of
the members. The Group notes that a Chartered Accountant, wherever available on the board,
is a member of the Audit Committee. The international best practice in this regard is to
constitute Audit Committees with only independent/non-executive directors. As regards the
composition of the Audit Committee, the Basel Committee has suggested that in order to
ensure its independence, the Audit Committee of the Board should be constituted with
external Board members who have banking or financial expertise, (Enhancing Corporate
Governance for Banking Organisations: Basel, September 1999). The Group is of the view
that ideally the Audit Committee should be constituted with independent/non-executive
directors and the Executive Director should only be a permanent invitee. However, keeping
in view the present circumstances, the existing arrangements where the Executive Director is
one of the members may continue, and may include the Executive Director and official
directors i.e., nominee of Government of India and R.B.I. in respect of public sector banks.
The Group is of view that the Chairman of Audit Committee need not be confined to the
Chartered Accountant profession but can be a person with knowledge of ‘finance’ or
‘banking’ so as to provide directions and guidance to the Audit Committee, since the
Committee not only looks at accounting role but also the overall management audit etc., of
the bank. Nomination Committee The Group is of the view that it is desirable to have a
Nomination Committee for appointing independent/non-executive directors of banks that
should scrutinise the nominations received for nomination of independent/non-executive
directors with reference to their qualifications, experience and other criteria proposed above.
The Group recognises that in the case of public sector banks, the nomination committees may
not be of immediate relevance, since the independent/non-executive directors (except
shareholder nominees in the case of banks which have issued capital to the public) are
appointed by the Central Government. The Group is of the view that in the context of a
number of public sector banks issuing capital to the public, a Nomination Committee of the
Board may be formed for nomination of directors representing shareholders. Shareholders’
Redressal Committee Since banks are increasingly accessing capital market, there is a need
for an effective machinery for redressal of investor grievances in banks. The Group notes that
as of now, the matters relating to investor complaints, etc., are looked after by the line staff.
With a view to building up credibility among the investor class, the Group recommends that a
Committee of the Board may be set up to look into the grievances of investors and share
holders, with the Company Secretary as a nodal point.

Risk Management Committee Notes The Group notes that in pursuance of the Guidelines
issued by the Reserve Bank of India, every banking organisation is required to set up Risk
Management Committees (for management of both credit risk and market risk) with Board
level representation to manage effectively the risk profile of the bank. The management of
risk particularly arising from over exposure to interconnected entities, came to the fore in the
recent past in respect of a few banks. The Group, therefore, recommends that the formation
and operationalisation of the Risk Management Committees should be speeded up and their
role further strengthened. Disclosure and Transparency The Group notes that disclosure
requirements for banks have been substantially enhanced in the recent period. Banks are now
required to disclose in the ‘Notes on Accounts’, exposure to sensitive sectors as also exposure
to capital market by way of (a) direct investment in shares and debentures, (b) advances
against shares and debentures and (c) guarantees issued on behalf of stockbrokers. The Group
suggests that it would be desirable if the exposure of a bank to stockbrokers and market
makers as a group, as also exposure to other sensitive sectors (viz., real estate), exposure to
various sectors, etc. are reported to the Board regularly. The Group recommends that the
following disclosures be made by banks to the board of directors at regular intervals as may
be prescribed by the board from time to time:

1. The progress made in putting in place a progressive risk management system—the risk
management policy and strategy followed by the bank.

2. Exposure to related entities, viz., details of lending to/investment in subsidiaries, the asset
classification of such lendings/investment, etc.
3. Conformity with Corporate Governance standards–structure, various committees, etc.–
should be ensured.

3.10 SUMMARY

The process of development of codes and guidelines is started with the setting up of different
committees on corporate governance. These committees gave formulated the codes of best
conducts, which covers the different areas such as board structure, remuneration of directors,
shareholders’ rights etc. Since banks are important players in the financial system, special
focus on the Corporate Governance in the banking sector becomes critical.

As per the recommendations made by the Ganguly committee, the banks could be asked to
come up with a strategy for implementation of the governance standards recommended. Once
the strategy is received from all banks, the progress of implementation could be reviewed
after a period of twelve months. Thereafter, the position could be reviewed half yearly or
annually, as deemed appropriate.

 Business and society complement each other.

 The government regulations have considerable influence on the company’s business

objectives.

 As a stakeholder, the government has to regulate the CSR activities of the business
organizations.

3.11 KEYWORDS

 Basel II: The second of the Basel Accords, which are recommendations on banking
laws and regulations issued by the Basel Committee on Banking Supervision.

 Executive director: Working director of a firm who is usually also its full time
employee and has a specified decision making role.

 Non-bank financial companies: Financial institutions that provide banking services

without meeting the legal definition of a bank.
  Non-executive director: Non-working director of a firm who is not an executive
director and, Notes therefore, does not participate in the day-to-day management of
the firm.

 Sarbanes-Oxley Act: Law which establishes a broad array of standards for public
companies, their management boards, and accounting firms.

 Whistle blowers: A person who tells the public or someone in authority about alleged
dishonest or illegal activities occurring in an organisation.

3.12 LEARNING ACTIVITY

1. What are the benefits which occur to an organisation by following good corporate
governance system?

___________________________________________________________________________
___________________________________________________________________________

2. Common the prime objectives of Corporate Governance to deliver efficient management

structure to strengthen the trust and confidence of stakeholders and ensure business growth.
Give at least two examples other objective of Corporate Governance

___________________________________________________________________________
___________________________________________________________________________

3.13 UNIT END QUESTIONS

A. Descriptive Questions

Short Questions

1. Define Good corporate governance.

2. How the reputation of a company can be defined?

3. What is the composition of board of directors?

4. Differentiate between organic and inorganic growth in business.

5. List down the components of external mechanism of corporate governance.

 6. Is it correct for the board to completely delegate all operational responsibilities to the
top executive and only focus on planning for the long term growth of the company?

7. Discuss the challenges that threaten the implementation of good governance strategies
in big corporations.

8. Why do you believe that smaller; family owned and closely held businesses also need
to think big in terms of maintaining a robust system of corporate governance?

Long Questions

1. Give main points of the Greenbury Report and the Hampel Report. Explain their
contributions.

2. Briefly explain Higgs Report. Also mention about the Redraft.

3. What were the guidelines laid for the Board of Directors, the Non-executive Directors
and the Executive Directors by the Cadbury Committee?

4. Bring out the main points of the Hampel and Turnbull Committee.

5. “In banking, special focus on corporate governance has become critical”. Discuss

6. Discuss the distinguishing features of Basel II.

7. Highlight on the recommendations of the Ganguly Committee with regards to the role
and responsibilities of the executive and non-executive directors.

8. Analyse the relevance of need based training in enhancing the ability of the board of
directors.

B. Multiple Choice Questions

1. In the long run investors are always interested in

a. Maximising the value of their investments

b. Good governance of the company

c. Compliance to all statutory requirements

d. All of these

2. Public perceptions towards business is _____________________

a. Interest of society towards business activity

 b. How the public looks at the company

c. Seeking benefits from the business

d. Interest to harm the business activity

3. ________________________ is the commitment of business to meet all government rules

and regulations.

a. Compliance to regulations

b. Interference in affairs

c. Democracy in appointments

d. Transparency in operations

4. The interest of companies seeking only high returns is called ______________

a. Growth oriented

b. Success oriented

c. Profit oriented

d. Compliance oriented

5. The prime objective of corporate governance mechanism is to guarantee ___________

a. payment of taxes on time

b. no harm is done to the society

c. rights of stakeholders are not curtailed

d. full cooperation of all board members

Answers

1-d, 2-b, 3-a, 4-c, 5-b.

3.14 REFERENCES

Textbooks

 A C Fernando, Corporate Governance: Principles, Policies and Practices, Pearson Dr.

S Singh

 Corporate Governance: Global Concepts and Practices, Excel Books Parthasarthy,

Corporate Governance: Principles, Mechanisms and Practices, Biztantra

 S.A. Sherlekar, Ethics in Management, Himalaya Publishing House

 William B. Werther and David B. Chandler, Strategic corporate social responsibility,

Sage Publications Inc

 Robert A.G. Monks and Nell Minow, Corporate governance, John Wiley and Sons

Reference

 W.H. Shaw, Business Ethics, Cengage Learning

 Beeslory, Michel and Evens, Corporate Social Responsibility, Taylor and Francis

 Philip Kotler and Nancy Lee, Corporate social responsibility: doing the most good for
company and your cause, Wiley

 Subhabrata Bobby Banerjee, Corporate social responsibility: the good, the bad and the
ugly, Edward Elgar Publishing

 Satheesh Kumar, Corporate governance, Oxford University, Press

Website

 http://business.gov.in/corporate_governance/cadbury_report.php

 www.cg.org.cn/theory/zlyz/greenbury.pdf

 www.rbi.org.in/upload/content/images/guidelines.html