CORPORATE GOVERNANCE REVIEW OF PRACTICEA study of corporate governance practices in leading corporates in India

December 2007

EXECUTIVE SUMMARYThe scope and significance of corporate governance in India increased sizeably in the recent period, particularly following the financial sector reforms. As Indian corporates are finding new space in domestic and global markets for business growth, their interaction with the financial markets and investing community too witnessed significant surge. In this process, corporate governance came as an effective instrument for companies to communicate with the various types of stakeholders in general and investors in particular. What began as an industry initiative of CII, corporate governance today became an essential part of the culture that defines better run companies and those held in esteem by the investors and stakeholders. As the rigour of the regulation intensified, governance standards began to be codified and formed an important part of the evaluation and assessment process. Clause 49 of the Listing Agreement of the Stock Exchanges is the key instrument that drives compliance of the corporate governance standards and practices by companies. Stock Exchanges and regulatory authorities which receive the compliance reports of the companies regularly assess the record of performance in this regard and take relevant actions. Securities and Exchange Board of India sending notices to 20 companies amongst which there are five public sector undertakings, is an instance of review processes following the receipt of information and filing of reports on

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compliance of corporate governance norms. Such measures will make companies more alert in adhering to the stipulated norms and guidelines. Notwithstanding the ongoing review process of the regulatory authorities, a scope exists for reviews and studies by independent agencies, and this study is an instance of such nature. The review makes an attempt to capture the essence of the quality of corporate governance practice in Indian companies. Given the huge mass of companies that India has, it would be rather difficult to take a large sample, which is a time consuming exercise and that require considerable resources. Moreover, it would be useful to know how the leading companies have devised effective ways of improving governance standards that could serve as benchmarks for the others. The review thus examined the practice of corporate governance in 42 companies across 12 sectors that represent the vital sections of the Indian industry. The information is obtained through corporate governance reports, published in the annual reports of the companies, feedback obtained through a questionnaire, consultations with officials of corporates, stock exchanges and regulatory authorities as also independent professionals and analysts. The outcome of the study is quite encouraging. India has advanced significantly in adopting better governance standards and its standing in the world is quite high in regard to designing effective policies and procedures. Several companies go beyond the mandatory requirements in fulfilling the corporate governance objectives. Companies have developed philosophies governing the governance practices that were introduced in their respective companies and the outcome that is being expected from these initiatives. Some of the modern governance practices such as separation of the Chair and the CEO, constitution of boards, representation of independent directors, meetings of the board and audit committees, discussion on the corporate governance practices in the annual reports, disclosure through a wide range of media and company sources etc., have greatly enhanced the image of the quality of corporate governance in India. India currently is ranked third in Asia for the overall quality of corporate governance.

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While great progress has been made in improving the governance standards, concerns about quality of enforcement, companies routinely fulfilling the requirements as a form of box ticking, deviating from the spirit of some of the important aspects of the compliance code etc., are a few of the issues that engage the attention of the policy makers and the regulatory agencies. Similarly, self evaluation processes for the board and audit committees are not yet formalized in many companies. Family ownership continues to dominate the corporate landscape thus providing a scope for inadequate disclosures in regard to subsidiary companies operations and related party transactions. As mentioned earlier, a beginning is made to review these practices which would be further supplemented by independent studies and analysis such as this report. The next round of reforms in the corporate governance would be in the realm of strengthening evaluation processes of the functioning of the board and its subcommittees, in particular the audit committee, as also greater discussion on the executive compensation policies, ombudsman for reviewing whistle blower policies etc., As Indian companies assume greater responsibilities in expanding business in domestic and global markets, compensation issues will become pertinent. Similarly, gender related issues of representation in the board too might assume importance. Only 8 percent women represent company board at present at the global level, with the scope for this ratio to grow being high in the Asia region. Some initial work in this regard may be evident in the medium term perspective of the governance reforms. The study is arranged in the following manner. Chapter I discusses the changes in the governance standards and key factors driving these changes, particularly the enormous growth of the financial markets and growing investor base from domestic and global financial markets. Chapter II presents a broad review of literature on the corporate governance and the emergence of issues central to good governance; Chapter II examines the scope of significance of important instruments of corporate governance; Chapter V discusses practice of corporates in India in regard to the compliance of corporate governance standards and norms. Since this chapter discusses the governance practices from the perspectives of the sectors, key corporate governance practice profiles of individual companies are given separately. Chapter VI looks at the issues and imperatives for better governance as an ongoing process.

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In preparation of this study, some of the sources that were used extensively to present the analysis and perspectives include; Clause 49 Listing Agreement of the Stock Exchanges; Year Book 2007 of the International Corporate Governance Network, Blue Ribbon Committee on the Audit Committee (NYSE/NASDAQ) etc. Acknowledgements of the references used in this study are made wherever appropriate. For increasing the reference value of the study, annexures on a number of aspects of the governance are attached. These include; objectives of the corporate governance as evolved by different companies in their annual reports, a questionnaire for self evaluation of the audit committee performance; indexes being developed to promote good governance; codes of corporate governance in different countries; comparative practices in corporate governance between India, China, Brazil and Malaysia; overview of the functions of the audit committees in the sample companies selected; differences in the US and Indian corporate governance etc., This study could serve as a beginning to promote independent assessment of the governance practices in Indian companies. Scope exists for further studies by expanding the size of the sample as also coverage of issues. Greater involvement of the companies in these exercises will lead better outcome in the form of experiences that could be useful for sharing and learning. It is hoped that similar studies are undertaken on a continuous basis to keep up the assessment and evaluation of quality of governance and its standards of compliance.

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CORPORATE GOVERNANCE REVIEW OF PRACTICE CONTENTSExecutive Summary 2 Chapter I Winds of Change 8 Governance standards surge on the back of financial sector development Chapter II Working of the Corporate Governance 20 Growing evidence of the positive effects of corporate governance Chapter III The Essence of Corporate Governance 34 Constituents of governance gain scope and significance Chapter IV India Rises 44 Corporate governance in India reaches global standards Chapter V Instruments of Importance Growing significance of Board and Its Committees 64

Chapter VI India Practice 78 Review of major governance practices in procedures amongst corporates in India Chapter VII Issues and Imperatives 99 Major issues and imperatives in corporate governance Corporate Governace Practice : Company Profiles Annexures 109 153

LISTS OF TABLES1: Equity Prices 2004-06 14

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2: Cumulative Net Foreign Institutional Investment: India 15 3: Share Turnover in Equities Markets: India 15 4 Recent Evolution of the Corporate Governance 36 5: A Decade of Developments in Corporate Governance 46 6: India ranks high among Asia governance league tables 47 7: India manages well despite constraints 47 8: Matching Rules and Regulations 48 9: Comparative Analysis of Clause 49 to SOX 62 10: Sample Companies 80 11: Summary of Corporate Governance Practice 82 12: A Snapshot of Corporate Governance 83 13: Average Number of Directors 84 14: Proportion of Non Executive and Independent Directors when the Chairman is Non Executive 87 15: Proportion of Non Executive and Independent Directors when the Chairman is Executive 89 16: Average number of meetings held 90 17: Shareholding Pattern 92 18: Sector wise Key Indicators of Corporate Governance Practice 93

BOX1: Working of the Compensation Committee 108

LISTS OF GRAPHS1: 2: 3: 4: 5: 6: 7: 8: 9: 10: 11: 12: 13: 14: 15: 16: 17: 18: 19: 20: Percentage of Companies with more than 33% Independent Directors Percentage of Companies disclosing director remuneration Percentage of companies separating the roles of CEO and Chair 10 Global IPO Activity Composition of Capital Flows ($bn) Net Equity and Debt Flows: 1990-2006 Stock Markets Indices: Emerging Markets Foreign Capital Raised by Developing Country Corporations, (left) and Foreign Companies Listed on Major Global Stock Exchanges (Right), 1998-2006 Percent of Directors who are women Distribution of Directors Comparative Analysis of Entire Sample Data Proportion of Directors in different categories Average No. of Directors Percentage Companies where the Chairman is Non Executive Composition of the Board when the Chairman is Non Executive 88 Percentage of Companies where the Chairman is Executive Composition of Board when the Chairman is Executive Average Meetings Shareholding Pattern Spaced Devoted to Corporate Governance in Annual Report 10 10 11 12 13 14 17 69 84 85 86 86 87 88 88 90 91 93

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Chapter IGovernance standards surge on the back of financial sector developmentFor corporate governance, it is now perhaps the best of the times. Usually, it is believed that governance takes a back seat in times of growth. However, in the back of unprecedented economic growth and wealth creation brought by large surge in financial markets in a major part of the world, huge improvements in the quality of corporate governance and standards of compliance are evident across a wide spectrum of mature and emerging markets. In a recent assessment (September 2007)1 on the implementation standards of corporate governance on sample of about 1600 companies worldwide, Ethical Investment Research Services (EIRIS), a UK based leading global provider of independent research into the social, environmental and governance (ESG) performance of companies that tracks performance of about 3000 companies across the world, has brought out some interesting insights. These include;

WINDS OF CHANGE

62% of the companies studied have boards containing more than a third of independent directors.However the proportion of independent directors varies greatly between countries. Over 90% of companies in North America, UK, Switzerland, the Netherlands, Norway, Finland and Australia have more than a third of independent directors, compared with less than 10% in Germany, Austria and Japan

Disclosure of directors remuneration is consistently high, with 96% of all companies disclosing this information.

In half of the countries studied over 90% of companies separate the roles of chair and chief executive However rates of separation are lower in the US (30%), Japan (54%) and France (56%). These differences are driven by the fact that companies largely adhere to their relevant national Corporate Governance guidelines

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The EIRIS Foundation is a UK based charity that supports ethical investment

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However corporate governance practices are converging. Governance codes are being revised to improve levels of transparency and independence, and the proportion of companies adopting western models of board structure is increasing.

Significant improvements were evident in respect of gender empowerment and representation in the boards as also corporate social responsibility and environment.

Increasingly, companies view equal opportunities less as a way to avoid criticism or lawsuits, but more as a means to build reputation and gain competitive advantage by accessing a broader skill set.

Around 90% of companies in North America (94%), Europe (88%) and Australia/New Zealand (87%) have basic or advanced equal opportunities policies. Conversely, just over 50% of Japanese and less than 25% of companies in Asia ex-Japan meet these standards. The pattern is slightly different for equal opportunities management systems. The criterion includes disclosure of staff demographics in relation to women and ethnic minorities as well as the presence of flexible working policies. Europe and Australia/New Zealand both perform well, with around 80% and 70% respectively demonstrating at least basic systems. Performance amongst Japanese companies is also strong at 60%, whereas it is weaker amongst US companies at 25%. In the US, companies are less inclined to disclose this information, possibly due to fear of litigation.

Worldwide, only 8.1% of board members are women. Representation of women on the board continues to be lowest in Japan at less than 1% and remains generally low in Mediterranean countries. These low levels are driven by a mixture of cultural factors including a history of fewer women in formal employment combined with weak legislative encouragement. The highest rate of 33% is seen in Norway where the government has enforced a quota for a minimum of 40% board members to be women by the end of 2007. The number of women on the board is set to increase Spain as

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the Spanish government has recently established a quota similar to that imposed in Norway. Graph1: Percentage of Companies with more than 33% Independent Directors

Graph2: Percentage of Companies disclosing director remuneration

Graph3: Percentage of companies separating the roles of CEO and Chair

Source: Ethitical Investment Research Service, 2007.

Good corporate governance standards assume significance from the enormous growth of the capital markets in the recent period as also emerging trends in global

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investing. An important aspect of the world economic growth is the growing influence of the emerging economies in contribution to the growth. At present, China and India are contributing to about 45 percent of the world economic growth which is likely to intensify further in the future. An important outcome of the rapid economic growth is the great surge in the financial market activity. Induced by liberalized global cross border financial flows, financial markets in a large number of countries witnessed exceptional growth in the recent period. A global IPO survey by Earnest and Young (E&Y)2 showed that In 2006, amount of new capital raised by global stock exchanges reached a record US$246 billion in 1729 deals. An interesting aspect of the global capital issuance is the strong share of the emerging markets. China alone raised about $57 billion with two of the largest ever share issues belonging to it; namely Industrial Commercial Bank of China and Bank of China which raised $22 bn and $11 bn respectively from the global financial markets in 2006. In 2006, India launched 78 Initial Public Offerings valued at $7.2 bn in 2007. The size of the one single issue of DLF, a real estate company was $2 bn. Emerging markets in the first five months of the year 2007 raised about $53.7 bn in global financial markets, which is considered highest ever raised in the first five months of a year Graph4: Global IPO Activity

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Globalisation: Global IPO Trends Report 2007. Earnest & Young

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It is not only issuance of fresh capital that got a big boost, but equally remarkable was the growth of secondary markets for securities leading to record levels of market capitalization. During the ten year period 1996-2006, market capitalization in the North America rose from $8.9 trillion to $23 trillion, in Europe/Middle East/Africa from $5.1trillion to $16.2 trillion and in the Asia Pacific $ 5 trillion to $11.8 trillion. Huge levels of capital flows to the equity markets in several emerging markets led to dramatic rise in securities prices. The flow of net foreign direct investment (FDI) into developing countries increased from $170bn in 1998 to $325 bn in 2006 and net portfolio equity flows increased from $6 to $94 bn during the same period. Net debt flows during this period are rather subdued with net debt flows from official creditors turning negative. Net portfolio equity flows to China between the year 2000 and 2006 rose from $6.9 bn to $32 bn and in India from $2.3 bn to $8.7 bn. In the first ten months of 2007 alone, foreign institutional investment flows into India peaked to about $18bn making it one of the most favored destination for global portfolio flows. Graph5: Composition of Capital Flows ($bn)

Graph6: Net Equity and Debt Flows: 1990-2006

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Global capital flows speeded up on the back growing institutional investment. Institutional investors have been the major source of capital markets growth. During the period 1995 and 2005, the assets under management of the institutional investors doubled from $21trn to $53 trn. The shift of home bias of the institutional investors into emerging markets stepped up the resource flows to the developing countries. For instance in the United States, in 1994, pension funds invested 41 percent of their portfolio in domestic equity and 7 percent in international equities, where as by 2005 that share rose to 48 percent in domestic equities and 15 percent in international equities. The portfolio allocation to bond markets during the same period reduced from 42 percent to 32 percent. Emerging markets received sizeable portion of the investments. In the US the dedicated Emerging Market mutual funs rose from about $27 billion in 2000 to $ 230 billion in 2006. Table 1: Equity Prices 2004-06 Particulars Average rate of change All Developing Countries 33.3 United States 21.5 Euro Area 12.7 Russa 60 Peru 39.2 Brazil 54.6 Colombia 75.1 India 45 China 17 Argentina 48.5 Mexico 42.5 Indonesia 39.5

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Nigeria

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Source: Global Development Finance. World Bank

Graph 7: Stock Markets Indices: Emerging Markets

Table2: Cumulative Net Foreign Institutional Investment: India Year 1992-93 1993-94 1994-95 1995-96 1996-97 1997-98 1998-99 1999-00 2000-01 2001-02 2002-03 2003-04 2004-05 2005-06 2006-07#provisional Source: Securities and Exchange Board of India

Cumulative Net Investment in US$ million 4 1638 3167 5202 7634 9284 8898 11237 13396 15242 15804 25755 35927 45259 65000#

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Table3: Share Turnover in Equities Markets: India Year 1992-93 1993-94 1994-95 1995-96 1996-97 1997-98 1998-99 1999-00 2000-01 2001-02 2002-03 2003-04 2004-05 2005-06 2006-07Source: SEBI

National Stock Exchange 1805 67287 295403 370193 414474 839052 133510 513167 617989 1099534 1140072 1569558 1945285

Bombay Stock Exchange 45696 84536 67749 50064 124190 207113 310750 686428 1000032 307292 314073 503053 518715 816074 956185

Following the foreign institutional investors, an important and emerging segment of global investing will be the Soverign Wealth Funds3. According to a recent estimate of the International Monetary Fund, assets held by Sovereign Wealth Funds include $5.6 trillion in foreign exchange reserves and upto $3 trillion sovereign wealth arrangements. IMF projects that the Sovereign Wealth Funds may accumulate international assets in range of $800-900 bn a year leading to its total assets base in the range of $12 trillion by 2012. The value of global financial assets, according to a study4 (2007) by the Mckinsey Global Institute is about $140 trillion assets. United States, the United Kingdom, the eurozone and Japan account for the more than 80 percent of the total. Equities accounted for nearly half of the growth of the financial assets in 2005. Every aspect of finance is assuming huge size. According to Market Metrics, a business and market intelligence network, in 2006, global mergers and acquisitions activity reached an all time high of $3.7 trillion, global direct real estate investments $600 bn, market value of global non-public 150 companies $7 trillion etc.,

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Regional Economic Outlook, October 2007, International Monetary Fund Mapping the Global Capital Market, January 2007, McKinsey Global Institute.

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Corporates from developing economies are making aggressive forays into business expansion and global reach and in this process are accessing global financial markets in a big way. World Banks Global Development Finance enumerates some significant facets of the globalization of the developing countries corporations. A few of these include; Developing countries companies in 2006, raised $156 bn through international offerings of corporate debt and equity. $245 billion through syndicated loans and engaged in cross border mergers and acquisitions involving developing countries corporation bidding for foreign targets to the tune of $ 100 bn. In 1987 cross border M&A of developing countries corporations amounted to $400 million.1 1

Regional Economic Outlook, October 2007, International Monetary Fund Mapping the Global Capital Market, January 2007, McKinsey Global Institute.

Amongst the Worlds top Fortune 500 companies, 40 are from the developing world and 394 developing country companies traded on the worlds major stock exchanges accounting for one third of the global overseas cross listings. Since 20025, 422 emerging market companies have tapped international bond markets at least once, 537 contracted bank loans and 360 raised capital on the one of the global major overseas stock exchanges. Private sector companies accounted for more than 60 percent of total bank borrowing and 75 percent of the new bond issuance during the period 2002-06. Graph8: Foreign Capital Raised by Developing Country Corporations, (left) and Foreign Companies Listed on Major Global Stock Exchanges (Right), 1998-2006

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Global Development Finance, 2007, The World Bank

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In 2006, of the 1328 foreign companies listed in the major global stock exchanges, 394 (30%) were from the developing countries. This share was about 13.1% in 1998. 20 emerging countries, with Brazil, China, India, Mexico and Russia with strong representation, accounted for 95 percent of the total bond issuance, 85 percent of the total bank borrowing and 95 percent of the total equity offerings by developing countries. These 20 countries account for 67 percent of the developing worlds population and source of 78 percent of its Gross Domestic Product. These 20 countries have aggregate stock market capitalization of $5.3 trillion, which accounts for 88 percent of the total for the developing world. These countries together have about 12,557 public traded companies that represent 95 percent of all those based in developing countries.1

Global Development Finance, 2007, The World Bank

In India too, the merger and acquisition activity increased substantially. Where as foreign acquisitions in India rose from $2.9 billion in 2005 to $28 billion in 2007, Indian acquisitions abroad rose from $1.5 billion to $18.1 billion during this period. In addition to technology companies such as Infosys, Wipro and TCS, major Indian corporates who conducted sizeable cross border mergers by acquiring foreign target companies included; Tata, Suzlon, Bharat Forge, Ranbaxy, Hindalco, United Breweries etc., In the first three quarters of the year 2007, Indian companies announced 150 foreign acquisitions with a total value of $18.1 billion, a four fold increase of the total value in 2005. A survey of 340 of the worlds largest manufacturers, by the paris based Capgemini Consulting revealed that India could challenge China as the leading manufacturing center of the world in the next three to five years. Simultaneous with growth and expansion challenges, concerns on stability and sustainability assume equal importance. A few major messages brought out in the Global Development Finance (2007) on the globalization of the developing countries corporations are pertinent in this regard. Global borrowing by developing country firms has surged in recent years The pace of corporate globalization in the developing world is likely to intensify in the medium term,

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Concerns are growing that corporate credit spreads may not fully reflect credit quality and that corporations may be underestimated global risk aversion Managing these risks requires a comprehensive reponse, from the level of the firm to the macro economic level Good policies reduce the cost of capital Greater coherence is needed in international standards for cross border listings and public offering of securities.

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A major challenge to manage the growth and sustain it in the long term is to evolve efficient processes of governance. It is important to continuously update governance standards as also enhance the skillssets, competence and capabilities of the instruments of governance to deal with the rapidly changing world of finance and infinite opportunities it offers and the challenges it poses. An aspect of promise is the prospects for better standards across the world with countries mutually learning from each other on the benchmarks and best practices. Having built up a strong base for the governance, the real test and challenge will be on enhancing its scope and significance so that it could continue to sub serve the growth objective in the long term.

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Chapter II

WORKING OF THE CORPORATE GOVERNANCEGrowing evidence of the positive effect of corporate governance

Early discussion on the governance rose from an analysis by Berle and Means6 (1932) following the Great Crash in the US in 1929, which traced the problem of governance due to the separation of ownership and control. The authors recommended stake holder value over the share holder value as essential for good governance, a premise on which formal securities regulation began in the US with the setting up of the Securities and Exchange Commission (1933). This debate led the governance being associated with the agency problem {Coase, 1937)7, (Jensen and Meckling8, 1976), (Fama and Jensen9,1983) in which the essence is the separation of ownership and control. Agency problem refers to the difficulties financiers have in assuring that their funds are not expropriated or wasted on unattractive projects {Shliefer and Vishny10,1997)) Early work in the corporate law development in the 18th and 19th centuries in Britain, Continental Europe and Russia has focused more on addressing the problem of managerial theft rather than that of shirking or even empire building. Shleifer and Vishny cite studies on vast mangerialist literature that explains how mangers use their effective control rights to pursue projects that benefit them rather than investors which are described as private benefits of control {Grossman and Hart11,1982)} Managers can expropriate shareholders by entrenching themselves and staying in the job even if they are no longer competent or qualified to run the firm. Poor managers who resist being replaced might be the costliest manifestation of the agency problem (Jensen and Ruback12, 1983) Agency theory considered the firm as a nexus of contracts; associating the firm and the entire group of resource contributors (the team of productive inputs) and analyzing the relationship between the principle (shareholders) and the agent (mangers), the conceptual framework which is found

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Berle A.A. and Means G.C.., The Modern Corporation and the Private Property, New York: MacMillan, 1932 Coase, Ronald (1937), The Nature of the Firm, Economica, 4, 386-405 8 Jensen, Micheal and William Meckling (1976), Theory of the Firm, Managerial Behaviour, Agency Costs, and Ownership Structure, Journal of Financial Economics, 3, 305-60 9 Fama, Eugene and Micheal Jensen (1983b), Separation of Ownership and Control, Journal of Law and Economcs, XXVI, 301-25 10 Shleifer, A.,and R.Vishny, 1997, A Survey of Corporate Governance, Journal of Finance, 52, 737-775 11 Grossman, Sanford., and Oliver D. Hart, 1982, Corporate Financial Structure and Managerial Incentives, in John J. McCall, ed.: The Economics of Information and Uncertainty (University of Chicago Press, Chicago, IL 12 Jensen, Michael and Richard Ruback,1983; The Market for Corporate Control: The Scientific Evidence, Journal of Financial Economics, 11, 5-50

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relevant even today. This perspective has lead to a wide range of studies relating to the board of directors, share holders meetings, remuneration system for managers, the legal and accounting regulations and takeover etc., With the enormous growth of financial markets, the interest on corporate governance flows beyond the finance and extends to law, economic, politics, sociology and management science. Historical developments that impact the overall scope of the corporate governance in different countries is discussed by Randall K. Morck, Lloyd Steir13 (2005) who observed that financial disasters tainted French confidence in financial securities early on, and set corporate governance in that country on a different parity from that of Britain, where a similar trauma was overcome and forgotten. Similarly historical trends such as imperial monopoly in China that was evident in the late 19th century, large scale trading networks belonging to particular communities and ethnic groups and sectarian groups in India, family and bank controlled pyramidal groups in Germany, Zeibatsu and Keiratsu in Japan and Chaebols in Korea etc., have influenced the process of growth of corporate governance in the respective countries. Certain features that are common to all countries that contributed to the varying types and pace of the corporate governance norms include; Accidents of history, ideas, families,business groups, trust, law, origins, evolution, transplants, large outside shareholders, financial development, politics and entrenchment, etc. Ownership is a key driver that determines the quality of governance. The first of the studies on the ownership of the global companies by Rafeal La Porta14 shows higher incidence of family ownership in global corporations that runs contrary to the earlier observation of widely held corporations analysed by Berley and Means. The study presents data on ownership structures of large corporations in 27 wealthy economies, making an effort to identify the ultimate controlling shareholders of these firms. The study found that except in economies with very good shareholder protection, relatively few of these firms are widely held. Rather, these firms are typically controlled by families or the State. Equity control by financial institutions or other widely held corporations is far less common. The controlling shareholders typically have power over firms significantly in excess of their cash flow rights, primarily through the use of pyramids and participation in

13 Morck, Randall K, Steier, Llyod, 2005, the Global History of Corporate Governance, an Introduction, NBER Working Paper No 11062, January 2005. 14 La Porta, Rafael, Florencia Lopez-de-Silanes, Andrei Shleifer and Robert Vishny, 1999, Corporate Ownership Around the World, Journal of Finance (54(2), 445-70

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management ownership issues; particularly the predominance of family owned companies remains an important issue in several emerging economies and forms an important aspect of the corporate governance reforms. Franklin Yale and Dougles Gale15 (2002) discuss the term corporate governance that is used in two distinct ways. In Anglo-Saxon countries like the US and UK good corporate governance involves firms pursuing the interests of shareholders. In other countries like Japan, Germany and France it involves pursuing the interests of all stakeholders including employees and customers as well as shareholders. Anglo-Saxon capitalism has been widely analyzed but stakeholder capitalism has not. The authors argue that stakeholder capitalism can often be superior when markets are not perfect and complete. Paolo Fulghieri and Matti Suominen16 (2005) find that the quality of the corporate governance system may have a significant impact on the economys level of competition and its degree of industry concentration. Poor corporate governance and low investor protection may in fact lead to high industry concentration. Craig Doidge, G. Andrew Karolyi, and Ren M. Stulz17 (2006) showed that the incentives to adopt better governance mechanisms at the firm level increase with a countrys financial and economic development. Further, these incentives increase or decrease with a countrys investor protection depending on whether firm-level governance mechanisms and country-level investor protection are substitutes or complements. The study observes that when economic and financial development is poor, the incentives to improve firmlevel governance are low because outside finance is expensive and the adoption of better governance mechanisms is expensive. A cross country study by Vidhi Chhaochharia and Luc Laeven18 (2007) shows that governance provisions adopted by firms beyond those imposed by regulations and common practices among firms in the country have a strong, positive effect on firm valuation. The study showed that, despite the costs associated with improving corporate governance at the firm level, many firms choose to adopt governance provisions beyond what

Allen, Franklin, Gale, Douglas, 2002, A Comparative Theory of Corporate Governance, Financial Institutions Center, Wharton University, 2002 16 Fulghieri, Paolo, Suominen, Matti, 2005, Does Bad Corporate Governance Lead to Too Little Competition?, Finance Working Paper No. 74/2005, March 2005, European Corporate Governance Institute. 17 Dodge, Craig, Karolyi, George Andrew, Stulz, Rene M, 2004, Finance Working Paper Ho. 50/2004, European Corporate Governance Institute, Charles A. Dice Center Working Paper No.2004-16 and Fisher College of Business Working Paper No.200603-008 18 Chhaochharia, Vidhi, Laeven, Luc, 2007, The Invisible Hand in Corporate Governance, Finance Working Paper No. 165/2007, April 2007

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considered the norm in the country, and these improvements in corporate governance have a positive effect on firm valuation. An Empirical analysis by Leora F. Klapper and Inessa Love19 (2002) of the World Bank showed that better corporate governance is highly correlated with better operating performance and market valuation. They provide the evidence that firm level corporate governance provisions matter more in countries with weak legal environments. The results suggest that firms can partially compensate for ineffective laws and enforcement by establishing good corporate governance and providing credible and investor protection. Good corporate governance commands high premium20. A CLSA April 2003 study showed that over the past five years, high CG stocks (ranked in the 1st quartile) outperformed the Sensex by 169%. The out-performance was at over 40% even if one excluded the software stocks. A study by Wolfganag Dorbetz, University of Basel showed that an investment strategy that bought high-CGR firms and shorted low CGR firms would have earned excess returns of 12% compared to the DAX 100 during 1998-2000. A Lipper-GMI Mutual Fund Report showed that Mutual funds that invest in companies with higher CG ratings have been rewarded with superior returns According to a Harvard Law School study21, the disregard for shareholder rights caused lower firm valuations to the extent of 7 percent per annum and large negative abnormal returns during the 1990-2003 period; A Deutsche Bank research showed that European companies with improving governing standards outperformed a portfolio of deterioriating companies by 4.4 per annum. A joint study of the European Corporate Governance Institute and London Business School showed that the governance focused Hermes UK Focus Fund outperformed its benchmark by an average 4.8% each year from 1999 through 2004. The CLSA/ACGA Governance Score for 27 countries confirms that firms with better governance outperform significantly even in bull markets when governance usually has a lower priority with investors. All these show positive effects of the good governance A 2002 McKinsey Survey revealed that investors then were willing to pay a premium of 23% for well governed companies in India which in the recent time came down to 5 to 10 percent due to overall improvement in the governance standards.

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Klapper, Leora F, Love, Inessa, 2002, Corporate Governance, Investor Protection and Performance in Emerging Markets, Policy Research Working Paper 2818, Development Research Group, The World Bank. 20 Corporate Governance Ratings and Audit, a presentation by ICRA, October, 2004 21 Bebchuk, Lucian, Cohen Alma, Ferrell, Alma, 2005, What Matters in Corporate Governance, Discussion Paper No. 491., revised 03/2005, Hardvard Law School, Cambridge, MA

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Christian Leuz, Karl V. Lins, Francis E. Warnock22 (2006), in their study using a set of foreign holdings by U.S. investors as a proxy for foreign investment that analysed a sample of 4,411 firms from 29 emerging market and developed economies found that, foreigners invest significantly less in firms that are poorly governed, i.e., firms that have ownership structures that are more conducive to outside investor expropriation Interestingly, this finding is not simply a matter of a countrys economic development but appears to be directly related to a countrys information rules and legal institutions. The authors argue that information problems faced by foreign investors play an important role in this result. Supporting this explanation, they argue that foreign investment is lower in firms that appear to engage in more earnings management. An event study by Bernard Black & Vikramaditya Khanna23 (2007) showed that good corporate governance benefits faster growing firms (esp. mid sized ones) than others and cross-listed firms get the benefit more than others. Alexander Dyck, Adair Morse, Luigi Zingales24(2007)examine how external control mechanisms are most effective in detecting corporate fraud. The authors study in depth all reported cases of corporate fraud in companies with more than 750 million dollars in assets between 1996 and 2004 and find that fraud detection does not rely on one single mechanism, but on a wide range of, often improbable, actors. Only 6% of the frauds are revealed by the SEC and 14% by the auditors. More important monitors are media (14%), industry regulators (16%), and employees (19%). Before SOX, only 35% of the cases were discovered by actors with an explicit mandate. After SOX, the performance of mandated actors improved, but still account for only slightly more than 50% of the cases. Gillan and Starks25 (1998) define corporate governance as the system of laws, rules, and factors that control operations at a company. The paper mentions governance consisting of two aspects: Internal governance with five major categories the board of directors, managerial incentives, capital structure, bylaw and charter provisions, internal control systems where as external governance consisting of law and regulation, capital markets; analysts, auditors, private sources of external oversight such as rating, media etc. Extensive research work on each of these aspects has been conducted in the recent times Extensive development work is being carried out in a large number of countries in making corporate governance comprehensive and effective. Major reforms in the corporate

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Leuz, Christian, Lins, Karl V, Warnock, Francis E., 2006, Do Foreigners Invest Less in Poorly Governed Firms, Finance Working Paper No. 43/2004, Revised version: April 2006, European Corporate Governance Institute 23 Black, Bernand S, Khanna, Vikramaditya S., Can Corporate Governance Reforms Increase Firms Market Values? Event Study Evidence from India, Havard Law School 24 Dyck, Alexander, Morse, Adair, Zingales, Luigi, 2007, Who Blows the Whistle on Corporate Fraud, 25 Gillan, Stuart L, and Laura T. Starks, 1998, A Survey of Shareholder Activism, Motivation and Empricial Evidence, Contemporary Finance Digest, 2,3, 10-34

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governance in selected countries as sourced from the Year Book 200726 of International Corporate Governance Network are reproduced below.

European Union27The EUs approach to corporate governance matters is principle-based. It seeks to ensure the adoption of certain key specific standards throughout the EU, while leaving it to Member States and market participants to determine how to best apply these standards. The EU corporate governance framework, which consists of a mix of binding and nonbinding rules, has as its cornerstone the comply or explain principle. Every listed EU company is under an obligation to make an annual statement indicating which Code of corporate governance it applies and declaring whether it complies with all the provisions of that Code. If that company does not comply with some provision of the Code, it must state to what extent and give a justification. Alongside the corporate governance statement, the Commission has adopted two non-binding recommendations on the remuneration of directors and on the role of independent directors, which contain key substantive standards. With these measures, the Commission seeks to encourage national corporate governance codes to converge gradually. The European Corporate Governance Forum, set up by the Commission and composed of fifteen high level experts, seeks to reinforce this through exchanges of views on best practices to promote the convergence of national corporate governance practices within the European Union. UK28 In June 2007, the EU adopted the Shareholder Rights Directive to create consistent standards across Member States and simplify cross-border investment. It aims to reduce problems associated with cross-border investment which include: a lack of sufficient information on a timely basis; the inability to trade shares ahead of general meetings (share blocking); and inefficient voting procedures and constraints. National governments are required to implement the Directive within two years. Some of the key measures of the Directive are: Share-blocking is banned. Instead, companies are required to set a

26 27

Year Book 2007, International Corporate Governance Network The Regulatory Regime: Focus in Europe by Charlie Mccreevy, European Commissioner for the Internal Market and Services, ICGN Year Book 2007. 28 The UK at the Hear of European Developments, Kerrie Waring, Corporate Governance Manager, Institute of Chartered Accountants of England and Wales, ICGN Year Book 2007.

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record date within a 30-day period before the election, giving the vote to whoever holds shares on that day. Notice of Annual General Meetings (AGM) must be at least 21 days in advance, or 14 days for special meetings. Shareholders must be able to ask questions related to AGM agenda items. Shareholders must have the opportunity to vote by post. Companies must disclose results on resolutions and this should be published on its website no more than 15 calendar days after the AGM. In April 2007 the Financial Reporting Council (FRC) issued a consultation on the Review of the Impact of the Combined Code. It will address the effectiveness of the comply or explain regime, the impact of the Combined Code on smaller companies, how it supports board performance and whether disclosures are considered useful and proportionate in terms of cost to companies

United States29In the United States, investor protection being governed by the federal and state laws, in addition to the implementation of the Sarbanes-Oxley corporate governance norms, different states have brought in several laws. These include; Under Delaware law: (1) any stockholder can inspect and copy a corporations stock ledger, a list of stockholders, and certain books and records of the corporation; (2) any stockholder can sue for an appraisal by the chancery court of the fair value of the stockholders stock in connection with certain mergers; and (3) interested director transactions are subject to heightened approval requirements. Further, the US federal securities laws and the SECs rules also contain provisions aimed at protecting individual shareholders, such as: (1) requiring heightened disclosure for going private transactions; (2) requiring issuers to send proxy materials to all shareholders (not just certain shareholders); and (3) mandating significant disclosures for related-party transactions. Simultaneously rigorous work on further areas of reforms on the governance are being actively pursued and these include; improved quality in compensation disclosure; advisory votes on executive compensation; access to the management proxy for shareholder designated board candidates; reform of shareholder communications and proxy voting mechanics; promotion of global corporate governance standards and cross-border voting protections; transparency in stock lending, empty voting and the governance impact of hedging and derivative trading strategies; reduction of regulatory costs; use of technology in disclosure and communications; alleviation of short-term investment and business focus; maintaining financial market efficiency and competitiveness.29

The Regulatory Year Book 2007.

Regime:

US

Perspective,

Roel

C.

Campos,

SEC

Commissioner,

ICGN

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China30The total market capitalisation at the end of March 2007 was RMB12.36 trillion, representing about 55% of the countrys GDP last year. From only about a dozen listed companies in 1990, there were 1459 listed companies by March of 2007. There are now 116 securities firms, with over 100,000 practitioners, and 82 million investor accounts. From 1991 to 2005, total funds raised by Chinese companies through public offerings reached RMB 1,159 billion. One of CSRCs major reforms is the requirement to have independent directors on the board to overcome the insider control problem in many of Chinas listed companies. The CSRC Guidelines on Independent Directors (August 2001) required that each listed company should have at least one third of the board made up of independent directors by June 2003. Independent directors are required to serve as chairs of audit, compensation, and nomination committees and major related-party transactions of the company have to be approved by independent directors. A recent survey showed that, as of December 2005, 4,640 independent directors had been appointed at shareholder meetings for the 1,381 listed companies in China. In most companies now at least one-third of the board are independent directors and it is evident that they are playing a more important role in corporate governance. A listed company is required to publish an audited annual report as well as a semi-annual report. From 2002, listed companies are also required to publish un-audited quarterly reports. The rules have recently been revised to simplify and streamline the format of these reports so that they would be more readable and easily understood by investors. To better protect the rights and interests of public investors, the CSRC issued The Provisions on Strengthening the Protection of Rights & Interests of Public Shareholders (December 2004). According to the Provisions, listed companies major business decisions, such as rights issues and issuing additional new shares, and equity-for-debt plans, should receive a majority of the votes from holders of tradable-shares present at the general shareholders meeting.

France31A law passed in July 2005 set things on course by requiring shareholder approval of the pension schemes of executive directors as well as golden parachutes and retirement schemes of managing directors. Another positive step was made with the introduction of a legal requirement for the chairman of the board of directors/ supervisory board to explain the remuneration policy to shareholders, who generally do not find these explanations

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Regulatory Issues in China: Progress and Challenges, Daochi Tong, Deputy Director General, Public Offering, China Securities Regulatory Commission, ICGN Year Book 2007. 31 Corporate Governance Progress in France, Josiane Fanguinoveny, Services Director, Governance for Owners, ICGN Year Book 2007.

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satisfactory. 1) The compensation review must be exhaustive, 2) compensation must be seen by reference to the relevant business lines, 3) performance criteria must correspond to corporate targets and be simple to determine. Current trends in AGM voting indicate that shareholders are voting against the following: Authorities to issue shares without preferential subscription rights. Poison pills and other takeover defences. Allocation of free shares to employees and stock option plans. Amendments to the articles of association relating to the threshold disclosure requirements. Share buy backs.

Germany32The survey shows that independent non-executive directors today comprise only 28% compared to the European average of 54%. Just 27% of the major companies have an independent chairman. The proportion of independent members of audit and remuneration committees in Germany is only 26% and 23% respectively. Only 7% of German supervisory boards are international board members compared to the UK with 31% and Switzerland with 45%. However, the 8th EU Directive (auditor directive) to be implemented by June 2008 could lead to a change of this proportion since it requires an independent chairman for the audit committee.

Russia33A survey on the corporate governance in Russia by the Russia Institute of Directors brings out the following features. Major areas of where improvement was evident included; the practice of recording the property title; board authority to approve material transactions; regulation of using insider information; ways of disclosing information to shareholders before the general meeting; cross-ownership of shares; dividend payments on common and preferred stock; the adoption of a corporate governance code. In respect of governance and control, major improvements were evident in ; bringing external (independent) directors to the boardroom; the regularity of board meetings; the establishment of board committees; having a regulatory framework for the board and the executive body; the introduction of board members remuneration practices; putting in place the procedures for identifying possible conflicts of interests in the board and amongst top managers; the establishment of internal control functions. Improvements observed in the disclosure standards include; information about the companys strategy; information about the composition of the companys governance

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The Progress of Corporate Governance in Germany-The Quality Question, Christian Stranger Member of the German Government Commission on Corporate Governance, ICGN Year Book 2007 33 Corporate Governance Practices in Russia : A Survey, Igor Belikov, CEO, Russian Institute of Directors, ICGN Year Book 2007.

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and control bodies; disclosure about general practices of corporate governance. Weaknesses that persist include; deficiencies in the procurement of goods and services; the involvement of independent appraisers; the practice of hiring external auditors; the existence of an approved dividend policy; the absence of formal corporate documents that outline the principles used for the calculation of dividends and the minimal share of net profit; the formalistic nature of many board committees; insufficient attention to the professional development of board members; the absence of a clear and understandable procedure of executive and board evaluation; the loose link between executive remuneration and the companys performance; poorly developed succession practices and succession planning; low level of independence and efficiency in the work of the audit commissions. poor disclosure of beneficiary ownership; poor disclosure about individual remuneration of members of the governance and control bodies and the principles on which such remuneration is based, insufficient use of available disclosure channels such as the annual report and corporate website.

South Africa34Some of the key reforms proposed in a recent Bill on the corporate governance include; (a) There should be a uniform accounting standard to ensure that any financial information published by a company is calculated in accordance with generally accepted accounting practice (GAAP), which has to be comparable with the international standards adopted by the International Accounting Standards Board. (b) A companies ombud is created which provides a forum for alternative dispute resolution on company issues. (c) The Bill introduces three categories of companies, with the one category, namely a public interest company, having greater responsibility to a wider public and more demanding disclosure and transparency provisions. (d) The Bill creates a capital maintenance regime based on solvency and liquidity requirements which is a shift from a regime based on par value. (e) The chapter on corporate governance provides for the codification of directors duties, provisions addressing conflicts of interest and an increase in directors liability. (f) The Bill sets out simplified and flexible processes for approval of transactions that will fundamentally alter the structure of a company. The provisions deal with the disposal of substantially all of a companys assets or an undertaking, a scheme of arrangement or a merger or amalgamation. Minority shareholders are also afforded better protection in line with modern international corporate law. g) Business rescue is being introduced in place of judicial management. Business rescue will be conducted by an independent supervisor

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South Africas Ambitions: Achieving International Standards of Governance, Mervyn King, Chairman of the Global Reporting Initiative, and Chairman, King Committee on Corporate Governance in South Africa. ICGN Year Book 2007.

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and subject to court intervention. The interests of shareholders, creditors and employees are recognised in the development and approval of a business rescue plan. Notably, the interests of workers are protected by recognising them as creditors of the company, with a voting interest to the extent of any unpaid remuneration. (h) The Bill tends to decriminalise non-compliance and uses a system of administrative enforcement

Middle East35The first Code of corporate governance was launched in Oman as early as 2002. Egypt has published two corporate governance Codes, one for listed companies and one for State Owned Enterprises. Egypt has sought to strengthen its listing rules and is focusing on implementation by launching the Egyptian Institute of Directors and a series of training programs being conducted by the Egyptian Banking Institute for bank directors. Bahrain, Morocco, Qatar, and Tunisia have facilitated the review of their legal and regulatory framework and are in the process of preparing a corporate governance Code. Jordan is developing a model corporate governance Code for listed companies. Lebanon has conducted a bank corporate governance survey and conducted a legal review followed by the Central Bank issuing a corporate governance regulation. Additionally the Lebanese corporate governance Task Force has spearheaded the development of a Code of corporate governance for non-listed companies and is working with Lebanese companies for voluntary compliance. In the UAE, the Central Bank has drafted corporate governance guidelines for banks, and the UAEs Securities and Commodities Authority has issued a corporate governance Code, setting a national governance standard, for both the Dubai Financial Markets and the Abu Dhabi Securities Market. Similarly, Saudi Arabias Capital Market Authority launched corporate governance regulations for its listed companies, and the banking sector is seriously looking at improving corporate governance standards. The West Bank/Gaza is also in the process of developing a Code of Corporate Governance, after a series of corporate governance awareness programs organised by business associations and regulatory authorities. Corporate governance plays an important role in investment decisions. In Brazil, Sau Paulo Stock Exchange launched a new market segment in 2001, The Novo Mercado where companies listed in this exchange have to comply with international standards and not those applicable to the companies listed in the main board. Institutional investors invested

A Dynamic and Changing Environment: Middle East and North Africa, Nsser Saidi, Executive Director, Hawkamah Institute for Corporate Governance and Chief Economist, Dubai International Financial Center. ICGN Year Book 2007.

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teams of people responsible for reviewing corporate governance practices in the companies in which they are investing. Morck and Steir (2007) sum up the essence of the evolution of the corporate governance in different countries Corporate governance deals with the mechanisms that ensure investors in corporations get a return on their investments (Shleifer and Vishny, 1997). Corporate governance varies widely across countries and across firms. Better governance enables firms to access capital markets on better terms, which is valuable for firms intending to raise funds. It is therefore expected that firms planning to access capital markets especially those with valuable growth opportunities that cannot be financed internally to adopt mechanisms that commit them to better governance. With the availability of data on corporate governance and disclosure practices of individual companies around the world, provided first by the Center for International Financial Analysis and Research (CIFAR) and, more recently, by Credit Lyonnais Securities Asia (CLSA), Standard and Poors (S&P), and Institutional Shareholder Services (ISS), several studies have investigated whether governance and transparency scores are related to firm characteristics. In general, they find that the quality of governance practices is positively related to growth opportunities, the need for external financing, and the protection of investor rights, and this rapidly developing body of literature began with the finding that the laws that protect investors differ significantly across countries, in part because of differences in legal origins (see La Porta, Lopez-de-Silanes, Shleifer and Vishny (1998). Recent literature finds that cross-country differences in laws and their enforcement affect ownership structure, dividend payout, availability and cost of external finance and market valuations.'is negatively related to the concentration of ownership. However, until now, the importance of other country characteristics, such as the financial and economic development of the country in which a company is domiciled, and how that importance is affected by financial globalization, has not been investigated. This is surprising since a number of studies show that other country characteristics besides measures of investor protection have a significant impact on country-level measures of governance.

The developments in corporate governance as described above show that; Corporate governance is catching up fast as a major instrument of corporate reform in several countries

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Good governance emerged as a major incentive for corporate growth and in pursuing global business aspirations Good companies are going beyond the mandatory requirements in adopting best practices in governance Greater interaction and sharing of knowledge is gaining ground across countries in setting effective governance frameworks Disclosure and transparency are emerging as the key determinants of good governance As the financial markets grow and the developing countries corporations increasingly explore global financial markets for resources and business, harmonization of the corporate governance increases and intensified

The pace of developments in strengthening corporate governance in different countries provides an insight on the urgency with which strong governance norms are devised and implemented all over the world.

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Chapter III

Constituents of governance gain scope and significanceCorporate governance has been defined by scholars and market practioners as per the perspective with which they were analyzing the subject. The practioners point of view that was powerfully conveyed was that of N.R. Narayana Murthy, Chairman, Committee on Corporate Governance, Securities and Exchange Board of India, 2003 and he himself a highly successful and globally acclaimed entrepreneur who built Infosys on the premise and foundations of a strong corporate governance The term corporate governance, is susceptible both to broad and narrow definitions. In fact, many of the codes do not even attempt to articulate what is encompassed by the term. The important point is that corporate governance is a concept, rather than an individual instrument. It includes debate on the appropriate management and control structures of a company. Further, it includes the rules relating to the power relations between owners, the Board of Directors, management and, last but not least, the stakeholders such as employees, suppliers, customers and the public at large:. From a policy perspective and who chaired the first ever influential and widely discussed report on the subject, Adrian Cadbury, the author of the Cadbury Report, said In its broadest sense, corporate governance is concerned with holding the balance between the economic and social goals and between individual and communal goals. The governance framework is there to encourage the efficient use of resources and equally to require accountability for the stewardship of those resources. The aim is to align as nearly as possible the interest of the individuals, of corporations and of society. The incentives to corporations and those who own and manage them to adopt internationally accepted governance standards is that these standards will assist them to achieve their aims and to attract investment. The incentive for their adoption by states is that these standards will strengthen their economies and encourage business probity. From a regulatory point of view Arthur Levitt, former chairman of the Securities and Exchange Commission, United States emphasized the importance of the corporate governance as If a country does not have a reputation for strong corporate governance

THE ESSENSE OF CORPORATE GOVERNANCE

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practices, capital will flow elsewhere. If investors are not confident with the level of disclosure, capital will flow elsewhere. If a country opts for a lax accounting and reporting standards, capital will flow elsewhere. All enterprises in that country- regardless of how steadfast a particular companys practices may be-suffer the consequences. Markets exist by the grace of investors. And it is todays more empowered investors that will determine which companies and markets will stand the test of time and endure the weight of greater competition. It serves us well to remember that no market has a divine right to investors capital. Organization of Economic Cooperation and Development (OECD) which spearheaded the design and development of corporate governance principles and guidelines defined it as Corporate governance involves a set of relationships between a companys management, its board, its shareholders, and other stakeholders. Corporate governance also provides the structure through which the objectives of the company are set and the means of attaining those objectives and monitoring performance are determined An institutional point of view presented by Ira Millstein, who worked on drafting the OECD corporate governance guidelines as also the co-chairman of the NYSE-NASDAQ constituted Blue Ribbon Committee36 (1998) that looked into important aspects of the audit committees, defined Corporate governance refers to that blend of law, regulation and appropriate voluntary private sector practices which enables the corporation to attract financial and human capital, perform efficiently and thereby perpetuate itself by generating long term economic value for its stakeholders, while respecting the interests of stakeholders and society as a whole. From an academic perspective based on extensive surveys and studies on the subject, Shleifer and Vishny (1997) define corporate governance as the ways in which suppliers of finance to corporations assure themselves of getting a return on their investments; Zingales (1998) views governance systems as the complex set of constraints that shape the ex post bargaining over the quasi-rents generated by the firm; Gillan and Stakes (1998) define corporate governance as the system of laws, rules, and factors that control operations at a company. To sum up, the important message of the need for good corporate governance is well articulated by M. Damodaran, Chairman, Securities and Exchange Board, who spearheaded36

Report and Recommendations of the Blue Ribbon Committee on Improving the Effectiveness of the Corporate Audit Committees. NYSE and NASDAQ, 1998.

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introduction of most significant reforms in the Indian stock markets, including the October 2007 guidelines on the Participatory Notes (PNs) observed There are those who will tell you that business and ethics cannot stand together. In the short run, it might appear that company pay a price for adhering to values while their competitors get ahead in a shorter time frame, but in the long run people would learn to distinguish, stakeholders learn to ask the right questions and distinguish between the grain and chaff. Those that dont subscribe to values will fall by the way side; those that subscribe to values will last the course and will set benchmarks. The roots of the recent developments in the corporate governance could traced to Treadway Commission (1985), United States which found that inadequate internal controls lead to financial failures, which later led to the Commission defining three objectives of the internal controls which are; (a) effectinvess and efficiency of operations (b) reliability of financial reporting and (c) compliance with laws and regulations and (d) safeguarding of assets. The evolution of the corporate governance guidelines is given in the chart below.Table 4 Recent Evolution of the Corporate Governance Cadbury Report, United Kingdom 1995 The objective of the Cadbury committee was to investigate how large public companies should adopt corporate governance guidelines with a focus on the procedures of financial report production and the role of the accounting profession. Issues included the role of the board of directors, standard s of financial reporting, accountability of the auditors and directors pay. The report dealt with the remuneration of executives and non-executives board members and recommended the setting up of a remuneration committee in each public company to determine remuneration packages for the board members. It also provided suggestions on the disclosure of remuneration and the setting up of remuneration policy and service contracts and compensation.

Greenbury Report, United Kingdom, 1995

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Hampel Report, United Kingdom, 1998 CII Voluntary Code of Corporate overnance,1998 Kumara Mangalam Birla Committee, India, 1999

Four major issues were discussed with practical guidelines offered; (a) the role of directors (b) directors compensation (c) the role of shareholders (d) accountability and audit. The first of the voluntarily evolved codes in India. The mandatory recommendations of the Kumar Mangalam committee include the constitution of Audit Committee and Remuneration Committee in all listed companies, appointment of one or more independent directors in them, recognition of the leadership role of the Chairman of a company, enforcement of Accounting Standards, the obligation to make more disclosures in annual financial reports, effective use of the power and influence of institutional shareholders, and so on. The Committee also recommended a few provisions, which are non- mandatory. A major initiative of corporate compliance, the SarbanesOxley Act of 2002, is also known as the Public Company Accounting Reform and Investor Protection Act of 2002 is a US federal law that has main features such as ; establishment of the Public Company Accounting Oversight Board (PCAOB), auditors independence, corporate responsibility, enhanced financial disclosures, analyst conflict of interest, commission resources and authority, corporate and criminal fraud accountability, while collar crime penalty enhancement, corporate tax returns and corporate fraud accountability. On non-executive directors. On Audit Committees. The key mandatory recommendations focus on strengthening the responsibilities of audit committees; improving the quality of financial disclosures, including those related to related party transactions and proceeds from initial public offerings; requiring corporate executive boards to assess and disclose business risks in the annual reports of companies; introducing responsibilities on boards to adopt formal codes of conduct; the position of nominee directors; and stock holder approval and improved disclosures relating to compensation paid to non-executive directors. Non-mandatory recommendations include moving to a regime where corporate financial statements are not qualified; instituting a system of training of board members; and the evaluation of performance of board members. The auditor-company relationship, Auditing the auditors Independent directors: Role, remuneration and training. The OECD Principles cover five aspects of governance (a) the rights of shareholders (b) the equitable treatment of shareholders (c) the role of stakeholders (d) disclosure and transparency (e) the responsibilities of the board.

Sabanes-Oxley Act, 2002

Higgs Report, 2003 Smith Report, 2003 Narayana Murthy Committee, 2002

Naresh Chandra Committee,2003 OECD Principles,2004

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Clause 49 of the Listing Agreement, 2005

A major compliance directive that came into force from the quarter ended June 2005, it has major aspects of compliance by listed companies that include; definition of independent directors; Non-Executive Directors compensation and disclosures, other provisions as to Board and Committees, Code of Conduct, Composition of Audit Committee, Meeting of Audit Committee, Subsidiary Companies, Disclosures pertaining to (a) basis of related transactions (b) accounting treatment (c) risk management (d) proceeds from public/rights/preferential issues (e) remuneration of directors and management discussion and analysis, CEO/CFO Certification, report on corporate governance, auditors certificate on compliance etc.,

Mature governance is caused by protection of property rights, enforcement of contractual rights, protection against fraud and unfair practices,, centralized banking laws, bankruptcy laws, strong and independent judiciary The quality of corporate governance of a company is a key determinant of its market performance. Institutional investors have a great hold on the market performance as also they contribute significantly in inducing companies to adopt best practices. It is in this regard, the guidelines evolved by CalPERS37, the leading institutional investor in the world are summarized below.

Core Principles on Corporate GovernanceCorporate governance practices should focus board attention on optimizing the companys operating performance and returns to shareowners. Directors should be accountable to shareowners, and management accountable to directors. To ensure this accountability, directors must be accessible to shareowner inquiry concerning their key decisions affecting the companys strategic direction. Information about companies must be readily transparent to permit accurate market comparisons; this includes disclosure and transparency of objective globally accepted minimum accounting standard. All investors must be treated equitably and upon the principle of one-share/onevote.

37

CalPERS, Core Principles of Accountable Governance.

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Proxy materials should be written in a manner designed to provide shareowners with the information necessary to make informed voting decisions. Similarly, proxy materials should be distributed in a manner designed to encourage shareowner participation. All shareowner votes, whether cast in person or by proxy, should be formally counted with vote outcomes formally announced.

Each capital market in which shares are issued and traded should adopt its own Code of Best Practices; and, where such a code is adopted, companies should disclose to their shareowners whether they are in compliance.

Corporate directors and management should have a long-term strategic vision that, at its core, emphasizes sustained shareowner value. In turn, despite differing investment strategies and tactics, shareowners should encourage corporate management to resist short-term behavior by supporting and rewarding long-term superior returns.

Board Independce and Leadership

At a minimum, a majority of the board consists of directors who are independent. Boards should strive to obtain board composition made up of a substantial majority of independent directors.

Independent directors meet periodically (at least once a year) alone in an executive session, without the CEO. The independent board chair or lead (or presiding) independent director should preside over this meeting.

Each company should disclose in its annual proxy statement the definition of independence adopted or relied upon by its board.

With each director nomination recommendation, the board should consider the issue of continuing director tenure and take steps as may be appropriate to ensure that the board maintains openness to new ideas and a willingness to critically reexamine the status quo.

Independent Board The board should be chaired by an independent director. The CEO and chair roles should only be combined in very limited circumstances; in these situations, the board should provide a written statement in the proxy materials discussing why the

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combined role is in the best interest of shareowners, and it should name a lead independent director to fulfill duties . When selecting a new chief executive officer, boards should re-examine the traditional combination of the chief executive and chair positions. Generally, a company's retiring CEO should not continue to serve as a director on the board and at the very least be prohibited from sitting on any of the board committees. Corporate insiders are not considered independent and should therefore not constitute any more than one board seat. Certain board committees consist entirely of independent directors. These include the committees who perform the audit, director nomination, CEO evaluation, and executive compensation functions. The full board is responsible for the oversight function on behalf of shareowners. Should the board decide to have other committees (e.g. executive committee) in addition to those required by law, the duties and membership of such committees should be fully disclosed. Board Evaluation The board has adopted and disclosed a written statement of its own governance principles, and regularly re-evaluates them. The board has adopted and disclosed an annual board, committee, and individual director evaluation process. With each director nomination recommendation, the board considers the mix of director characteristics, experiences, diverse perspectives and skills that is most appropriate for the company. The board should address historically underrepresented groups on the board, including women and minorities. Companies should submit executive compensation policies to shareowners for nonbinding approval. Executive contracts should be fully disclosed, with adequate information to judge the "drivers" of incentive components of compensation packages.

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Director compensation should be a combination of cash and stock in the company.

Audit Integrity The selection of the independent external auditor should be ratified by shareowners annually. The board, through its independent Audit Committee, should ensure that excessive non-audit fees are prohibited. To limit the risk of possible conflicts of interest and independence of the auditor, non-audit services and fees paid to auditors for nonaudit services should both be approved in advance by the Audit Committee and disclosed in the proxy statement on an annual basis.

Shareholder Rights A majority of proxies cast should be able to amend the company's bylaws by shareowner proposal. A majority of shareowners should be able to call special meetings or act by written consent. In an uncontested director election, a majority of proxies cast should be required to elect a director. In a contested election, a plurality of proxies cast should be required to elect a director. A majority of proxies cast should be able to remove a director with or without cause. Unless the incumbent director has earlier resigned, the term of the incumbent director should not exceed 90 days after the date on which the voting results are determined. Shareowners should have the right to sponsor resolutions. A shareowner resolution that is approved by a majority of proxies cast should be implemented by the board. Every company should prohibit greenmail. No board should enact nor amend a poison pill except with shareowner approval. Every director should be elected annually.

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Proxies should be kept confidential from the company, except at the express request of shareowners.

Broker non-votes should be counted for quorum purposes only. Shareowners should have effective access to the director nomination process. Shareowners should have the right to cumulate votes.

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Chapter IVCorporate governance in India reaches global standards

INDIA RISES

An assessment by the Institute of International Finance38 (Corporate Governance in India, An Investor Perspective, February 2006) brings out the following features of governance practice in India. Corporate governance-related requirements in India are largely based on the recommendations of the Cadbury and Higgs Reports and the Sarbanes-Oxley Act. SEBI has been proactive in keeping Indias corporate governance rules and regulations in line with best practices in the world. The state of corporate governance in India has improved over the last four years particularly among large cap Indian companies. In many large Indian companies, globalization- and not regulatory requirementshas served as the impetus for adoption of corporate governance best practices. High market premiums that the stock of these (good corporate governance) companies command has reinforced the belief among Indian investors and, more importantly, other Indian companies that better corporate governance contributes to a high stock price and provides access to cheaper capital. Improvements in corporate governance in Indian companies seem largely to be voluntary and driven by globalization Companies that wish to access markets for capital or that wish to become leading global suppliers to corporations in developed markets are becoming increasingly transparent and more willing to adopt higher corporate governance standards.

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Institute of International Finance, Inc, Corporate Governance in India, An Investor Perspective, IIF Equity Advisory Group, Task Force Report, February 2006

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These governance changes are having a trickle-down effect on smaller Indian companies. Stock exchanges are viewed as being at the front line of the surveillance function for compliance with all listing requirements, including those that pertain to corporate governance. Corporate governance practice and procedures underwent dramatic changes during the period 1997-2007. Major economic and financial developments that have during period such as Asian financial crisis (1997-98), burst of the dotcom bubble (2000), major corporate failures (Enron, WorldCom), large scale mis-statement of financial information (Parmalat, Ahold, Alstom), surge in non-performing loans in several countries etc., have reinforced the need to tighten governance standards and brought into focus the scope and need for a wide of range of reforms in this regard. These initiatives have begun to pay off as could be evident from the vast improvement in the governance form and practice Asia as evident from several studies focused on assessment of the quality of the governance. From the year 2003 onwards CLSA and Asia Corporate Governance Network39 together collaborated in bringing performance scores of countries in the Asian region in regard to corporate governance. The first of the report, CG Watch 2003, had an interesting title, Faking It : Board Games in Asia perhaps most appropriate at that time in the background of global meltdown of stock markets brought about by severe inadequacies and abuses in corporate conduct and disclosure standards. The 2004 report had a more promising title Spreading the Word. Changing Rules in Asia reflecting changing landscape of the corporate governance brought out in the backdrop of Sarbanes-Oxley and a host of regulatory reforms that came into being a number of countries. The CG Watch 2005 had the title Holy Grail : Quality at Reasonable Price(QARP) showing growing commitment towards, better corporate governance. The 2007 report had a much more encouraging theme On a Wing and a Prayer: Greening of the Governance that brought out the significant changes in the corporate governance practice in the Asia region. The 2007 survey assessed the quality of corporate governance in 11 Asian markets that included Japan for the first time, and provided aggregate data from 582 companies in the region.

Table5: A Decade of Developments in Corporate Governance

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Allen, Jamie, 2007,.The Benefits of Corporate Governance to Emerging Economies, Asian Corporate Governance Network.

41

Country/ Market Was there an official code of best practice? Yes (but very short -

1997 Did the idea of the Independ ent director exist? Yes Yes Yes Did the idea of the audit ctee exist? Yes Yes Yes Date of main code (s)

2007 Are independent directors required? Yes Yes Yes Yes Optional Yes Yes Yes Yes Yes (certain firms) Yes Are audit committ ees required Yes Yes Yes Yes Optional Yes Yes Yes Yes Yes (certain firms) Yes

China Hong Kong India Indonesia Japan Korea Malaysia Philippines Singapore Taiwan Thailand

2002/2005 1993/2004 1999/2005 / 2007 2001/2006 (2003)/ 2004 1999/2003 2001 2002 2001/2005 2002 1999/2006

Source: ACGA research.

Corporate governance score of all countries in Asia have improved sizeably. India now ranks third after Singapore and Hong Kong in regard to performance in corporate governance. The slight decline in the 2007 score is not due to lowering of standards but due to inclusion of a larger number of parameters for evaluation, that was common to all the countries. The 2007 study has also included Japan in among the countries assessed. The CG Watch 2007 has this to say on the quality of governance standards in India A large population (hence low GNI per-capita); economic reform started much later than China (1991) vs 1978); yet corporate governance reform started early by regional standards (1998) and the country has some pockets of world-class corporate governance.

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Table6: India ranks high among Asia governance league tablesCountry40 Singapore Hong Kong India Malaysia Taiwan Korea Thailand Philippines China Indonesia 2000 75 71 56 32 57 52 28 29 36 29 2001 74 68 54 37 53 38 37 33 34 32 2002 74 72 59 47 58 47 38 36 39 29 200341 77 73 66 55 58 55 46 37 43 32 200442 75 67 62 60 55 58 53 50 48 40 200543 70 69 61 56 52 50 50 48 44 37 2007 65 67 56 49 54 49 47 41 45 37

Source: CG Watch, a joint report by CLSA Asia- Pacific Markets and ACGA.

The credibility of India, in regard to corporate governance, comes into review, in the light of vast improvements made in the back ground of lower per capita gross national income as also the absence of a full fledged independent agency for fighting corruption, which indicates that most of the initiatives were proactive in nature and the processes evolved and practice standards are mostly voluntary in nature.

Table7: India manages well despite constraintsCountry / Market Hong Kong Singapore India Taiwan Japan Korea Malaysia Thailand China Philippines Indonesia CG macro quality v/s national income CG Watch GNI per capita ($ 2007 score :2006) 67% 28, 460 65% 29, 320 56% 820 54% NA 51% 38, 410 49% 17, 690 49% 5, 490 47% 2, 990 45% 2.010 41% 1, 420 37% 1, 420 CG macro quality v/s corruption Is there an independent agency fighting corruption Yes (for a long time) Yes (for a long time) Marginally Somewhat Largely Marginally Marginally No Marginally Somewhat (but recently) Yes (but recently)

Source: Asian Corporate Governance Association.

4041

Ranked in descending order according to 2005 score First year in which ACGA collaborated with CLSA 42 Introduced more rigorous scoring methodology in 2004 43 Enhanced methodology further in 2005

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India now fulfills all the standards regard best practices in corporate governance and compares quite favorably with all the major countries in the Asia region. Much of the progress has happened in the last decade that enabled India to make a big leap in the league tables of best practices.Table8: Matching Rules and Regulations Question Is quarterly reporting mandatory Are Auidt committees mandatory? Must ownership stakes above 5% be disclosed? Detailed disclosure of material transactions? Is the national code of CG based largely on International standards? Is there n national policy to converge with IAS/IFRS? China Yes Yes Yes HK No Yes Yes India Yes Yes Yes Indo nesia Yes Yes Some SKorea Mala ysia Yes Yes Some Yes Yes Yes Phil Yes Yes Yes Sing Yes Yes Yes Tai Yes No Som e Thai Yes Yes YesSourc e: CLSA / ACGA CG Watc h 2005: The Holy Grail .

Some

Yes

Yes

Some

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Some

Yes

Yes

Yes

Yes

Yes

Yes

The ext ensi ve

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

Yes

wor k carr ied

by the policy and regulation in developing an effective framework induced companies to improve the quality of their governance and enabled them to adopt best practices which provided an opportunity to scale higher in quality and performance. India is recognized as a market having best corporate governance standards, though issues of quality of enforcement, review and effectiveness continue to be raised. A broad outline of the framework for the corporate governance network in India that formed a recent assessment of the Institutional Institute of Finance is reproduced below. The assessment provides the current status of the regulatory framework from the point of view a global markets perspective.Legal Framework

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Indias legal framework for corporate governance is found in the Companies Act of 1956, most recently amended in 2002, and in Clause 49 of SEBIs requirements for listed companies. Minority Shareholder Protection The legal structure for corporate governance in India provides for strong minority shareholder protection compared w