Anderson, the fifth largest accounting firm in the US, on the verge of demise after being found guilty of obstructing justice in the Enron case, is expected to stop auditing publicly traded US companies from August 31, 2002. As a fall out of this, accountants the world over are worried whether the limited liability partnership that almost all accounting firms are structured as can withstand a guilty verdict. That structure is designed to protect individual partners from liability in case of malpractice, but has never been tested on a scale like this.


On the domestic front, a worry in India lately has been with the delisting fever, that was already reported in our columns. SEBI has appointed a committee to look into the issues surrounding delisting by MNCs. Liberalisation of the buy back provisions was permitted following a sharp decline in share prices in March 2001 as a measure to revive the capital markets and not as an instrument to facilitate de-listing. A number of multinational companies have already resorted to buy back of their shares in a bid to get de-listed from the Indian stock exchanges. These include Cadbury India, Castrol, Carrier Aircon, Industrial Oxygen Otis Elevators, Phillips India and Thomas Cook. When a company gets its securities de-listed, it not only denies to the investing public the opportunity to share in its prosperity, but it frees itself from the obligation of complying with disclosure norms which are currently applicable only to listed companies. Issues arising out of such de-listing need to be debated in public. We invite views and rejoinders from our readers.

Editor

It is a privilege to be addressing this gathering and I am grateful to Sri.D.K Verma and Sri.U.K.Diskshit who have invited me to share my perspectives on the corporate governance challenges facing the state controlled enterprises. I am also honoured to have Sri. Arvind Pande and Sri. Subir Raha chairing this session. The title has two critical phrases and I propose to cover these in two parts - the first describing the critical theoretical propositions of corporate governance for the Public Sector Undertakings (PSUs) and the second debating the dimensions of empowerment of boards, of listed or unlisted companies.

I.                    Critical Theoretical Propositions for the PSUs:

Theoretical View Points:

1.      In discussing the corporate governance of PSUs, it is important to recall the two dominant theoretical viewpoints, as they will remain the foundations of the debate.  The first is that corporate governance arose due to the dynamics of ownership and control, to ensure that the control of the firm does not shift in favor of the management or in favor of dominant shareholders causing relative deprivation of information, rights, and equitable treatment of the others.  Thus, diversified ownership - whether in the public sector or the private - which creates such conditions, is the basis for debating the classic case.

2.      Corporate governance will still be of importance to the fully-owned state owned, unlisted corporations, but the issues could be more related to the logic of the current controls and processes, their effect on competitiveness with the private sector, and the concerns of employees as important stakeholders, about the loss of wealth due to high transaction costs.  Evidently, these are part of the wider policy debate of government’s public investment and ownership choices, their allocative efficiency and stakeholder interests and socio-economic welfare at large.

3.      The second theoretical viewpoint arises from the in-built agency-problem and the related transaction costs of aligning the decisions and their outcome at the management levels with the assumed interests of the shareholders. Obviously, the problem becomes more apparent when there is diversity in ownership, docile/passive ownership, misaligned managerial incentives and the like.

Ownership and Independence of Boards:

4.      In a fully owned company, the management, Board and the shareholders are perceived as one integrated set of interests, even if they have differing legal obligations. The shareholder (the concerned ministries on behalf of the President of India) it is hoped will structure and constitute the Board in a manner that would align the behaviors of the management with the expectations and interests of the shareholder incurring least cost and effort. Overall efficiency of the vertical processes among managers, Boards and the owner will be the main concern here.

5.      Obviously, typical corporate governance issues are discernible when shareholders are several due to partial disinvestments and public offerings.  In this situation, the Board becomes the critical intermediary to achieve the coordination among all shareholders and represent this diverse interests objectively and with a sense of duty. However, if the Board comprises mostly of whole time/executive directors and an insufficient number of independent directors who are “fit, qualified, and competent”, the Board assumes the character of management. Obviously, executive directors cannot challenge and supervise their own managerial role. They will be able only to fulfill the legal/procedural obligations of the Board.

6.      Thus, in the strict sense of Corporate Governance, board effectiveness does not relate to mere adherence to the procedures and law alone. It is intimately related, in the case of publicly listed companies, to independence in sufficient degree. Separation of the Chairman and the CEO roles and the need for audit committees and sufficient (one-third or one-half, as the case may be) number of independent directors revolve around the assumptions behind public listing. The definition of independent director, the aspects of director disclosures, conflicts of interests etc flow from the proposition of bringing in objectivity, transparency and accountability to multiple shareholders.  

Expediency:

7.      The current frame of thinking in corporate governance circles, supports multi-pronged activism, separation of roles and interests and a Board that challenges management, even if such stand appears to be adversarial .  In such a situation

(a)    Management actions, reporting and analysis will be actively supervised by a Board that has good number of truly independent and competent non-executive directors and the Board meets frequently and votes often on critical issues;

(b)   The shareholders meetings are active demanding responsibility and accountability of the Board and its committees and evaluate the Board and management against international standards of corporate governance.

(c)    The media and intermediaries such as research analysts send frequent signals and information that support active stands and the incentive/disincentive mechanisms.

A desirable Situation

8.      The international principles – as in the case of OECD and the Commonwealth Association of Corporate Governance – emphasize the rights of minority shareholders and their equitable treatment; the role of stakeholders; disclosures; and transparency and responsibilities of the Board.  The question that arises in the case of state owned enterprise is whether the dominant shareholder is adhering to these principles at all?  Whether the current practices as also the special provisions and controls for “government companies” support corporate governance?

9.      The debate on corporate governance of public enterprises often include the nature of decisions - whether decisions made at the Board level are “efficient” in a professional sense or “expedient” to serve the interests of the civil servants and politicians who represent public ownership.  Relatedly, whether the shareholder rights are being exercised by them transparently through the Board and shareholder meetings or whether the exercise of rights is transformed into exercise of informal power through informal relationships.

10.   There are, undoubtedly, definitional issues – what is being caricatured as “expedient” by the management may be argued as pursuit of “welfare” which may be better understood by policy makers who happen to represent the government than managers.  On the other hand, the preference for non-transparent, non-undisclosed/reportable informal directions outside the Board and shareholder meeting mechanisms could be difficult to defend.

11.  It would be interesting to weigh the clamor for “board managed” Public Enterprises against the corporate governance framework. In the corporate governance frame, the “board” actually infers the non-executive directors and particularly the extent of independence in it.  In a 100% owned company, the Board is wholly of “insiders”, and perceived as a legal requirement than that of governance. At the other extreme, if the company is a widely held government company (say 24% equity with public) but has no independent directors, the corporate governance frame crumbles totally. Hence, to be  “board managed”, the company must have sufficient number of active independent directors.

12.  Further, to be a “board managed” company, the ownership rights have to be exercised by the government diligently and formally.  In some countries, the ownership rights of government have been vested with one ministry or a special purpose vehicle.  Such a move appears to have the potential of building formal and workable protocols.  South Africa gives a good example of such a protocol and a shareholder compact to cover the transition dynamics of disinvestments and privatization that may involve induction of several shareholders in a phased manner.

13.   New Zealand gives us an understanding of government’s efforts to make the director appointment process as transparent, and objective as possible keeping away potential political cronyism. The effort has been to induct independent Directors, whether the firm is listed or otherwise, which is done by the Crown Company Monitoring Unit (CCMAU). This unit is independent of the ministers who are the shareholders of the enterprises concerned (see annexure-1).

14.   It may be worthwhile to study the developments worldwide in the government’s policies and processes of exercising its ownership rights and devising mechanisms that would enhance objectivity, professionalism and independence of Boards from political pulls and pressures and to serve the best interests of the company.  The first duty of any director, as per the principles of corporate governance, must be to the company – not to the appointing authority, any one shareholder or stakeholder.  The structures and processes are required to ensure that the directors are enabled to carry out this duty.

The New Zealand Model

II.   Empowerment of Boards

1. Indian literature on public enterprise management is replete with pleas for empowerment of the Boards.  That Boards need to be empowered is beyond any debate. There are, however, two elements to the concept and practice of empowerment while the clamor is for greater delegation of financial powers. Empowerment is, in fact, not synonymous with delegation.

2. The first requirement for empowerment of a Board is that adequate space is created by the macro-policy environment that can foster initiative and timely decisions by the Boards.  The company law and articles of association broadly define the boundaries for the board functioning. Yet special legal provisions, controls, regulations, directives, rules and informal practices may restrict this space for a particular segment of the industry as in the case of the public enterprises.  The need for empowerment has arisen from the belief that the set of impeding conditions be reformed so that a similar situation as assumed for the private sector, governs the public enterprises. The imperative here is for restructuring the relationship of the government and its agencies vis-a-vis the pubic enterprise Board. It implies not only changes in Law to minimize special provisions and controls over government companies but also to ensure that Board, assuming it is well constructed, is empowered to take decisions so as to carry out its duties well. Such restructuring and reform would create the needed space for the Boards to balance the “performance” criteria better with “conformance” requirements and provide the logic for holding the Boards responsible and accountable to the shareholders. It is well known that Boards, which are merely conformance oriented, tend to lead the firm to its doom fast.

3. The other requirement of empowered behavior is the evidence that the Board is actually proactive and motivated sufficiently to take the needed initiative. While reform of external conditions is essential, it is obviously not sufficient to bring about empowerment – as there are several instances in the private sector of docile Boards in an empowered environment leading to corporate disasters (Enron and Barings, for example). Empowered behaviour is evident when Boards fully utilize the space provided by the existing frame and push for grater space without flouting the standards of control and risk management. To this extent, empowerment is more of “taking charge” than an external stimulus. It is a process of “inside out” than outside in.

4. Do Board members have the competence to be empowered? This has been a serious concern the world over. International surveys have revealed astonishingly high gaps in competence to govern – functional expertise does not assure Board competence and the ability to govern. Consequently, empowerment of PSU Boards will require massive programs of capacity and knowledge building through Board development.

5. Board development may comprise of several elements such as Board assessments/ ratings; competency profiling; director contracts/non-disclosure agreements; appointment of independent directors; director remuneration design; evaluation systems for the directors; reform in the quality of Board discussions, practices; increased content of strategy; authority for acquiring data, information, risk assessment, scenarios, etc; director induction, development and certification; preparation of best practice guidelines/manuals and the like.

6. The proposed center of excellence for corporate governance of the SCOPE will be a good platform to take up the internal challenge of board development and also to create sufficient motivation for reform of the Government - PSU relationships, exercise of ownership rights, board appointment processes and the like. Several countries have progressed dramatically in meeting the international standards of corporate governance and India is falling behind even in this new race. It must be borne in mind that continuance of low standards of corporate governance will be an expensive sacrifice in economic growth as well as shareholder value. Finance now flows only where there is good corporate governance. I have been saying “ Finance flows where corporate governance grows”.

7. Any competition for cheaper finance in adequate measure to fuel the growth aspirations of PSUs have to be founded upon a set of good corporate governance standards and practices. Long-term competitiveness of the public enterprises is inextricably linked to meeting the international standards and expectations and it is indeed a long and complicated haul. Governance premium in India can be 25-27%. Put in another way, the shareholder discount because of poor corporate governance standards can be about 25-27%. The opportunity is too huge to be foregone, as it eventually affects not just the owners and the employees but the socio-economic well being of our people.
   

Annexure-1

Director Appointment Process- CCMAU, New Zealand

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USA
ENRON: The Houston-based energy trading company filed for bankruptcy in Dec2001. Investigations revealed dubious accounting practices that hid some US$22bn debt off its books. Arthur Anderson, the auditors of the firm, found guilty of destroying evidence.

GLOBAL CROSSING: The start-up telecom firm headquartered in Bermuda filed for bankruptcy in Jan 2002 amid reports that accounting gimmicks inflated revenues. The firm, like Enron, had strong political ties and was audited by Arthur Anderson. Criminal and civil probes are under way.

TYCO INTERNATIONAL: The Bermuda-headquartered industrial conglomerate was reported to have spent US$8bn on more than 700 acquisitions that were not announced. CEO Dennis Kozlowski was forced t resign and was indicted for conspiring to avoid paying up sales taxes.

XEROX: Xerox Corporation, which paid a record US$10mn fine for accounting violations, in June revised downward its pretax profit by US$1.4bn over a five-year period and wrote down its equity by US$1.3bn.

RITE AID: Former executives at drugstore chain RITE AID were charged with criminal fraud in an accounting scheme that authorities said resulted in the largest restatement of corporate earnings in US History to date, US$1.6bn.

ADELPHIA: The sixth largest US Cable television operator filed for bankruptcy in June, 2002 after revealing US$3.1bn in questionable loans to members of the controlling Riga’s family. Investigations of deals are under way.

WORLDCOM: The telecom giant sent shock waves around the world with disclosure on the 25th June that it improperly booked some US$3.8bn in expenses, wiping out its entire US$1.4bn profit in 2001. A stunned Whitehouse rushed to act on new corporate regulatory controls to restore confidence.

QWEST: Denver-based QWEST, another telecom firm stung by concerns about its accounting for capacity swaps, said it cannot confirm reports in July, ’02 it is the subject of a criminal inquiry. Its newly-named CEO said the firm will cooperate with investigations.

ASIA:
A November 2001 survey by China’s National Audit Office found that 14 out of 16 accounting firms had issued ‘seriously falsified” reports on behalf of their clients.

Chinese retailer Zhen Zhou Baiwen Co was fined last year by regulators for faking financial statements.

Brilliance China Automotive Holdings Ltd., China’s largest mini-bus maker, had seven pages of related-party transactions in its 2001 annual report. An estimated 14.5 percent of its mini-bus sales derived from affiliated companies, according to a Salomon Smith Barney research report.

Singapore’s Asia Pulp and Paper Co., with US$ 13bn of debt in default said in Pril,”02 its financial statements from 1997 to 199 cannot be relied upon.

Gay Giano International Group of Honking said last week (week ending 14th July,’02) that it would rehire Chairman Cheung Sing-chi as a consultant two-days after he resigned following his arrest for what police said was conspiring to manipulate retailers’ shares.

My cal Corp, Japan’s fourth biggest retailer and Sogo Corp, previously the country’s ninth biggest departmental store operator filed for protection from creditors with 1.55trillion yen and with 689bn yen respectively, in debt. When they went in depth they realized that there were pretty big problems that the certified financial statements for years failed to reveal. It is very difficult to sue accountants in Japan very easily.

Standard & Poor’s warned last week that large Japanese Banks are exploiting favorable accounting rules to produce extra revenues. The Banks showed an increase in revenue by as much as 13 percent for the year ending March 2002 thanks to interest rate swaps and bond trading, the rating company said.

In South Korea, prosecutors have charged Yoo Sang, Chairman of POSCO, the world’s second largest steelmaker, with ordering affiliates to buy shares in a company that operates gambling pools. They paid a 75 percent premium to the market price in exchange for political favors, local media reported. Yoo has denied the charges.

Thai Petrochemical industry Pcl, Thailand’s biggest debt defaulter under court receivership is seeking a repayment of about 6bn Baht in loans owned by companies controlled by its former chief executive and founder, Prachai Leophairatana. Prachai lost control to creditors in 2000 after he refused to repay US$3.7bn of debt.

The US law makers are struggling to bring regulatory changes that would lead to better standards of corporate governance. However, the Wall Street wants minimal government interference, figuring that the markets can mete out harsher, swifter penalties to offenders than Washington ever could. The legislators and Government want to placate voters as they would like to show that a culture of see-no-evil among regulators is being changed-for good. Asian countries have tried to improve disclosure and enforcement standards. South Korea, in the year 2001, required one-third of a company’s Board to be independent directors. Japanese companies were required report consolidated results staring two years ago. Thailand, at the beginning of this year, set up a National Board of Corporate Governance and the Prime Minister Thaksin Shinawatra is its Chairman. One of the measures contemplated is reduction in the number of firms to be audited by an Auditing Firm to just 50.

The Securities and Exchange Board of India and the Reserve Bank of India woke up from slumber lately to evolve and implement a code of Corporate Governance in the corporate and financial sectors. But what about the accounting standards of the auditing firms in India and the regulations that would require to be imposed by the Institute of Chartered Accountants of India, Institute of Company Secretaries of India, and Institute of Cost and Works Accountants of India? A lot needs to be done in India both through public debate and rigid regulatory practices that would impose better corporate governance where even its basic understanding needs to be developed.

More than anything, it is corporate ethics and social responsibility that would require immediate attention of the regulators.

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