The collapse of companies such as Enron, WorldCom, Satyam Computers, and Merrill Lynch is attributed to unethical practices or non-existent corporate governance mechanisms. As a result, the academic discourse has largely been in favour of the management of businesses in an ethical manner for the benefit of the stakeholders. The unprecedented growth in the social and economic power of the businesses and their capacity to impact the well-being of a large number of stakeholders has also contributed to the rise in the demand for the companies to be managed ethically for the benefit of the stakeholders – both internal and external. This paper first defines both corporate governance and ethics and then goes on to discuss a complex interplay between the two concepts before presenting a synopsis of the legal framework dealing with ethics and corporate governance in India.
In its earliest forms, corporate governance was viewed as a system that protected investors’ interests. Later on, it was defined as a mechanism based on which “investors protect their interests against managers and controlling shareholders.” The scholars such as Picou and Rubach defined corporate governance as a method by which agency cost is reduced and the interests of boards and investors are aligned. Further, in the Cadbury Report of 1992, corporate governance was defined as a system by which companies are directed and controlled. Also, as per the Organisation for Economic Co-operation and Development (OECD), corporate governance is identified as a practice of forging better relationships between the board, the shareholders and the other stakeholders.
In India, the report of the Kumar Mangalam Birla Committee on Corporate Governance (KM Birla Report) published in 1999 provides that corporate governance is when the boards and management have sufficient freedom to make decisions for the progress of their companies while remaining within a framework of effective accountability. Further, the Report of the SEBI Committee on Corporate Governance published in 2003 (Narayan Murthy Report) provided that “corporate governance is about ethical conduct in business.” The report also puts emphasis on the relationship between shareholders, the board, management, and the stakeholders such as employees, suppliers, customers and the public at large. The KM Birla Report identified both shareholders and stakeholders as claimants in corporate governance.
Finally, the Institute of Company Secretaries of India (ICSI) defines corporate governance as “the application of best Management Practices, Compliance of Laws in true letter and spirit and adherence to ethical standards for effective management and distribution of wealth and discharge of social responsibility for sustainable development of all stakeholders.” This is perhaps the most comprehensive definition of corporate governance which encompasses everything within its ambit from compliance with the laws, ethical decision-making, corporate social responsibility, sustainable development, and the protection of the interest of stakeholders.
As per A C Fernando, ethics helps us decide when our actions are moral and when they are immoral. It is a conception of right and wrong behaviour. Business ethics on the other hand is the application of general ethical ideas in the course of a business. AC Fernando states that “business ethics is the art and discipline of applying ethical principles to examine and solve complex moral dilemmas.” It is based on integrity and fairness and focuses on the benefits of the stakeholders. Business ethics is also closely related to trust. A business that is managed ethically is likely to be trustworthy. Therefore, it can also be said that ethics is about developing trust so that a company flourishes financially and maintains a good reputation. The lack of ethics in an organisation would lead to unethical practices and the eventual collapse of that organisation. As per A C Fernando, honesty, integrity, and transparency are the touchstones of business ethics.
Be it India or elsewhere, the increased emphasis on corporate governance and ethics is linked with financial crises, corporate scandals and frauds leading to their failure and abuse of managerial powers. The notable examples include the Wall Street crash of 1929, the collapse of German Harstatt Bank in 1970 and IBH Holding in 1980, the collapse of Polly Pack and Bank of Commerce and Credit International, which resulted in Cadbury Report of 1992, the collapse of Enron in 2001 and WorldCom in 2002, Asian financial crisis that brought corporate governance to the fore in Asia, and the collapse of Satyam Computers in 2009, which led to some key regulatory changes in India. These incidents are said to have shifted the emphasis on compliance with substance over form and have shown the importance of intellectual honesty and integrity.
There is also a substantial growth in social and economic power and influence of corporations. The revenues of modern companies have witnessed substantial growth and have even surpassed the gross domestic product of some of the developing countries. At the global level, the companies are now in a position to assume the functions that have traditionally been assumed by the governments. As a result, they are compelled to assume the responsibility for balancing their own interest with those of the society and the environment in which they operate.
The members of the board of directors of a company face the issue as to what is right or wrong at the time of making a decision. Most of the time, these business judgements involve non-moral issues. In some cases, there is no freedom to make a choice because of the legal constraints. However, in relation to the decisions involving major decisions such as those relating to mergers, acquisitions, demergers, or major investments, law or business judgements may not be sufficiently clear. This is where a question of morality as to the rightness of decisions comes into play.
In the boardroom, important decision-making is a matter of ethics. As per Donald Nordberg, “there is a moral hazard associated with the accumulation of financial resources and power in the hands of corporations when the directors of these corporations, are unaccountable and open to corruption.” The Narayan Murthy Report shows this by stating that the information provided by the firms is as good and honest as the people sitting behind them. It puts emphasis on the ethical conduct of businesses and highlights how ethics play an important role in corporate governance, for example, by guiding managers or directors in making a decision as to what is the right course of action and what is wrong. The report also highlights how ethical dilemmas arise due to the conflicting interests of the parties involved and when they arise, the managers often rely on a set of principles influenced by the value, context, and culture of the organisation. The report goes on to say that a corporation will not be able to succeed if it fails to embrace and demonstrate ethical conduct. Indeed, in the studies concerning major corporate scandals, unethical practices have been identified as one of the leading causes.
As a remedy, Stephen D. Potts and Ingrid Lohr Matuszewski suggest that companies should ensure that strong ethical values are ingrained in organisational culture. Those who are entrusted with the task of overseeing compliance and corporate values must not engage in mere window dressing. In the case of Satyam Computers, for example, the audit committee was not fully independent and empowered leading to the accounting fraud and collapse of the company. Window dressing should therefore be avoided. The perspective of a person responsible for corporate governance must be heard by the management and leaders in the organisation must respect and model the ethics process. Once ethics become part of the organisational culture, they help prevent problems and provide solutions to the problems once they arise.
The firms should also not allow the allegations to be suppressed with the help of sanitized reports or misleading verbal briefings. Concealments, untrue, and incomplete disclosures can have a potential adverse impact on the organisation’s credibility and it can lead to the worst outcomes. On the contrary, if an organisation adheres to ethical standards, it shall result in greater respect for the organisation and its credibility and integrity shall be enhanced. Stephen D. Potts and Ingrid Lohr Matuszewski also emphasise that ethics and integrity are important for a company and they can help in the development of a better relationship with vendors, customers, investors and other stakeholders. This is something in line with how OECD and ICSI define corporate governance. Furthermore, strong value-based ethics also help in the responsible management and exercise of vast economic and social powers of the companies in the interest of the overall health of the country.
However, at the same time, there is doubt as to which theory of ethics should best guide the managers. In general, corporate governance encompasses consequential (or teleological) and idealistic (or deontological) approaches. Deciding the right course of action is often based on an assessment of the outcomes of the action, which can be done, for example, based on utilitarianism, which propagates the greatest good for the greatest number. On the other hand, there is also something called ethical egoism based on which an action can be justified and which helps in the prioritisation of one’s own interest over the others. The managers who adhere to ethical egoism shall take a decision that favours them the most rather than the interest of the shareholders or the stakeholders at large.
Nonetheless, the theories of corporate governance such as the agency theory operate as a restraint to unabated ethical egoism-based decisions. It is often done with the help of contracts and legal provisions. The corporate governance framework puts a check on the undesirable self-prioritising actions of a manager without creating hurdles for a manager’s thrust to succeed. Often the energy is channelled towards a common goal with the help of negotiations and adjustments in the pay policy. This is one of the major reasons behind the popularity of stock options and other equity-based incentives. They help in aligning the interests of both owners and the managers. They ensure that managers, instead of diverting the company’s resources for their private use, understand that they have much more to gain from taking actions that benefit both the shareholders and themselves. In an attempt to maximise his own wealth, the manager would also maximise the wealth of shareholders.
Similarly, stakeholder theory provides for the decisions to be made based on idealistic (or deontological) approaches ruling out the possibility of self-prioritisation. In particular, the advocates of corporate social responsibility are vocal about such approaches. The concept of corporate social responsibility, which is giving rise to the development of socially responsible businesses and ethical investors, is said to have its roots in the stakeholder theory of corporate governance. As said in the Narayan Murthy Report, what is good for society is said to be good for the company. The deontological roots also give rise to the stewardship theory. While stewardship theory is generally associated with charities in which the actors are presumed to be working for the greater good, it can also be associated with for-profit businesses. In the words of Perella Weinberg, a former executive of Goldman Sachs, “Serving on a board is like taking on a position in public service. It is not a wealth creation opportunity but a chance to play a role in the proper workings of our marketplace.” A person assuming the position of a steward shall not place his or her interest before the interest of the stakeholders.
Therefore, it would not be incorrect to hold a view that the theories of corporate governance exist because there is a possibility that the managers shall divert the funds of the shareholders for their personal gain. On this backdrop, the concept of corporate governance comes to play an important role by ensuring that the funds of the shareholders are not diverted for personal gains and that the managers make timely and accurate disclosures to provide shareholders with necessary information based on which they could decide whether they should continue with the investment or not. Ethics also have a role to play in the management of the business for the benefit of all stakeholders whether internal or external. Corporate governance requires the managers to make a decision not for their personal gain but for the benefit of stakeholders as a whole. Thus, ethics is indeed a founding pillar of corporate governance. Something that is held to be unethical would fall out of the corporate governance framework established by theories such as agency theory, stakeholder theory, stewardship theory, and shareholder value.
The preceding sections of this paper demonstrate how ethical decision-making in the interest of all stakeholders whether internal or external is the crux of corporate governance. It has also been discussed that integrity, honesty, and transparency are the touchstones of ethics. Now, in this part, the legal framework concerning corporate governance has been discussed in brief. In India, the Companies Act 2013 is the primary legislation that covers areas such as the appointment of independent directors, meetings of the members, related party transitions, formation of the committees viz. audit committee, nomination and remuneration committee, and stakeholder relationship committee, and the disclosures that are required to be made in the board report and the financial statements of the companies (among others).
In addition to the Companies Act 2013, the regulations of the Securities and Exchange Board of India, which mostly apply to a listed entity or an entity that is proposed to be listed, contain provisions related to corporate governance. In particular, Chapter IV of the SEBI (Listing Obligations and Disclosure Requirements) Regulations 2015 contains the provisions related to corporate governance. The matters covered under Chapter IV of the SEBI (Listing Obligations and Disclosure Requirements) Regulations 2015 include the composition of the board of directors, board meetings, the appointment of the independent directors, maximum number of directorship, constitution of the committees such as the audit committee, nomination and remuneration committee, stakeholders relationship committee, risk management committee, establishment of a vigil mechanism, and related party transactions (among others).
Most importantly, the fundamental principles governing disclosures and obligations provided under Regulation 4 of the SEBI (Listing Obligations and Disclosure Requirements) Regulations 2015 provides (among others) that “the board of directors shall maintain high ethical standards and shall take into account the interests of stakeholders.” It also requires the establishment of a vigil mechanism that could enable the stakeholders to report unlawful and unethical practices in the company. All these provisions effectively establish ethics as the most crucial aspect of corporate governance.
In conclusion, ethics is indeed the founding pillar of corporate governance for it provides a basis for corporate governance to exist. The absence of ethics may result in unethical practices and the eventual collapse of the companies and financial markets. Prioritisation of personal interest over the interest of the stakeholders by the managers is one such practice. Conversely, when true and fair disclosures are made and the decisions are taken keeping in view the interest of the stakeholders, it is said that the company is being managed ethically. The theories of corporate governance strive to achieve the same by requiring the managers to make decisions, for example, in the interest of stakeholders.
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