Corporate Governance and Its Importance
A total mix of a system of rules, policies, practices, and processes that direct and control a business’s behaviour is what we call Corporate Governance. It includes the framework that establishes a relationship between shareholders, management, the Board of Directors, and other important stakeholders.
Mandatory v. Voluntary Corporate Governance
In Mandatory governance, if a firm fails to comply with the legal principle, penalties are imposed. In Voluntary governance, a firm adopts its corporate governance standards in the absence of any such imposed legal requirement. However, corporate governance reforms, policies and standards are additions to a legal regime that is already mandatory in nature and place.
a) Minimum Standards – In Mandatory structure, the state establishes the legal structure and minimum standards to which the firms must adhere. In this, the state can achieve its goals directly as the market participants will be compelled to comply since they do not want to face any punishment. Thus, there is a formation of healthy capital markets as regimes are formed with strong investor protection.
Whereas in Voluntary Legislation there is no guarantee that the minimum standards set by the state will be achieved.
A mandatory governance regime helps the state in developing sustainable capital markets as well as safeguarding interests of investors.
b) Compliance Levels – Compliance will be generally high if the penalties for the same are burdensome. There is a level of consistency if there has been a regime in place for the market participants for several years. In a mandatory regime, the rates of compliance over time are both consistent and predictable. And they achieve their objective more directly.
In Voluntary regime, compliances are on a weaker side. If the State establishes certain compliance to be followed, there is no assurance that market participants will abide by them, since there are no penalties attached to those who fail to comply. But voluntary can encourage compliance in the long run. As more and more market participants adopt such voluntary regimes, they become the norm among most participants and is called the ‘snowball’ or ‘cluster’ effect.
c) Cost to Investors – Mandatory rules as mentioned in the Corporate law are intended to protect the investors. The rules act as a shield for these investors against the undisclosed information. The firm’s governance practices strength is easily assessed thereby safeguarding a rational investor. Thus, this helps the investor in assessing potential investments and the rules embodied in that mandatory regime.
Under the Voluntary system, market participants are free to set their terms of reference. The cost of becoming an informed investor in such a system varies by a huge margin as it is difficult for investors to assess the relative strength of a firms governance practices and also the practices followed by other firms are different. Also, it is less certain that a firm is indeed complying with the guidelines.
d) Cost to the State and Firms – In Mandatory structure, the state will bear policy design costs, implementation, and enforcement costs. In addition to this, costs to firms arise from assessing their internal practices, implementing new governance structures, etc. There may also be some hidden costs associated with this regime.
Not all these costs exist under a voluntary regime. There are two costs which will be reduced under this system. First are the issuer’s compliance costs which are further divided into direct and indirect compliance costs. These costs generally do not arise since the firms decide which costs they wish to incur and when. Second, are the state’s enforcement costs and these can be significant. However, these costs will not be as high as there is no requirement for implementing governance policies as there is no corresponding legal action to the non-compliance of the same.
Because of reduced compliance costs, the costs involved in a voluntary system are lesser than that of the mandatory system
e) Flexibility – Mandatory regimes are inflexible in nature. The state establishes both the objective to be achieved by a firm and also the means to achieve the same.
As capital markets are populated by market participants of different sizes and types thus in a voluntary regime there is flexibility for issuers. Thus, flexibility in corporate governance regime is majorly important for both regulators and firms.
Corporate Governance: Regulatory Framework
The Corporate Governance structure for Indian companies is mentioned in the following:
1. The Companies Act, 2013 – It consists of provisions revolving around board meetings, audit committees, general meetings, party transactions, the constitution of the board, etc.
2. Guidelines listed by the SEBI – SEBI issues regulations, rules, and guidelines to companies to ensure the protection of the investors.
3. Standard Listing Agreement of Stock Exchanges – This includes the companies whose shares are listed on different stock exchanges.
4. Accounting Standards issued by ICAI – ICAI issues accounting standards relating to the disclosure of financial information. Thus, the information contained in the financial statements must comply with the accounting standards.
5. Secretarial Standards issued by ICSI – ICSI issues secretarial standards relating to the New Companies Act. The same is to be followed by registered companies.
In a voluntary regime system, the first year may see a few firms complying with the voluntary code. Over time, more and more firms may comply thereby increasing the compliance and can continue to do so thereafter. The clustering effect is a market apparatus that can occur without the presence of legal rules. Thus, an optimal regulatory framework/regime takes care of the benefits and costs of all stakeholders and investors.
Jean Zhang, What is corporate governance and why is it important?, Accru (Jun. 19, 2019), https://www.accru.com/2019/06/what-is-corporate-governance/.
Anita Indira Anand, Voluntary vs Mandatory Corporate Governance, Semanticsscholar, https://pdfs.semanticscholar.org/494c/d15540c6211a5976892977b06f9ab04746c1.pdf.
Vaish Associates Advocates, Corporate Governance Framework in India, Mondaq (Jan. 8, 2016),http://www.mondaq.com/india/shareholders/456460/corporate-governance-framework-in-india.
This blog is authored by Niket Khandelwal student at Faculty of Law, Delhi University.