‘Corporate Governance’ — these words have been hitting the headlines of financial magazines for quite some years, particularly post Enron, and in India they have once again triggered debates post Satyam scam. Satyam — this word would no longer be used as an adjective to signify the attribute of truthfulness, but will now be used as a noun to signify systemic failure in history of Indian corporate governance system. Satyam story holds within it, legion of myriad hidden lessons for a spectrum of bodies, from directors to investors and from auditors to regulators.

A lot has been and will be written and discoursed on the concept of corporate governance and its raison d’être. This article discusses one of such aspects. In the first part, it highlights the portent of Adam Smith and tries to prove how Adam Smith had prescient of the inherent flaw in the model — ‘Corporation’. The second part advocates a prescription for good governance practice.

Smith’s Portent & Prophecy :

Corporations today are based on, ‘Agency Theory’ (a branch of organisational behaviour) wherein the owners of funds (alias principals) invest their money in a company that is managed by altogether different group of people called directors and managers (alias agents); this agency relationship between the shareholders and directors is based on the premise of trust; shareholders lend their money to directors under trust that the latter shall deploy the money in a manner that would maximise shareholders’ interests.

Agency Theory is defined by Chartered Institute of Management Accountants as — ‘Hypothesis that attempts to explain elements of organisational behaviour through an understanding of the relationships between principals (shareholders) and agents (directors and managers). A conflict may exist between the actions undertaken by agents in furtherance of their own self interest and those required to promote the interest of principals.’

Some of the instances wherein a conflict can exist between owners and managers can be :

  • Managers are interested in short-term profits against long-term shareholders’ value, as it has positive impacts on their compensation, incentives, bonus and promotion. The episode of sub-prime crises in United States exemplifies this conflict wherein the investment bankers and financial institutions took recourse to highly complex derivative products in order to inflate short-term profits and thereby inflate their incentives.
  • Management myopia on short-term profits also motivates them to resort to creative accounting, inflating the top line and bottom line. Enron’s episode best exemplifies such myopia where the company resorted to creative accounting to show better profitability.
  • Quite often, managers having financial interest in their own company tend to send wrong cues to the market in order to inflate the share prices and ultimately increase their own wealth.
  • Managers deploy shareholders’ funds in risky investments so as to get quick and immediate returns, at the cost of preserving shareholders’ wealth.
  • Shareholders’ funds are siphoned into projects in which the management may have personal interest; examples of this can be — deploying funds in a company that is owned by a relative of the managing director or awarding a contract to a vendor company that is operated by a relative of one of the executives.
  • Managers of companies that are subject to a takeover bid often put up a defence to repel the predator, even though such a takeover may be in the long-term interest of shareholders of the acquired company; managers of the acquired company do so in fear of losing their jobs or status to the managers and functional heads of the predator company.

Adam Smith, known as father of economics, was highly cynical and pessimistic about the success of corporation as a model of creating wealth and pursuing economic growth. The entire idea of dilution of ownership, whereby the owner and manager of funds are two different groups/persons, was not at all invidious to Smith. Smith had prescience of the inherent and institutional flaw in the model of corporations. He wrote in his book ‘The Wealth of Nations’ (abbreviated name for An Inquiry into the Nature and Causes of the Wealth of Nations’) :

‘The directors of such companies . . . . being the managers of other people’s money rather than of their own, it cannot well be expected that they should watch over it with the same anxious vigilance with which the partners in a private co-partnery frequently watch over their own. Like stewards of rich man, they are apt to consider attention to small matters as not for their master’s honour and very easily give themselves a dispensation from having it. Negligence and profusion, therefore, must always prevail, more or less, in the management of the affairs of such a company . . .’

This statement of Smith came in 1776, almost 200 years after incorporation of East India Company in 1600 — the Company that ruled India and which was the first company to hold democratic general meeting of shareholders and was later on accused of mis-management aimed at generating personal gain (in violation of the ‘agency theory’).

Smith believed so strongly in the power of self interest and the conflicts it generates, that he was extremely pessimistic about the ability of the joint stock company to survive in any but the simplest of activities where management’s behavior could be easily monitored.

Without a monopoly a joint stock company cannot long carry on any branch of foreign trade. To buy in one market, in order to sell, with profit, in another, when there are many competitors in both; to watch over, not only the occasional variations in the demand, but the much greater and more frequent variations in the competition, or in the supply which that is likely to get from other people, and to suit with dexterity and judgment both the quantity and quality of each assortment of goods to all these circumstances, is a species of warfare of which the operations are continually changing, and which can scarce ever be conducted successfully, without such an unremitting exertion of vigilance and attention, as cannot long be expected from the directors of a joint stock company’.

Smith had strong surmise about the sustainability of a corporation without it being granted a state monopoly. Only activities where this model can work, according to Smith, were those that were easily monitored; Smith implicates this when he says in his words — “which all the operations are capable of being reduced to what is called a routine, or to such a uniformity of method as admits of little or no variation”.

Smith was well aware of the benefits of corporations, including their ability to concentrate large amounts of money into capital-intensive undertakings. But he thought and believed that :

  • The costs of agency relationship would always be too high. (Today there is intense debate in the USA on ‘managerial remuneration’.)
  • Those costs shall rise with the increase in size of business.
  • Bigger a business got, the worse would be waste because of negligence.
  • Negligence, profusion and conflict of interest would ruin the corporation as its business scaled high and it would be predicament for anyone to preclude these costs, by whatsoever checks, balances, controls and regulations being instituted. (Pending outcome of investigation, it was negligence and profusion that resided at the bottom of Satyam pyramid.)

These agency costs viz. negligence, profusion and conflict of interest, are today reflected in the form of corporate debacles, be it Enron, World-com or Satyam. It is sad, but the fact is that Smith has been proven right hitherto specifically in last decade if one is to go purely on regression analysis.

Smith’s prophecy that ‘negligence and profusion must always prevail’ made 200 years before, still holds good today. The irony is : it is only now when we realise the unfathomable truth in his profound statement.

To conclude : Enron brought a sea change in our perspective towards corporate governance; it had its own lessons to teach and so would Satyam. Stringent and vigilant controls would be instituted by regulatory bodies, in the form of codes, rules, audits, and peer reviews; investigations will be carried out, special committees will be appointed, white papers will be issued and; significant amount of research would be done in investigating why this happened, how this happened, could it have been prevented or at least predicted, what to do to prevent its re-occurrence, who should be held responsible, how should they be punished, etcetera. However, the fact is and as Smith aptly wrote, this model of corporation possesses an inherent flaw and this would time and again be reflected in the form of more Enrons and Satyams. These are bound to take place in future, irrespective of checks and balances because of the inherent greed and conflict of interest.

Prescription for good governance practice :

In the midst of academic debate as to what constitutes good governance practices, below are a few canons that inter alia form the basis for good governance. These are simple principles and values taken from different sources of management theory that have been practised at different times in history. Co-incidentally, these canons also happen to be in order of vowels of English literature (AEIOU) and therefore, one may also term them as vowels of good governance practice.

1. Altruism :

Etymologically, altruism origins from the word alter, which is the latin word for other. An altruist is a person who works for the benefit of others and who is more concerned with welfare of others. Likewise, the board and management need to practise altruism, whereby their actions are directed in maximising interest of shareholders and other stakeholders, instead of their own.

2. Egalitarianism :

Egalitarianism is a principle or belief that all the people are equal and deserve equal rights and opportunities. Relating it to ‘governance practice’, it basically means that board should adopt a stakeholder approach, rather than a shareholders’ approach in performing its actions.

Lately, although stakeholder approach has been adopted by academia, it has not been reflected in governance practice in real life. In fact, in Germany the legal system itself mandates explicitly that firms do not have a sole duty to pursue the interest of shareholders and that other stakeholders also need to be represented on the board. The Germans have the system of co-determination, in which employees and shareholders in large corporations share an equal number of seats on the supervisory board of the company, so that the interests of both are taken into account. Japan and France have also adopted stakeholders’ approach in governance of companies. This is not the case in other developed countries like US and UK. Even in India, the directors on board represent and are accountable to shareholders. However, several reports now advocate a ‘Stake-holder’ approach and advocate the three P approach to governance.

3. Integrity and independence :

Integrity is the attribute of having moral principles; being straightforward and honest. It means being ethical in discharging one’s duty. In terms of governance, it primarily means being transparent in disclosing information to shareholders and other stakeholders.

Independence stands for the strength of an individual to adopt an unbiased view on the matters, undaunted by any favour or frown. Relating it to governance practice it means the board must be independent in its actions whereby it should not be subordinated by the wishes or directions of management. This particular attribute of governance is one of the imperative corner stones of good governance practice.

4. Oracle :

Oracle is basically a noun, rather than an adjective. It means having a vision and an ability to foresee future. In terms of governance practice it means that the board needs to have vision and provide strategy to management for execution. One of the important roles of a board is to set objectives — objectives that translate long-term vision of the board, which is in the interest of stakeholders.

5. Utilitarianism :

Utilitarianism is a doctrine that emphasises that actions are right if they are useful or for the benefit of a majority; it emphasises : greatest happiness of greatest number. This is one of the most precious attributes that one can gain from Indian epics, both Ramayana and Mahabharata. This attribute also augments the canon of egalitarianism.

The board while dealing with different interests of different stakeholder groups cannot satisfy all the interests of all the stakeholders at the same time. There are bound to be conflicts between interests of different stakeholders. For instance — shareholders may often question the expenditure on corporate social responsibility as it ultimately impacts their dividend. The board is often confronted with such a dilemma wherein interest of two or more stakeholders conflict. It is at this point where the board needs to exercise the canon of utilitarianism i.e., it must act in a manner that provides greatest benefit to greatest number.

Author/s :

S. S. Sanghani, Chartered Accountant

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