Is the performance of private unlisted companies worse than the listed companies? The Business World - India looked at the top 100 companies and they compare as below. Are there more "transmission losses" in the unlisted companies before the residual income? Are there more "value transfers" to suppliers and the retail network than in the listed companies?

Figures in Rs. Crore except where indicated ( Rs 1 Crore is equilant to US$ 2,10,000)

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Infosys Technologies, Bangalore has bagged the first position for being the best-governed company in India. The second position has been taken by BSES(the private sector electricity company based in Mumbai).

Institute of Companies Secretaries of India, which present this award, also conferred two lifetime achievement awards for translating corporate governance into reality.

These were conferred to Varghese Kurien of National Dairy Development Board and Oberoi Group chairman Rai Bahadur M S Oberoi.

The award distribution ceremony was presided over by Vice-president Krishna Kant who also distributed the awards to the winners. Mr. Arun Jaitley, Union minister for law, justice and company affairs was the guest of honour for the award distribution ceremony. The jury was headed by Mr Justice M.N.Venkatachaliah, Chairman, National Commission to Review the working of the Constitution.

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The report was prepared by Yaga Consulting Pvt. Ltd., on the initiating of "Standing Conference of Public Enterprises" and with the support of "Forum for Policy promotion"

In a private letter, Dr. Arun Shourie, Minister, Department of Disinvestment, Government of India, had commented that "I have read it with the great care it deserves, and learnt a good deal from it".

The report was cited by Dr. S. S. Tarapore, Former Deputy Governor, Reserve Bank of India and currently Chairman of Discount and Finance House of India Limited in his editorial Are regulators getting lost?- for Financial Express. He drew the attention of the regulators to say "The proposed consultative group of directors of banks/financial institutions, to suggest measures to strengthen the internal supervisory role of boards, is welcome. In this context it would be apposite to draw attention to a document by Dr Y R K Reddy of Yaga Consulting Pvt Ltd, on The First Principles of Corporate Governance for Public Enterprises in India (October 2001).

The report inter alia stresses the need for developing a best practice manual for board processes, procedures and formats, conduct of board meetings and evaluation of board members. It is further argued that it is necessary to build board capacities by an accreditation process and directors should have expertise in one or more disciplines relevant to the concerned board. In the UK, Australia and New Zealand there are facilities for director training and accreditation".

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The Minister for Law, Justice and Company Affairs, Mr Arun Jaitley, on Monday launched the ACCA award scheme, at a conference on `Environmental reporting and corporate governance', organised by ACCA in collaboration with TERI, New Delhi. Mr Jaitley said that he favours voluntary environmental audit by the corporate sector rather than make it mandatory through legislation. He felt that as corporate governance goes up, the responsibilities of the Government would come down. Mandatory legislation would be resorted by the Government only as the last resort.

Further, the Minister stressed the need for the corporate sector to take up more sectors so that the Government can gradually vacate them. ACCA is one of the largest professional accounting bodies in the world. Mr Roger Adams, Head of Technical Services and Research, ACCA, launched the environmental reporting awards in India. The awards are designed to encourage, identify and reward the best practices in corporate environmental reporting.

These awards are expected to encourage improved corporate governance by addressing social, ethical and environmental issues.(Source: Business Line).

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Administrative Staff College of India (ASCI) held a conference on "Governance in Banks and Financial Institutions". This is the third in the series after the initiative by Yaga Consulting Pvt. Ltd., in 1999 in collaboration with ASCI.

The programme was inaugurated by Sri. Vepa Kamasam, Deputy Governor, Reserve Bank of India. The speakers included Dr. Yerram Raju, Chairman, Agriculture and Rural Development Area, ASCI, Prof. Y. R. K. Reddy, Chairman, Yaga Consulting Pvt. Ltd., Dr. Jayati Sarkar, Associate Professor, Indira Gandhi Institute of Developmental Research; Dr. P. V. S Jaganmohan Rao, President, ICSI; Dr. K. Kannan, Former Chairman, Bank of Baroda; Shri. B. V. Goud, M.D, Stock Holding Corporation of India Limited (SHCIL); Prof. N. Balasubramanian, Professor, IIM, Bangalore; and Shri. K. R. Rammorthy, Chairman, Vysya Bank. Participants were senior management and directors from commercial banks, central bank and financial institutions.

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The Political and Economic Risk Consultancy (PERC) report on Transparency appears to have applied a different methodology than the transparency international, but the results appear to be equally distressing for the Asian region. The Hong Kong based risk consultancy cited three reasons for the elusiveness of transparency in most of the Asian region.The Hong Kong based risk consultancy cited three reasons for the elusiveness of transparency in most of the Asian region.

"For one 'there is frequently complicity between the publicly listed companies and their bankers to avoid publishing the full scale of problems', it said. 'Second, government regulators tend to cover-up the problems of big, well-connected companies and third, there is a lack of legal and other institutional structures through which minority shareholders can compel firms toward full disclosure'.

'Hong Kong and Singapore are perhaps the only two Asian systems covered in our survey where regulators and market forces deal harshly and quickly with publicly traded companies that get into trouble,' PERC said. Asian governments would often 'create the impression that all is well,' allowing problems to mount, it added.

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Press Release by Mr. Geoffrey Bowes, Chief Executive, CACG.

The Commonwealth Association for Corporate Governance (CACG) conducted its Annual Workshop in Kuala Lumpur on 12 and 13 November 2001.

Outgoing President, Marvyn King, from South Africa, commented the Association and urged it to continue its practical on the ground approach of working with the directors of the various countries within the Commonwealth. "CACG works with rather than talks at, the practitioners. Standards of one country cannot be imposed on another. The culture varies from country to country and so will the governance of corporations".

The Commonwealth Association for Corporate Governance was established after the Edinburgh Heads of Commonwealth Meeting and its brief is to promote excellence in Corporate Governance in Commonwealth countries. To date it has conducted workshops in some 25 countries and facilitated the establishment of institutions in all of these countries, which promote Corporate Governance by education and information.

The Association is currently conducting a series of Five Day Company Directors courses throughout the Commonwealth. These courses have been very well received. Ambassador B. Kiplagat, Chairman Nairobi Stock Exchange has said.

"Directors of all public companies, co-operative societies and state owned enterprises should be required to attend the 5-day director's training course, before taking up positions of directorship.

Indeed, it is my considered view that all public leaders-be they ministers, permanent secretaries or managers of local authorities - would greatly benefit from attending this course".

Mombasa, Kenya
28th September 2001
(After attending the 5-day course)

CACG conducts the first course and then hands the material over to local trainers who then adapt the course to suit local conditions although the fundamentals remain the same. The aim is to train a critical mass of directors in each country by the end of 2002.

The Association has also produced some publications on Corporate Governance, which are designed to assist countries in producing their own publications on "Best Practice" for Corporate Governance. The first of these - "CACG Guidelines - Principles for Corporate Governance in the Commonwealth" was ratified by Commonwealth Heads of Government in Durban in 1999. as CACG points out, these guidelines cover Principles that a country or entity can use in developing their own Codes on Best Practice for Director.

CACG's practical facilitated approach has been applauded by International commentators. Its Chief Executive, Geoffrey Bowes from New Zealand, says that CACG facilitates rather than dictates to its affiliates. More than 35 institutions from throughout the world are affiliated to CACG. "It has the widest network of institutions promoting Corporate Governance in the world," says Bowes.

Twenty Commonwealth countries were represented at the CACG conference in Kuala Lumpur. At its AGM on 11 November Dato' Mohammed Azlan Hashim, The Chairman of the Kuala Lumpur Stock Exchange, was elected to be President of CACG to replace Mervyn King who was the inaugural President .

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The central problem in corporate governance in India today is sociological. Mr. Rahul Bajaj epitomized the problem recently. He said at a seminar on corporate governance in Mumbai in November, 1996 that:

"All of us know what boards and managements should do, but are doing what we should not do. We have done things that are questionable - legal but questionable. Why should we need a committee to tell us what to do?"

Paradoxically, Mr. Bajaj was the chairman of the task force of the Confederation of Indian Industry (CII) entrusted with the task of preparing a code of corporate governance. The corporate governance problem in India crystallizes into the following questions:

• Why do business leaders do things they know should not be done?
• What are the pressures or fears that force them to do so?
• How can they be helped to be more integral to their own beings?
• How can the board of directors play a more useful role?

The Mumbai seminar added another sociological problem to the schizophrenic character of corporate governance, namely the import of western forms as solutions, instead of addressing the problems that afflict our behavior. Speaking at the seminar, Sir Adrian Cadbury advised Indian business leaders not to import systems of corporate governance but to adapt internationally recognized principles to suit the country's requirements because governance systems are not exportable.

Yet, import is what appears to have happened. Neither Mr. Bajaj nor his task force attempted to answer the question Mr. Bajaj himself raised. The CII code was modeled on the lines of the Cadbury Committee in the UK (Varma, 1997). Perhaps, there is a surface rationality in that as well. Why should we take the trouble of adapting international principles to our requirements, when, as Mr. Bajaj said, "We do not do what we know is right."

No wonder corporate governance is more a topic for debate than action. "Everybody is talking about it - the Finance Ministry, RBI, Indian industry representatives and all the pink newspapers. And they are talking of little else. And what is this weighty topic - why, it is corporate governance, stupid" (Bhalla, 1996). Apart from the CII, several organizations such as FICCI and the Rajiv Gandhi Institute for Contemporary Studies have organized seminars in recent years.

Stakeholder concerns

It is instructive to ask why corporate governance has acquired such importance in India and what the issues are that our business leaders are addressing. The CII rationale for setting-up the Rahul Bajaj Task Force in mid-1996 provides an answer. The foreword to the code states that:

"In recognition of the key importance of corporate governance at this time when the Indian economy is integrating with the global economy and Indian industry is striving for international competitiveness, the CII National Council considered it essential to take a special initiative and set-up a National Task Force on Corporate Governance" (CII, 1997).

Liberalization has ushered in a new breed of foreign direct and institutional investors into Indian industry and financial markets. In the process of accessing foreign financial markets through global depository receipts and borrowing, large Indian companies have acquired new types of stakeholders. Their options and expectations differ from those of other stakeholders that Indian companies have been accustomed to.

The raised decibel level is perhaps a way of addressing the need to incorporate new stakeholders into the Indian systems of corporate governance or a way of reassuring the new stakeholders that Indian firms will adopt the same forms of corporate governance as do their western counterparts.

The code of desirable corporate governance (CII, 1997), reflecting this concern with the expectations of new stakeholders, recognizes the need to satisfy creditors. Several of the 17 recommendations in the code emphasize the need for the board of directors to honestly discharge their fiduciary responsibilities towards the company's shareholders and creditors.

Are creditors on a higher pedestal now? Is the new code intended to assure new stakeholders that they won't go the way of Indian banks and financial institutions carrying a large load of non-performing assets? Will such responses be adequate to attract investors and lenders (both domestic and foreign) on a scale that is necessary for the future? Can adequate and continued support of these stakeholders be ensured without addressing the basic problems of why the Indian system of corporate governance has failed to address the problems of its old stakeholders?

What are the current concerns of old stakeholders in Indian corporations? To identify the flavor of current concerns, I surveyed news items reported in The Times of India during 1997-98 (Annexure-1). The list points out the nature of concerns that include cheating of investors and depositors, payment defaults, insider trading and cornering of stock, violation of laws and norms, evasion of excise duty, indifference to the rights of minority and institutional shareholders, and nexus of corruption with officials and politicians.

As Rao (1998) puts it:

"Over the past years of restrictive legislation and penal rates of taxation, a culture of avoidance, even evasion, has entered many companies, and become deep-seated enough to affect all levels in these corporations. Cornering of industrial licenses, using import licenses to make a quick profit in the market, illegally holding money abroad to meet business expenses and investments for which government would not allow enough funds, trying to gain special advantages for the business by bribery of concerned officials, generating unaccounted money in the business so as to compensate for penal levels of taxation, other 'business' expenses and political donations were just some of the practices that became common in many businesses.

The extraordinarily high income tax levels of the 1960s led many companies to devise tax free elements in compensation packages for their senior and middle level employees. These elements which were small at the outset, grew in value over the years, and skating at the outset on the margin of the law, many times cross the line of legality. Overseas holidays for families disguised as business trips, expensive housing treated as being for office use and hence escaping tax, cars for personal use but shown as being used for work, furniture and furnishings, clothing, food and most household expenses being met by the company employees, became relatively common practices. The economy lost tax revenues and the organization fostered an acceptance of ignoring and violating of laws that were regarded as unacceptable by the company."

Instances of cheating, default, and violation of laws can be found in any complex economy today. We have no data on how widespread and deep these are in different countries. India has been ranked among the three most corrupt countries in the world in recent years in a distillation of international comparative studies. Can the license-permit raj and the state-centered development model be blamed for the current state of affairs? Will the process of liberalization now underway remove the ills of our corporate governance?

Market environment and corporate governance

There is no doubt that the license-permit raj of the past has lowered the norms of corporate governance in our country. But it is far from clear whether the forces of competition will exploit the situation or set it right! The key to better corporate governance in India today lies in a more efficient and vibrant capital market argues Varma (1997). He expects competitive market forces to eliminate the conflict between the dominant and minority shareholders, the central problem of poor corporate governance in India. This argument fails to explain why minority shareholders have become wary of the capital markets in India, or for that matter, why poor corporate governance has continued to be a vexing issue even in advanced market economies.

Varma's (1997) argument, however, assumes a significant correlation between financial performance and good corporate governance. It should be clear from the existence of various kinds of regulators and the increasing demand for more regulation against the backdrop of such correlation as might exist in society is neither automatic nor sustained. Irrespective of ownership pattern, even professionals (leave alone dominant owners), under pressure for short-term competitive performance, can and do resort to short cuts. The problem in corporate governance is the achievement of a balance between autonomy for management and accountability to the organization's various stakeholders.

Autonomy can create scope for both desirable and undesirable behaviors just as accountability can curb both. A preponderance of desirable behavior tends to reduce the emphasis on accountability while a preponderance (or even glaring examples) of the undesirable focuses attention on accountability. This asymmetry in autonomy and accountability and the need to provide room for desirable new initiatives under changing technological conditions, levels of risk and uncertainties is at the heart of the corporate governance problem. That requires a sociological and evolutionary approach to improving governance practices.

Approaches to corporate governance

Different countries have evolved different patterns for achieving a balance between autonomy for managers on the one hand and how managers are to be held accountable to the stakeholders on the other. The function of a code of desirable conduct or corporate governance is to enhance the degree of acceptability of the corporate form as a public limited liability company in perpetuity and the board of directors as a body responsible to the stakeholders. There is no universal method to do so, although the corporate form and the board structure have become near universal.

Whatever be the method adopted the degree of trust and acceptability of the process of accountability will be enhanced only if such systems suit the history and socio-cultural ethos in which the corporation has to function. Greater trust and accountability enlarges:

• The corporation's scope for mobilizing resources beyond what would be available to the individual owner or promoter.
• The society's ability to bear the risks and uncertainties.

In achieving a balance between autonomy for managers and their accountability to stakeholders, the approach in USA is to view the interests of various stakeholders separately and to protect each one's legal rights. A market-cum-legal system is the basis for reconciling conflicting interests. As Keller (1998) puts it:

"The large business corporation has a firm place in the American imagination as the dark repository of private power. There are no more reliable villains on TV or in movies than these shadowy, soulless, omnipresent institutions and the faceless, greedy men and women who serve them. And yet today as much as ever before, corporations are accepted as the driving engines of our economy, as the places where most of us work."

The tension between the public character and private purposes of corporations has been handled with caution, ensuring legal and information rights to non-owning stakeholders, while leaving the residual power and autonomy to owners. The separation of ownership and control in large corporations has created problems of trust and accountability of managers, or the board of directors, to the owners or shareholders. "How could non-owner managers be counted on to maximize profits and secure the health of the company, rather than seek perquisites and power for themselves?" (Keller, 1998).

In the market-cum-legal approach, designing proper contracts for managers (such as stock options) are expected to resolve any conflict of interests. As Keller (1998) argues, "Much of the corporation's relative immunity from broad political assault exists because it has been able to lay claim to the status - and the legitimacy - that comes from being an old, massive, generally successful American institution." Acquiring and enhancing such acceptability should be the goal of any effort to modify corporate governance practices.

Corporate governance in USA has, in recent years, been responding to the decline in competitiveness of American industry in the 1980s. There has been an increase in the number and role of outside directors on the boards and an emphasis on getting board sub-committees take direct responsibility for:

• Nominations of members of the board, including the CEO.
• Compensation of senior managers, including the CEO.
• Audit of accounts and processes of accounting.

In Germany, property owners are regarded as having an acknowledged responsibility for public welfare. The dichotomy and conflict between self and community interests are not considered as sharp as in the USA (Charkham, 1994). The stock market too plays a relatively lesser role in determining the German corporate destiny. As a result, Germany has chosen a governance structure at the enterprise-level that integrates the interests of owners, creditors and employees. Most large corporations in Germany have a two-tier structure:

• A supervisory board with representatives of employees, owners and also creditors.
• A management board consisting of operating management and employee representatives.

Besides providing short and long term finance to companies, banks not only hold their own shares in the company but also proxies of small shareowners. As a result, they play a powerful role on the supervisory board which can appoint management and change it and is responsible for the company's accounts, capital expenditure and strategic initiatives. The companies generally operate around a consensus among management and supervisory boards.

In contrast to the German approach of structured integration at the enterprise-level, the approach to corporate governance in Japan, where also corporate accountability to the community is considered high, is informal and culturally based. Consultation and understanding among key stakeholders takes place at the level of inter-connected groups of companies, which has implicit support, trust, and loyalty of employees.

Differences in approaches to corporate governance appear to be related more to historical evolution of corporations in response to socio-cultural pressures than the extent of concentration or diffusion of shareholding. For example, shareholding in Germany is even more concentrated than in India. A single shareholder owned more than 50% of the stock even in large listed German companies in the early 1990s. Yet, governance systems and the degree of acceptability of the institution of public limited companies are far different in the two countries.

The board of directors has not been central to corporate governance in India. While the government has, in the name of accountability to parliament, tended to displace the functioning of boards in the public sector, dominant shareholding families controlling private sector companies, have typically treated boards as a mere legal formality. The evolution of corporate governance in India has emphasized growth of companies and the spread of entrepreneurship at the expense of their accountability to stakeholders and public interest.

Nominee directors

Based on a general argument that public interest and not merely private profit should guide the operations of the private sector, the Dutt Committee wanted public financial institutions to participate in the control and management of assisted companies. From 1970, these institutions have been appointing nominee directors on the boards of large assisted companies (Gupta, 1997).

Because of the ideological overtones of the 1970s and that of the Dutt Committee, there has been corporate resistance to direct involvement of financial institutions, and indirectly of the government, which owns and manages financial institutions in the country. As a result, nominee directors have been absorbed into the current board culture in which having a board is a legal formality and the function of the board is to rubber stamp the promoter's interest.

Yet, Gupta's (1997) survey of the early 1980s found that the nominee director's presence had brought about some formality and openness to board practices. He says:

"Before 1971, many companies did not observe even the elementary conventions such as sending notices of meetings and the agenda to the board members in advance, bringing all important matters before the board, furnishing the annual operating budgets and periodic reports on performance to the directors, allowing a proper discussion at board meetings, etc. A not uncommon experience even in well-established companies was for board meetings to be brief - lasting less than 20 minutes. Boards were neither involved in supervision of management nor in decision-making, but simply in fulfilling a legal responsibility. This is changing under the influence of public financial institutions and their nominee directors, for although there is still a long way to go to secure board effectiveness in the real sense, the 'outer' discipline in board functioning, i.e. observance of proper procedures, has distinctly improved."

Sociology of corporate governance

Mr. S.H. Khan, former chairman of the Industrial Development Bank of India, quoted a study on corporate governance of 30 companies which found that companies with low promoter shareholding and chairman from outside the promoter group were having more effective corporate governance practices and the presence of outside directors was said to have helped corporate performance (The Economic Times, Mumbai Bureau, 1998).

Yet, the CII code on desirable corporate governance takes no note of these findings. It, in fact, recommends that non-defaulting companies should be freed from nominee directors of financial institutions. The CII code does not explain how the presence of nominee directors has hurt corporate governance in India or how corporate governance will be better served if nominee directors are removed.

The CII code recommends that any listed company with a turnover of Rs. 100 crore should have a professionally competent and acclaimed non-executive directors who should constitute at least 30% of the board, and if the chairman and managing director is the same person, at least 50%. The code also provides for setting-up of audit committees for large listed companies. The key to improvement in governance in the Indian corporate context lies in the board's ability to address the concerns of stakeholders long before they explode into a disaster for the company. Mr. Bajaj pinpointed the root social malaise that has to be overcome:

"Many family-owned companies have several executive directors…Does it mean they are best managed? Of course, it is an unholy club…school ties, relatives, etc."

Will non-executive directors be acceptable? Will they also go along as the nominee directors did? Unless promoters and controlling directors accept the board as an important decision-making body, and provide them with full information, the board cannot be effective. Directors, even friends and relatives, are unable to raise basic questions, or alert management about what is in the best interests of the company. The CII needs to do more than produce a code given the sociology of corporate boards at present.

The CII has to take initiatives to find ways of changing this culture of corporate governance. It has to educate promoters on the proper role of the board, on the long-term advantages of good corporate governance practices and show how these practices contribute to improving long-term corporate performance.

It has to convince business leaders that corporate governance will not be as irrelevant as in the past and that the success of Indian businesses in the liberalized market environment depends on the legitimacy and acceptability of Indian corporations in a global society. As Rao (1998) points out, governance is a problem "that all of our society must resolve if we are not to decline into a wholly lawless and criminal society."

References

Bhalla, S.S. (1996, December 2). Corporate governance: A dead end. The Economic Times (Bangalore), p. 2.
Business Times Bureau. (1996, November 28). Board should be more powerful than the CEO, says Adrian Cadbury. The Times of India (Bangalore), p. 14.
Charkham, J. (1994). Keeping good company: A study of corporate governance in five countries. Oxford: Clarendon Press.
Confederation of Indian Industry (1997). Desirable corporate governance: A code. New Delhi: CII.
Gupta, L.C. (1997). Corporate boards and nominee directors: Making the boards work. Delhi: Oxford University Press.
Mumbai Bureau. (1998). Best practices prevail in companies with low promoter holdings. The Economic Times (Bangalore), p. 10.
Murthy, K.R.S. (1996). Corporate governance worldwide. Management Review, 8 (3&4).
Keller, M. (1998). The making of the modern corporation. Span, May-June, 3-10.
Rao, S.L. (1998). Corporate governance and ethics: The issues. Project No. 22. New Delhi: Rajiv Gandhi Institute for Contemporary Studies.
Varma, J.R. (1997). Corporate governance in India: Disciplining the dominant shareholder. Management Review, October-December, 5-18

Annexure - 1 Current concerns on corporate governance (1997-98)

(Source: ASCI Journal Vol.27 (1&2))

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Attention to corporate governance is not new, nor is the field of business ethics. To cite two examples, the National Association of Corporate Directors (NACD) was founded in 1977 with the explicit mission of enhancing corporate governance and performance of business entities. With well over 2000 members, its publications, conferences and training sessions for directors help promote high professional standards.

At the same time the NACD was established, the Center for Business Ethics opened its doors at Bentley College in Massachusetts. Its biennial conferences, extensive research library, executive fellows and the ethics journals, ethics societies and national Ethics Officer Association that the center spawned coincided with an explosion of interest in the field of business ethics.(note 1)

So much for the old news. Twenty years after these two organizations began, what is new is the convergence of the two fields of corporate governance and business ethics. Today directors realize that within their solemn obligation to represent the shareholders comes the ultimate responsibility for business ethics. Financial oversight is not enough - they must establish, maintain and monitor the ethical culture of the enterprise.

Why ethics?

One need look no further than to the investment community's rapidly disintegrating confidence in parts of Asia (Lewis, 1998) to realize that maintaining the integrity of business institutions is critical for continued economic success. As former Chancellor William T. Allen of the influential Delaware Court of Chancery said, "Governance contributes legitimacy to an enterprise" (Allen, 1998). He might have added, "Attention to ethics contributes legitimacy to corporate governance."

The marriage of ethics and corporate governance is not just a romance. It is a partnership oriented to the bottom-line with many compelling reasons for the two disciplines to stay together. Consider a few recent headlines:

• In a settlement obtained by the Equal Employment Opportunity Commission, Astra USA, a US subsidiary of a Swedish company, agreed to pay nearly $10 million to settle its sexual harassment case. While the board may have been unaware of the ongoing hostile work environment fostered by its former president, Peter Bildman, when the scandal broke it wasted little time in dismissing him and suing him for his actions, including financial fraud.
• AT&T, the communications giant, has been criticized for having an ineffective board of directors after its second-ranking executive, John Walter, was dismissed after seven months work with a separation package of $26 million. According to Business Week magazine, AT&T's directors sit on too many boards, own little stock and lack outsiders with high technology expertise (Bryne, 1996).
• Prudential Insurance Company of America agreed to pay over $400 million in 1996 to settle the claims of hundreds of customers in a wide-reaching investigation of deceptive sales practices. The company's own internal auditors had warned its directors as early as 1982 that some of the company's agents were using trickery and fraud to boost sales (Scism & Paltrow, 1997).

Carrots and sticks

Directors who habitually read the daily business press need little convincing that a business without ethics is a business at risk. But even many directors who do not keep up with contemporary business scandals are aware of a major development seven years ago that helped push the subject of ethics up to the board level. The Federal Sentencing Guidelines (note 2) adopted in November of 1991, operate like the proverbial carrot and stick.

The stick, or threat, contained in the Guidelines is a mandatory system of stiff fines, penalties and even jail time for executives convicted of federal crimes. Increasingly, statutes and regulations adopted to proscribe all types of business conduct - from price-fixing and polluting the environment to falsifying paperwork - consider such violations to be criminal offenses. Suddenly both deliberate acts of malfeasance and unwitting oversights can land executives in serious trouble. Companies and their boards began to pay attention.

To avoid harsh penalties (and the resulting likelihood of bankruptcy or closure) diligent executives worked with their boards to implement the carrot aspect of the Sentencing Guidelines. A company could dramatically reduce penalties, or even escape prosecution altogether, if it could prove it had in place, before the offense occurred, an effective system to prevent and detect violations of law.

There are three key words here (before, system, and detect). Closing the barn door after the horse has escaped will not help. The Sentencing Guidelines, which offer commitment to companies to reward good behavior, insists that the good behavior, evidenced by ethics and compliance programs, occur before the bad behavior.

System is not an undefined term. The Sentencing Guidelines are marked by structured flexibility (Swenson & Clark, 1991) and call for, at a minimum, seven elements, including standards and procedures, effective communications and a system to report misconduct. The Sentencing Guidelines element that has caught the attention of boards of directors is the requirement that a senior officer be in charge of the ethics or compliance program.

While some companies have appointed full time ethics officers (note 3) in other companies, the board signals the importance of ethics by giving its top executive the responsibility. Some do both. For example, at USAA, the diversified financial services company, Chief Executive Officer Robert T. Herres is the Chief Ethics Officer, and Elizabeth Gusich, who oversees the program, carries the title of Ethics Coordinator. (note 4)

Designating a senior officer to be responsible for ethics is not the only way a board can show proper respect for ethical conduct. Increasingly the audit committee of the board, comprised only of independent directors, assumes responsibility for ethical oversight. Audit committees have always had responsibility for internal control, but assessing the quality of internal controls involves a consideration of the environment, as well as the day-to-day mechanics of checks and balances.

Boards are asking such tough questions as "Does management set unrealistic objectives that can result in pressure on personnel to act unethically to achieve them?" "Does the organization make a concerted effort to hire the best people, to train and motive them and reward or punish behavior appropriately?" "What is management's philosophy and operating style?"

Good news/bad news

If boards of directors missed the story of the Federal Sentencing Guidelines, they were given a wake-up call in 1996, with the legal case now known simply as Caremark(note 5). The highly influential chancery court in the state of Delaware, where many corporations are incorporated, issued an opinion in September of that year that changed the standard for directors' oversight of ethical wrongdoing and illegalities.

Caremark, a medical services company, had been investigated by government regulators for making illegal payments to induce doctors to prescribe Caremark's services. The company and its executives were indicted and eventually paid $250 million in fines, reimbursements and other penalties. Because of the scandal, the directors of Caremark were sued by shareholders who alleged that the directors breached their fiduciary duty of care to the company by failing to adequately supervise the conduct of its employees.

The directors won, but not without a stern warning from the court. The good news is that the court decided the directors did not breach their duty of care, because both prior to and during the government's investigation of the company, Caremark had designated the Chief Financial Officer as the compliance officer. In addition, they had an ongoing ethics and compliance-training program for employees; an internal audit plan designed to ensure compliance with ethics, and a board audit and ethics committee.

But the court did not pat the Caremark directors on the head for their attention to ethics; the settlement agreement required the board to take additional steps to ensure that all of Caremark's business units were in compliance and to reduce the chance of future violations.

Furthermore, the Caremark case contained bad news for all other boards of directors. The court delivered an unambiguous message that if boards had not paid attention to ethics and compliance in the past, they should. Failure by boards to insure that a company has adequate corporate information reporting systems may render a director liable for losses caused by noncompliance with applicable legal standards.

If the standard for directors was once to pay attention and to take action only when they had knowledge of a problem, now the criterion has changed. The flow of information is a two-way street and directors can no longer claim ignorance as a defense. Caremark has made it clear that directors have an affirmative obligation to find out what is going on.

Nothing catches a director's attention more than the word liable. Since Caremark, boards have taken the ethical bull by the horns, specifically authorizing compliance programs and formally electing the compliance or ethics officer. Many boards require regular reports from the ethics officer, in writing and in person. Some meet privately with the ethics officer, as they do with internal auditors. To set an example, some boards have drafted their own code of ethics for directors and either formed an ethics committee for the board or incorporated the subject of board ethics into existing corporate governance committees.

Ethics by example

All of the public commitments to ethics initiatives by directors aren't worth much if the board itself isn't ethical. Too often, directors forget to look at their own habits and practices.

First, who are the directors and how were they chosen? Do they have a personal reputation for integrity? Ideally, independent directors are selected solely by other independent directors, to combat even the appearance of being beholden to management. And independent must be taken literally: no representatives of major suppliers, outside counsel or accounting firms, individuals who went to university with the chief executive officer or even heads of organizations that receive significant company contributions.

They should not hold positions on boards of other directors' companies, or serve on boards of companies having a major business relationship with the company.

Some of the best models for corporate governance are quite clear on the issue of independence. Two are illustrative. The Bosch Report states, "The majority of non-executive directors should preferably be independent, not only of management but of any other external influence that could detract from their ability to act in the interests of the company as a whole. (note 6) "The Dey Report states, "An unrelated director is a director who is free from any interest and any business or other relationship which could, or could reasonably be perceived to, materially interfere with the director's ability to act with a view to the best interests of the corporation, other than interests and relationships arising from shareholding." (note 7)

By contrast, a look at one company is indicative of how not to build a board. Archer-Daniels-Midland Company often makes the lists of worst boards, especially after the government started its criminal antitrust investigation of the company and its senior executives for price-fixing and illegal compensation.

Angry critics of the company, including large institutional investors and management experts, derided the board for its inherent conflicts of interest and acquiescence to management. For example, the son, nephew and brother of the chairman and CEO were directors. Other directors included the father of the company treasurer and the brother-in-law of a fellow director (chairman of an ADM unit), as well as several presidents of joint partners with ADM.

Even the independent directors had a conflict. Two were lawyers used by ADM and two other outside directors were longtime friends of the chairman (Lublin, 1995). Archer-Daniels-Midland eventually paid $100 million in criminal fines and agreed to train its board in corporate governance principles.

In addition to its composition, the best boards have carefully considered their mission, although the scope of these missions varies greatly. For example, General Motors' Board of Directors quite rightly emphasizes that it represents the owners' interest in perpetuating a successful business, including optimizing long-term financial returns. But then the board notes that in addition to fulfilling its obligations for increased stockholder value, the board has responsibility to GM's customers, employees, suppliers and to the communities where it operates (note 8) - a notion often encouraged by those in the social responsibility movement, but not universally accepted as necessary by other boards.

The Business Roundtable Report is opposite and equally clear. "The principal objective of a business enterprise is to generate economic returns to its owners," it states. " (note 9) The notion that the board must somehow balance the interests of stockholders against the interest of the stakeholders fundamentally misconstrues the role of directors." (note 10)

Whatever side one takes in the debate about stockholders and/or stakeholders and the role of the board, it is crucial that the directors make such decisions and draft their mission.

Furthermore, they should include an explicit expression of their obligation to set and oversee the ethical culture of the organization.

While some corporate governance commentators have advocated that an independent director chair the board instead of the CEO, it is not necessarily unethical for the CEO to act as chairman. What does matter, however, is the information flow to the board and whether the board culture allows it to make decisions contrary to management's interests. If the agenda is tightly controlled and access to the board is limited, it will be difficult to develop an open environment in which issues are discussed, mistakes are bared and no question or course of action is regarded as inappropriate.

No doubt the directors of the United Way of America (included among them such captains of industry as John Akers, the former chairman of IBM; W.R. Howell, the former chairman of J.C. Penney; James Robinson, the former chairman and CEO of American Express; and Edward Brennan, the former chairman of Sears, Roebuck) wished they had paid more attention to ethics and corporate governance, even at a nonprofit agency.

The prestigious national charity was run by a dynamic and energetic president, William Aramony, who had done a fine job building it into a $3 billion organization. So the directors paid scant attention when they all received an anonymous letter accusing Aramony of having an affair with a young woman and using United Way money to hush it up. He denied the charge and they ignored it. Unfortunately, that was not the end of the story. The directors' lack of due diligence resulted in a major public scandal when a newspaper expose revealed the details of Aramony's indiscretions two years later. Aramony was ultimately convicted of 25 felony counts including conspiracy, fraud, money-laundering and filing false tax returns and received a 7-year prison sentence.

After the scandal the board was faced with some soul-searching. They liked Aramony and believed him. They didn't delve into details. Board meetings were infrequent. Aramony controlled the agenda and the upbeat reports. Yes, the wrongdoing was the fault of Aramony and other United Way executives who knew it was going on, but the board faced up to its own shortcomings. It added eight new members, including representatives of local chapters. It created six new board committees with responsibility for areas such as budget and finance. It wrote and distributed a code of ethics and tightened up internal financial controls throughout the organization (Driscoll, Hoffman & Petry, 1995).

Other boards can learn from the experience at United Way and scrutinize the number, frequency, agenda and makeup of board committees to insure that all viewpoints are heard. On paper, directors are a democracy; one person, one vote. In practice, however, some voices speak louder than others do. Some directors have great influence and others have little. For that reason, directors may choose to rotate service on committees or institute term limits. All bring different experiences and backgrounds to the table and sometimes a fresh view is beneficial and even essential.

Evaluating the CEO and senior management is an important board activity, but the best boards also conduct self-initiated and peer evaluations of the board's own effectiveness. If a board periodically evaluates itself regarding its candor, about the willingness of directors to raise ethical issues and the respect accorded to each other's views, it is less likely to let difficult subjects slide under the table.

The problem of aging directors who sleep through meetings or come to meetings unprepared, directors who do not own stock in the company despite a board policy which encourages it, directors who pointedly solicit the CEO to co-sponsor the director's favorite charity dinner, directors whose partners are receiving substantial consulting fees from the company, directors whose spouses are royally hosted at the annual board retreat in the Caribbean, are all examples of serious ethical problems that need frank discussion and resolution. Only the board that is comfortable and practiced in self-examination and the pursuit of excellence in corporate governance will tackle them head-on.

Ethics training: Not for employees only

Directors are beginning to understand that setting an ethical tone plays an important role in their deliberations and carries as much responsibility as does fiscal oversight. But while many directors are comfortable and experienced analyzing financial statements, balance sheets, quarterly profit and loss reports and auditors' reports, it is the rare director who is equally facile discussing ethical principles.

And yet directors must not wait until the ethical crisis hits the company to arrive at a board consensus about its ethical values. Chicago Bulls basketball star Michael Jordan doesn't shoot a three-point shot at the buzzer to win a National Basketball Association game without having made the shot hundreds of times before.

Directors need to take the time to practice conversations about ethics and hear each other's views. They might discover that when presented with a hypothetical situation, one director doesn't see any ethical dilemma, while another is ready to call in outside counsel, government regulators, a public relations firm and a priest.

Korn/Ferry International, the international executive search firm, worked in conjunction with the Center for Effective Organizations and The Leadership Institute at the University of Southern California to define several best practices that would improve board performance. Perhaps surprisingly, two of the twenty ideas suggest that boards may need outside help in learning new subjects and developing group decision-making skills. "Boards should spend some time on a regular basis focusing on how they want to operate in terms of decision-making, group discussion and interpersonal relations," the report recommended.(note 11)

Many boards that have considered the relationship between ethics and corporate governance have set aside time at board meetings or retreats for training in ethics. In some cases, an ethics crisis at a competitor has prompted them to action; in other cases, government regulators or shareholder lawsuits may occasion the need for off-the-record debates on how the board would resolve a similar situation should it occur at their company.

While there is no single correct approach to ethics training for boards of directors, several elements are essential. First, directors must clear their minds of past problems and the present agenda. They should approach the subject of business ethics with few preconceived notions and give themselves permission to openly express their personal values. They should ask, "What do I believe?" "What is truly important to us as a board and a company?" From freewheeling discussion often emerges group consensus, centered on words like "fairness," "honesty," "responsibility."

Second, directors should focus on the business at hand. The directors' choice of company values must be realistic and fit the appropriate competitive and regulatory framework within which the company operates. For that reason, the core ethical principles of a company in the steel industry, for example, may be different from those of a health care organization. Finally, the directors should discuss the values they expect their company to exemplify. Some prefer not to use the word ethics at all but to talk about "how we do business".

If the message from the board is "make the numbers", almost any executive can do so by playing accounting games, pressuring managers and salespersons and taking drastic short term actions that will only hurt the company in the future. A board directive that states "deliver revenues and profits by absolutely adhering to our company's ethical principles" conveys a far different message.

At this point in the training, the board is ready to tackle some hypothetical mini-cases, often drawn from the company's business experiences, or "red flag warnings" that have appeared in officer reports to the board (note 12). The cases should be short and simple: A shoe manufacturer is opening several facilities in an Asian country known for below-poverty wages, child labor and human rights abuses.

Expense account transgressions of a highly valued senior executive are overlooked, while an entry level employee is fired for the same offense. An insurance company's regional manager approved a claim of a high net worth customer who threatened to complain to the local newspaper, reversing the design of the claims clerk, who followed company procedure and rejected it.

In dissecting the mini-cases, the directors should debate two questions: Do they think there is an ethical issue? What course of action do they pursue, if anything? The variety of answers are often surprising and occasion further debate about which ethical principles the board holds as inviolate and the proper role of the board in setting the moral tone for the company without yielding to the temptation to micromanage.

Directors who are ready to tackle the tough issue of ethics at the board level spend their time on mini-cases involving directors, sometimes a more difficult assignment. Those cases are targeted to corporate governance practices and problems.

After one such board training session, when the directors realized they could only complete six of the twenty mini-cases presented, one director asked the facilitators for the right answers to the remaining problems. There are no so-called right answers, he was told, only decisions the board arrives at as it sets its own ethical values in place for the company and for the board itself. The process by which the board arrives at its conclusions and the seriousness with which the board addresses its ethical responsibility are crucial to the appropriateness of the decisions at which the board finally arrives.

Conclusion: A warning sign

It is clear that standards for ethical behavior have been raised today for boards of directors and corporate governance generally. Directors have a lot to consider as they rethink their ethical responsibilities and the fiduciary oversight of their respective organizations.

But no discussion of business ethics and corporate governance would be complete without a specific mention of one of the warning signs for which directors should be watchful as they strengthen their ethical awareness, decision-making and corporate governance oversight. That red flag is ethical complacency.

This is one of the most difficult warnings to see since complacency diverts people's attention. In the case of ethical complacency, directors, managers and other employees think that an ethical problem can't happen to them because "we are good people" or "we just wrote a new code of ethics" or "we've never had a problem" or some other rationalization.

As soon as a company and its directors begin to take ethics for granted, they are in danger, even if the company once went to great lengths to develop its ethical culture and reputation. Directors must therefore be alert to subtle signs of ethical complacency. Or better yet, they should work vigilantly to make sure this curse never sets in by making sure that the ethical health of the company is constantly being monitored, habitualized, strengthened and discussed.

It is the responsibility of directors to ensure that ethics is always in the forefront of the company's list of obligations. This starts with the conduct of the board of directors itself. By so doing they will be providing the kind of leadership that their corporate governance responsibilities demand.

Notes

1. "The Center has been central in the development of business ethics as a field. It's been a model in that it has brought together practitioners with people form academia." Richard De George, President, International Society for Business, Economics and Ethics, in Origins of a movement (Waltham, MA: Center for Business Ethics, 1996), p. 5.

2. United States Sentencing Guidelines, Chapter 8, Sentencing of organizations (Washington D.C., November 1, 1991).

3. The Ethics Officer Association, founded in 1991, now includes over 500 members. Based in Belmont, Massachusetts, it is a nonprofit organization comprised of individuals who are responsible for implementing and administering their organization's ethics/compliance and business conduct programs.

4. The Ethics Coordinator is part of the Office of the CEO and works closely with USAA's Ethics Council, a group of senior-level executives who review issues of major significance and take appropriate actions.

5. In re Caremark International Inc. Derivative Litigation, 1996 WL 549894 (Del. Chancery C.A. 13670), 15 September 1996.

6. The report goes on to explain. "Independence is more likely to be assured when the director (i) is not a substantial shareholder of the company, (ii) has not been employed in any executive capacity by the company within the last few years, (iii) is not retained as a professional adviser by the company (either personally or through their firm), (iv) is not a significant supplier to the or customer of the company, and (v) has no significant contractual relationship with the company other than as a director. Guideline 1.1. Working Group representing Australian Institute of Company Directors, Australian Society of Certified Practicing Accountants, Business Council of Australia, Law Council of Australia, The Institute of Chartered Accountants in Australia & The Securities Institute of Australia, Corporate practices and conduct (Bosch Report) (3rd. Ed. 1995).

7. Guideline 2. Toronto Stock Exchange Committee on Corporate Governance in Canada, "Where were the directors?" guidelines for improved corporate governance in Canada (Dey Report) (December 1994).

8. General Motors Board of Directors, GM board of directors corporate governance guidelines on significant corporate governance issues (January 1994; revised August 1995; revised June 1997).

9. The Business Roundtable, Statement on corporate governance (September 1997), p. 1.

10. The Business Roundtable, Statement on corporate governance (September 1997), p. 3-4

11. Board Meeting in Session: Twenty "Best Practices" to Improve Board Performance (New York, NY: Korn/Ferry International, 1997), p. 9.

12. For examples of red flag issues for directors, see Dawn-Marie Driscoll and W. Michael Hoffman, "Doing the right thing: Business ethics and boards of directors," Director's Monthly, 18 (November 1994), 1-7.

References

Allen, W.T. (1998). Independence, integrity and the governance of institutions. Director's Monthly, 22 (1), 13.
Byrne, J.A. (1996, November 25). The best and worst boards. Business Week, p. 85.
Driscoll, D.M., Hoffman, W.M., & Petry, E.S. (1995). The ethical edge: Tales of organizations that have faced moral crises. New York: Master Media Ltd.
Lewis, M. (1998, May 31). The world's biggest going-out-of-business sale. The New York Times Magazine, 34-69.
Lublin, J.S. (1995, October 17). Is ADM's board too big, cozy and well-paid?" The Wall Street Journal, p. B1.
Scism, L. & Paltrow, S.J. (1997, August 7). Prudential's auditors gave early warnings about sales abuses. The Wall Street Journal, p. 1.
Swenson W. & Clark, N. (1991). The new federal sentencing guidelines: Three keys to understanding the credit for compliance programs. Corporate Conduct Quarterly, 1 (Winter), 1-3.

(Source: ASCI Journal Vol.27 (1&2))

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