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Importance of good corporate governance

Pratap Ravindran

THE IMPORTANCE of good governance has, in recent years, come to be accepted by corporates in India partly because, one suspects, the scrips of companies associated with sound and transparent management practices tend to attract higher premia in th e bourses than those of entities that, to all intents and purposes, behave like private limited or partnership firms.

While good corporate governance is, undoubtedly, of considerable value to those who have invested their money in the firms that adhere to its tenets, there is no justification to conclude that it is sufficient in itself.

The fact is that companies that practice good governance are of interest to investors because they (the latter) believe these companies will perform well, resulting eventually in an increase in their share prices. In other words, good corporate governanc e is valued only inasmuch as it is linked directly to the long-term upside potential of a company.

World over, progressive opinion now recognises the need for broader accounting by corporates, encompassing social performance of significance to stakeholders as against mere bottomline accounting that is of interest only to stockholders. Thus, the oil ma jor, Shell, has institutionalised stakeholder consultations as part of its corporate strategy, and its statement of business principles now includes its responsibilities towards customers and employees -- in addition to shareholders.

Interestingly enough, Shell says that its responsibility to shareholders is to provide ``acceptable'' returns as against maximised returns. And then again, IBM's current corporate social responsibility strategy refers to enhancing stakeholder value and t o the delivery of measurable results to society at large. Similarly, Dow Chemicals includes service to stakeholders in its vision statement which says: ``To be successful, we have to provide a balance to the needs of all four of these groups (customers, employees, shareholders and society). If we maximise the return to any one or two of these stakeholder groups at the expense of the others, we won't survive very long.''

The general public perception is that stockholders are part-owners of the companies they are invested in, and that their interests need not necessarily be congruent with those of society in which these firms function. While there is undoubted validity to this proposition in the manner it is framed, it rests upon a differentiation that may not be as watertight as it appears. After all, both stockholders and stakeholders are...investors in any given company.

An investor, by definition, is anyone who commits something of value to risk in the expectation of a return. The term ``something of value'' can obviously cover time, effort and other values which may not have anything to do directly with money. Take an employee. He or she ``invests'' his or her life (or, at least, a part of it) in the employer. As such, an employee can be legitimately said to hold equity in the company.

Having established that stockholders and stakeholders are both investors in a company, we can now turn to what economists refer to as external diseconomies or social costs.

These terms merit examination in some detail. In the mid-1990s, an academic, Dr. Ralph Estes, Professor of Business Administration at American University, published a paper, `The Public Cost of Private Corporations' in the journal Advances in Public Inte rest Accounting.

Dr. Estes' basic contention was simple: Corporations pay the internal costs of doing business -- but they do not pay, or even calculate, the costs that their operations impose on society at large.

In other words, Dr. Estes wrote that the profit and loss statements revealed only the costs companies had internalised and not the uncompensated costs to society, the external diseconomies. For the persons affected, these represented ``coerced assessment s,'' a form of hidden taxation.

``While difficult to measure, these costs are unquestionably real to those on whom they are imposed. They are, however, never reckoned in corporate accounting's narrow calculus. When policy issues such as corporate regulation, taxation, defence contracti ng, and the system of subsidies, incentives, tax credits, bail-outs, price supports, and below market-price fees for grazing, mining and timber rights on public lands that is sometimes referred to as `corporate welfare' are debated, these social costs sh ould be matched against the social benefits obtained.

``To improve public policymaking, we should also re-evaluate how we assess the performance of corporations. A scorecard that ignores social costs presents a distorted picture of performance that can influence policymakers to be excessively generous with taxpayer-funded corporate benefits, and overly lax in enforcing corporate regulations.''

While these ideas were bad enough (as far as the corporates were concerned), what really caught people on the back foot was Dr. Estes' computation that these social costs or external diseconomies added up to $2.6 trillions (1994), almost twice the entire US federal budget and more than ten times the annual federal deficit.

Even worse, as annual corporate profits in the US, on an average, worked out only to about $1 trillion or thereabouts, it was obvious that they were coming from the pockets of stakeholders.

It is in this context that a North American advocacy group, The Stakeholder Alliance, is attempting to promote ``more responsible capitalism by pressing corporations to become fully accountable to their stakeholders.''

The alliance has come out with what it calls the Sunshine Standards to provide direction for corporates reporting to stakeholders -- the employees, customers, communities, suppliers, as well as financial investors -- who contribute significantly to the s uccess of corporations or are affected significantly by their actions.

According to the alliance, these standards are intended to supersede the Generally Accepted Accounting Principles (GAAP) issued by the Financial Accounting Standards Board (FASB) and its predecessors that currently govern corporate reporting to stockhold ers.

The fundamental principle underlying the Sunshine Standards has been enunciated as follows: ``All information should be provided that stakeholders may need to make rational, informed decisions in the marketplace, and to protect themselves from negative c onsequences of corporate actions; this disclosure must be complete, accurate, timely, objective, understandable and public.''

Thus, the advocacy group, dealing with customer information needs, stresses the need for corporates to disclose actions brought by customers and regulatory authorities regarding products, services and market practices:

Comprehensive legal record relating to products and services, including product liability, injury and wrongful death claims, covering all jurisdictions for five years; and

Indictments and citations for regulatory violations, giving details of each incident and resulting penalty, settlement, or other disposition.

The information needs of customers further include:

Risks of injury from normal usage;

Noise, odours and other nuisances or problems associated with use;

Design for recycling;

Biodegradability of products and packaging;

Unusual life cycle costs, including repairs, energy consumption and disposal that will be borne by parties other than the producer or seller;

Warnings, with appropriate detail, regarding unusual contamination and adulteration exposure and risks during production, shipping, marketing and storage;

Content, additives and treatments of food and medicines, sufficient to allow reasonably-informed consumers to make rational market decisions and to protect themselves and their families -- appropriate descriptions may include pesticides used on fruits an d vegetables, hormones and chemicals used in growing and processing meat, and substances in cosmetics and personal grooming products to which some consumers may be allergic; and

``Well hidden characteristics'' or those product qualities which, regardless of expense or purchase frequency, remain hidden even after use -- such as the amount of toxic chemicals and nicotine in cigarettes.

The alliance has pointed out that customers, in choosing from competing producers and vendors, may legitimately consider standards of social responsibility. These might include such issues as the working conditions under which products are manufactured, sustainability of production and business methods and so on. Decisions that may appear to be `merely' economic are, to many customers, reflections of personal -- and possibly intense -- religious, moral, political and social convictions.

Elaborating on its contention that the Sunshine Standards should supersede GAAP, The Stakeholders Alliance has argued that the scorecard widely used today, accounting's profit and loss statement, is not sufficient.

As stakeholders contribute significantly to the success of the enterprise or are considerably affected by its actions, they are owed an accounting. Quite simply, they require a better scorecard.

With a broader scorecard, one that reports effects on all stakeholders, managers will make different decisions. When managers are held directly accountable for injuries that result from their decisions, when the costs of those injuries to employees and c ustomers are reported publicly, and when managers' compensation is affected directly, different decisions will be made. When managers are credited for benefits to the community from pollution reduction, instead of only being penalised for the expenditure s, they will be better able to weigh effects on all stakeholders.

The alliance has stated in this regard: ``When corporations are fully accountable to stakeholders, when stakeholders are properly viewed as investors in the enterprise instead of merely resources to be consumed, and when managers are held personally resp onsible for the effects of their actions on stakeholders, corporate managers will behave differently. Their decisions will be directed towards nurturing and developing (instead of merely using or exploiting) the resources the corporation needs for long-t erm health. Stakeholders will give more to the corporation in return.''

Corrupting public purpose

A quick survey of the history of corporates establishes that they started off as entities formed for public purpose and that, over time, this purpose was corrupted.

According to A Brief History of Corporate Accountability put together by The Stakeholder Alliance, it all began in 1601 when Queen Elizabeth chartered the East India Trading Company. At this point of time, all corporations were chartered for public purpo se -- to serve the interests of the sovereign and the state. Private financiers were invited to invest, with the prospect, but no assurance of, gain. These investors hired auditors ``to listen'' and report back to them.

By the late 1800s, corporate purpose had been perverted to serve only stockholder interests. Populists had pushed for the freedom of incorporation for all -- as against the favoured -- and had successfully seen to it that incorporation was viewed as a ri ght, not a privilege.

As corporations grew in size, the robber barons who had founded them replaced themselves with ``professional'' managers, followers of Frederick Taylor's ``scientific management.''

By the 1930s, the corporate purpose had been perverted completely with various countries passing securities laws which rested on the premise that corporations were accountable only to stockholders.