Should Corporate Governance in India be Voluntary or Mandatory

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By Ashish K Bhattacharyya:

Today no one argues against the need for a system of good corporate governance to attract capital to the corporate sector. Regulators, which have the responsibility to protect the interest of shareholders, continuously endeavour to improve the standard of corporate governance. There is a trend towards the convergence of the Anglo-Saxon corporate governance model.

The corporate governance structure, which requires a balanced board of directors with adequate number of independent directors, is widely accepted. It is also widely accepted that the role of the board of directors is to protect the interest of non-controlling shareholders through effective monitoring. But, in practice, companies do not prefer a monitoring board of directors.

They see value in having an advisory board of directors. This is so because companies do not see a business case for a board of directors, which effectively monitors the executive management. Although researchers argue that good and effective corporate governance system in a company reduces the cost of capital, their research findings do not provide conclusive evidence of reduced cost of capital.

The argument is based on the principle that higher the risk, higher is the expected return. Therefore, if corporate governance reduces the total risk by reducing the risk of expropriation of shareholders’ wealth by the executive management, the return expected by shareholders, which measures the cost of capital, should also reduce.

The logic is simple. But that may not work in practice. If corporate governance results in too much and too many controls, it kills the managerial entrepreneurship and innovation resulting in less than the optimal performance. Shareholders are not benefitted as both the expected return and actual return on investment are reduced. This is likely to happen if independent directors exercise too much control over the executive management. Performance of companies improve if, independent directors restrain themselves from imposing controls on the management and intervene when there are signs of mismanagement. Therefore, companies prefer advisory board of directors and shareholders do not resent to the same.

Shareholders are not too much bothered about the quality of corporate governance in a company because the quality of corporate governance is not observable. What is observable is the composition of board, qualifications of board of directors, number of meetings held, number of meetings attended by each board member, constitution of various board committees and number of meetings held by them and attendance members in those meetings. The board process is not observable to those who are not privy to board proceedings. Therefore, the adequacy of the corporate governance system can be observed but its effectiveness cannot be observed.

On the other hand, performance of the company is observable. Often, enterprise performance is used as a measure of the effectiveness of the corporate governance system. Capital flows to companies, have good track rec-ord of economic performance in terms of creating shareholders’ wea-lth. In fact, shareholders have little to choose between companies in terms of the corporate governance system because the corporate governance system is uniform for all the companies.

The government has interest in reducing the cost of capital for companies. If the cost of capital can be reduced, some projects that are unviable will become viable with reduced cost of capital. Companies prefer to use effective supervisory board to improve performance rather than establishing an effective monitoring board. The alternative way of reducing the cost of capital is to reduce the information asymmetry between the executive management and the capital market and to reduce the chances of earnings management.

These also strengthen the passive monitoring by capital market participants and others and enhance activities in the corporate control market. Quality of Accounting practices, disclosures in annual reports and in financial statements, disclosures to investors through stock exchanges and audit effectiveness reduces information asymmetry and chances of earnings management. Therefore, the government should focus on all those aspects.

The Institute of Chartered Accountants of India (ICAI) should also play its role effectively in establishing sound accounting practices and in enhancing the audit quality.

The audit committee of the board of directors should be accountable for non-compliance of accounting rules and for earnings management resorted to by the company.

Tweaking of the corporate governance code to compel companies to improve the monitoring function of the board of director is unlikely to produce the desired result.

(Ashish K Bhattacharyya is the Professor, Finance & Control, Indian Institute of Management Calcutta, D.H. Road, Joka, Kolkata – 700104. He can be reached at Email: asish.bhattacharyya@gmail.com

(Sourced from Business Standard, 7 March 2011)

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