“Well performing companies are often destroyed by Bad Governance”

By Dinesh Weerakkody

Professor P. C. Narayan of the highly renowned Indian Institute of Management, Bangalore says, the responsibility to understand the risks associated with profit-linked executive compensation and taking short-term corrective measures and more importantly long-term preventive measures should be a top priority for the Board.

Professor Narayan was also of the view that almost always it is the Board and the Top management of these companies that ruin good firms and take them rapidly down. Professor P. C. Narayan was in Colombo last week to address the Institute of Chartered Accountants National Conference.

Professor P. C. Narayan

Q: The scale of the corporate collapses across the globe in the recent past and the ramifications for the rest of the global economy are now well documented. The cumulative collapse of shareholder value around the world is directly attributed to the failure of Corporate Governance. What does your research tell you?

A: Well performing companies were destroyed by bad governance... that is what the Enrons, the Worldcoms, the Satyams and all the scam tainted companies are all about. Almost always it is the Board and the Top management of these companies that ruin these firms and take them rapidly down. These are classic examples of Board Room and Top management failure in discharging their fiduciary responsibility to shareholders and their failure to ensure the long-term health of the company. Most legislative and regulatory action by Governments is geared towards preventing such episodes! At the same time, however, it would be unfair to extrapolate such gross irresponsible Board behaviour across the entire population of publicly listed companies around the World! Overall, many more firms have created value than destroyed value for the shareholder!

Q: All governance codes recommend a majority of non-executive independent directors on public boards. What is your interpretation of non-executive independent in an Indian Context?

A: I would not limit my response to the India context, since this is a hotly debated subject in several countries. Independence is not about ‘no-Shareholding’, it is more about how independent is the director in his thinking beyond and his ability to challenge proposals at the Board meeting and beyond. I do subscribe to the view that non-executive directors are the ones who really perform the real role of independent directors, since executive directors are often left to defend decisions and proposals in Board meetings!

Q: Most codes require nomination committees for the appointment of new directors. The main purpose is to ensure that there is a transparent appointment process, which is not under the control of management alone, and to ensure that the right balance of skills and experience is brought to the board table. In practice the search for new directors is often now outsourced to headhunters, what is your experience?

A: Any attempt to ‘outsource’ the choice of new directors to headhunters, if it is true, is indeed a very sad reflection on the Board! Responsible Boards almost always engage in this activity themselves, although I have seen several examples of Boards picking directors who are like-minded and would be a part-of-the-club! This runs the risk of the Boards losing their heterogeneous character and consequently their ability to meaningfully challenge proposals, protect shareholder interests and the long-term health of the company.

Q: There is a requirement now for a compensation or remuneration committee. These are principally designed to deal with the remuneration of directors, and especially executive directors. Given the experience of the Financial Crisis, there is a good argument to be made that the scope of the remuneration committees should be increased to oversee the broad principles underpinning remuneration of senior managers throughout the organisation, What do you recommend?

A: This is more applicable to firms in the banking and financial services domain, arising particularly from the financial crisis of 2008, which has raised some very interesting questions on this subject. With an eye on their bonus payments that were linked to profits, top management of several investment and commercial banks had subjected their firms to huge risks over an extended period of time. As a consequence, when the whole market fell apart, the compensation of several of these executives came under scrutiny and a hot debate ensued on the role of the Board in determining executive compensation and bonuses! As I mentioned in my address at the recently concluded ICASL conference, the underlying issue here is not one of compensation but one of risk management. The responsibility to understand the risks associated with profit-linked executive compensation and taking short-term corrective measures and more importantly long-term preventive measures should be a priority for the Board of the concerned companies. And this is unlikely to be achieved without legislative intervention and additions/amendments to existing laws relating to executive compensation. Boards collectively will need to get tough on this on priority!

Q: Some governance Codes also requires an evaluation of individual board member performance. How effectively is this done in India?

A: I am not aware of any initiative to evaluate individual Board members, nor is this debated actively in the media or in any public or academic forum. I firmly believe that the Board of a company is accountable as a group, since their functioning is essentially collegial in nature. Directors on the board of companies having to retire by rotation and being eligible for re-appointment implicitly ensures some form of evaluation.

Q: Governance, risk and compliance activities are increasingly being integrated and aligned to some extent in order to avoid conflicts, wasteful overlaps and gaps. Has this worked well as an integrated function?

A: The responsibility for Governance rests entirely with the Board. As for risk management, it should be overseen by the Board, managed by line management and discussed freely across multiple forums in the organisation. Compliance activities should be overseen by the audit (or similar) department and the appropriate committee of the Board. Alignment can be effectively achieved with this clear allocation of responsibility, without the need to ‘integrate’ these aspects.

Q: Widespread interest in Governance, Risk and Compliance (GRC) was sparked by the US Sarbanes-Oxley Act and the need for US listed companies to design and implement suitable governance controls for SOX compliance, but the focus of GRC has since shifted towards adding business value through improving operational decision making and strategic planning. In your view has the GRC relevance now gone beyond the SOX world?

A:SOX compliance has come to be regarded as a hugely expensive way to enforce GRC. The cost of SOX compliance had become so prohibitive that several mid-market firms in the United States are believed to have delisted from the Stock Exchanges, given the fact that unlisted companies were not required to comply with SOX! This was evidenced by the high volume of ‘going private’ transactions witnessed in the United States consequent to the SOX Act coming into being.

Clearly that points to a singular truth: GRC cannot be enforced by legislative action alone; the focus of Corporate Boards should be and should continue to be a shift to the more basic and necessary aspects, i.e. creating value through strategic planning, encouraging product and market innovation, demanding a high level of operation efficiency and high ethical standards in conducting the business. More importantly, financial reporting should be accurate and truthful, without engaging in ‘earnings manipulation’ and other tactics that inflate the firm’s market capitalisation in the short term, inflated bonus payments to top management, expropriating minority shareholders, etc.

(The writer is CEO of HR Cornucopia)