Investment: The company you keep

By: and |
Published: June 2, 2015 12:07:02 AM

Corporate governance isn’t just about complying with guidelines — it has a direct bearing on your investments

CORPORATE governance has always been a topic of interest and, even more so today, as the past decade of business around the world has highlighted the role it plays in maintaining viable entities and safeguarding investor interest.

Governance failures at well-known global firms, from Enron Corporation, WorldCom, Parmalat and Lehman Brothers Holdings to Indian companies like Satyam, Saradha group and others, illustrate the risks posed by a corporate governance breakdown.

What is corporate governance?

Corporate governance is a system of internal controls and procedures through which individual companies are managed. It provides a framework that defines the rights, roles and responsibilities of various groups, such as the management, board, controlling shareholders and minority or non-controlling shareholders within an organisation.

At its core, corporate governance is the arrangement of checks, balances and incentives a company needs to minimise and manage the conflicting interests between insiders and external shareholders. Its purpose is to prevent one group from expropriating the cash flows and assets of one or more other groups.

Investors are owners and they provide capital

Investors are central to developing an effective corporate governance framework. It is, after all, the investors who provide the capital that businesses need to grow, compete, succeed and create jobs. They are, in a very real way, the fuel that keeps the engine of our economy running.

Investors, of course, are not limited to the institutional investors. In fact, a vast majority of investors make their living not on the Dalal Street. The range from school teachers to factory workers and, indeed, anyone with a mutual funds to save for retirement, to put together a downpayment on a house, or to pay for their children’s higher education.

What does it mean for investors?

It means the owners of a company are those who have paid to own its shares and that management are merely their employees. The separation of ownership and control is the hallmark of the modern corporation. It would be neither possible nor desirable for the many, widely dispersed shareholders of any public company to come together and manage that company’s business and affairs. As a result, full-time management is essential for public companies to operate, and any investor will tell you that talented management is extremely valuable.

But even the most capable management, left unchecked, can make bad decisions, leading to undesirable results for a company and its shareholders. That is why shareholders elect a board of directors to represent their interests. Good corporate governance helps shareholders and their representatives hire the right managers, and ensures that the managers remember they ultimately answer to shareholders.

Factors to be considered

The prospective investors and existing shareholders should determine whether a company’s board has, at a minimum, a majority of independent board members; whether board members have the qualification the company needs for the challenges it faces; if the board members are elected annually or whether the company has adopted a process that staggers elections; and determine whether the board and its committees have budgetary authority to hire independent third-party consultants without having to receive approval from management. How well a company achieves these goals depends in large part on (a) the adequacy of the company’s corporate governance structure; and (b) the strength of the shareholders’ voice in corporate governance matters through shareholder voting rights.

Where to find all this information

Most listed companies post the names and qualification of board members, board structure, number of meetings, presence of various committees such as audit committee, appointment committee, remuneration committee, etc., on their websites apart from their annual corporate governance reports.

Research studies linking corporate governance to performance are continually being published and it is empirically proved that good corporate governance leads to better results for companies and investors. Corporate governance, therefore, is a factor that investors cannot ignore, but should consider in seeking the best possible results for themselves. Hence, it is essential for investors to ask pertinent governance questions of the companies in which they invest.

Run these checks
* Determine whether:
– a company board has, at a minimum, a majority of independent members;
– the members are qualified to handle the company’s challenges;
– the members are elected annually or the company staggers elections; and
– the board and its panels have the budgetary authority to hire independent third-party consultants
* Most listed firms post information on names and qualification of board members, board structure, number of meetings, various committees, and appointments on their websites

P Saravanan teaches finance and accounting at IIM Shillong

Tara Shankar Shaw teaches economics at IIT, Bombay

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