Internal Corporate Governance

What is Internal Corporate Governance?

Internal corporate governance is a framework or system of rules, practices and processes designed in an organisation by the internal human force. This framework is generally developed and managed by the top management of the organisation.

The internal governing framework acts as a roadmap for both internal and external stakeholders to ensure the ethical functioning of the organisation. The internal corporate governance framework differs from across organisations based on various factors such as sociocultural environment, economic environment, government policies and financial market systems.

Although there are many differences in the structure of internal corporate governance of organisations, any internal corporate governance framework is incomplete without a proper code of conduct in place. A code of conduct is a set of rules, responsibilities and practices of individuals in an organisation. Apart from employees, the organisation is also responsible for abiding by the code of conduct itself first in order to encourage the employees to do the same.

A code of conduct generally focuses on promoting fairness and preventing discrimination on the basis of sex, race or religion. In addition, it makes it mandatory for the top management to act in accordance with a pre-specified set of guidelines whenever it exercises authority or control. As discussed, corporate governance is an approach to create a balance between internal and external stakeholders such as management, customers, suppliers, financiers, government and the community.

An organisation would be able to coordinate with external stakeholders if its internal stakeholders comply with the defined code of conduct. For instance, an organisation needs to promise its shareholders for paying decent dividends in the upcoming year. In such a case, if the internal management does not act as per the rules prescribed in the dividend policy of the organisation, it may damage the image of the organisation in the market.

The effective implementation of the code of conduct depends a great deal on the board of directors (BODs) of an organisation and the committees formed by them. Let us discuss the important components of the internal corporate governance in the next sections.

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Board of Directors

BODs are vested with the responsibility of governing an organisation. The directors are appointed by the shareholders of the organisation. The board further appoints one or more Managing Directors (MDs) or Executive Directors (EDs) after due approval from shareholders.

Good internal corporate governance depends largely on the level of communication and understanding among the directors and the shareholders. Therefore, there should be effective coordination among shareholders and directors so that any conflicts of interest can be avoided.

BODs are accountable towards all the stakeholders pertaining to the functional attributes of the organisation and resolving issues between various stakeholders, such as shareholders, customers, lenders and promoters.

The size of the board is mainly determined by the size of the organisation. In India, it has been observed that the size of the board is usually large in industries like banking, petroleum, textiles, iron and steel, telecommunication, while in IT and pharmaceutical organisations, there are 4–9 board members.

In the board, those who are employed in any of the management position and are full-time employees are known as inside directors or executive directors; while those who are not employed in any management position are referred to as non-executive directors or outside directors.

The key roles of the board as per Section 166 of the Companies Act, 2013 of India are explained as follows:

• Act in accordance with the Company’s Articles of Association.
  
  
• Act in good faith in order to promote the objects of the Company for the benefit of its members as a whole, and in the best interest of the Company, its employees, shareholders, community and for the protection of environment
  
  
• Exercise your duties with due and reasonable care, skill and diligence
  
  
• Not involve yourself in a situation in which you may have a direct or indirect interest that conflicts, or possibly may conflict, with the interest of the Company
  
  
• Not achieve or attempt to achieve any undue gain or advantage either to yourself or to your relatives, partners or associates
  
  
• Not assign your office as Director and any assignments so made shall be void

As per the Principles of Corporate Governance (2004) given by the Organization for Economic Cooperation and Development (OECD), the responsibilities of the board are as follows:

• Act ethically and in good faith with due diligence and care, in the best interest of the company and shareholders.
  
  
• Review and guide the corporate strategy, objective setting, major plans of action, risk policy, capital plans and annual budgets
  
  
• Oversee major acquisitions and divestitures
  
  
• Select, compensate, monitor and replace key executives and oversee succession planning
  
  
• Align key executive and board remuneration (pay) with the longterm interests of the company and its shareholders
  
  
• Ensure a formal and transparent board member nomination and election process
  
  
• Ensure the integrity of accounting and financial reporting systems
  
  
• Ensure that appropriate systems of internal control are established
  
  
• Supervise the process of disclosure and communication
  
  
• Define and communicate the mandate, composition and working procedures of committees

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Functional Committees of Board

The BODs of an organisation form various committees to divide work among groups. This is done for avoiding corporate failures and downfalls and increasing the efficiency of the board. In an organisation, there is a clearly specified set of duties for each director who is a member of any functional committee.

The three committees that are generally constituted are nomination committee, audit committee and remuneration committee. Let us discuss the functions of these committees in detail in the next sections.

Nomination Committee

The nomination committee is made up of outside independent directors. It is headed by the chairman of the company and is a means by which new non-executive directors are brought for the selection to the board.

The following are the functions of the nomination committee:

• Oversee and evaluate the performance of the board
  
  
• Ensure that the company adheres to the prescribed compliance and all the regulations, guidelines and principles pertaining to corporate governance
  
  
• Assess the performance of individuals and identify individuals qualified to become board members
  
  
• Make recommendations to the board for the proposed nominees for the board membership
  
  
• Make recommendations to the directors to serve on each standing committee.

The nomination committee possesses the following rights:

• The committee has unrestricted access to all information.
  
  
• All employees are directed to cooperate as per the rules and regulations made by the members of the committee.
  
  
• The committee can obtain advice and assistance from outside or other advisors provided their discretion is required to assist the committee in fulfilling its responsibilities.

The responsibilities of the nomination committee towards corporate governance are as follows:

• The committee ensures that all the aspects of corporate governance are taken care of by the BODs.
  
  
• The committee makes recommendations to the board pertaining to corporate governance comprising various policies, practices and procedures made by the organisation.
  
  
• The committee monitors and ensures that the organisation complies with the set corporate governance policies.
  
  
• The committee provides advice on the issues of corporate governance to the BODs.
  
  
• The committee reviews and approves any changes recommended by management pertaining to the organisation’s corporate disclosure policies.
  
  
• The committee can amend the organisation’s corporate governance policies pertaining to various attributes such as insider trading in the organisation’s securities, code of business conduct and ethics for directors, officers and employees.

Audit Committee

The members of the audit committee members are responsible for reporting financial proceedings of the organisation to the board. It acts as a useful link between outside auditors and the board.

The committee resolves matters, such as the scope of the audit, issues raised by auditors with regard to management systems and control or any disagreement or conflict of interest related to the published financial statements. It also gives recommendations on audit fees or reappointment or replacement of auditors. Apart from this, an audit committee keeps checks against the executives on the board. The auditors in this committee are responsible for reviewing systems and practicing internal control through an objective review of the progress made.

In Australia and Canada, it is mandatory for all listed companies to have audit committees. On the other hand, in countries like India, the US and the UK, it is a listing requirement for stock exchange in order to prevent fraud, cognitive omissions and management errors.

Under the provision of the Companies Act 1956, there must be at least three members from the board out of which, two-third of members will be independent directors in an audit committee.

According to Clause 49 of the Listing Agreement, such members must have financial knowledge in terms of corporate clients and must be experts in accounting aspects.

There are many corporate houses in India that have set up audit committees in their organisation but have failed to comply with the full requirements of Clause 49 of the Listing Agreement due to non-disclosure of information about:

• Literacy and expertise of the members in the committee in the field of law, finance and accounts
  
  
• Participation of finance, statutory and internal auditors in the committee
  
  
• Audit committee charter and terms of reference
  
  
• Audit committee reports in the annual reports of companies

The following are the major roles of an audit committee:

• To assess and evaluate the integrity of the company’s financial statements and announcements
  
  
• To review the internal financial controls mechanism (unless there is a separate risk committee) and ensure the effectiveness of risk management systems
  
  
• To monitor and review the internal audit function
  
  
• To make recommendations pertaining to the appointment or replacement of external auditors and ensure the effectiveness of their work by reviewing the same

There should be a right blend of audit committee members in order to execute corporate governance successfully. The task of the audit committee depends on its members and their knowledge about the business of the organisation.

Auditors would be encouraged to work efficiently and perform fairly if the committee has power to perform independently and raise questions to management.

The responsibilities of an auditor include the following:

• To make certain inquiries
• To create report on the accounts examined
• To make a proclamation in terms of the provisions set
• To detect, report and prevent a fraud
• To maintain substantial precision in auditing

Remuneration Committee

There is a remuneration committee in every large organisation. The main function of this committee is to set and check monetary benefits offered by the company to BODs. The committee comprises independent directors who are well-informed about compensation trends in similar and other industries.

It is responsible for setting a clear policy on the remuneration of directors, which is supported by all shareholders. This is because shareholders have a right to sue the directors in case their pay scale is more than the stated amount or they take a large share of profit instead of distributing it as dividends.

In India, having a remuneration committee is a non-mandatory requirement as per Clause 49 of the Listing Agreement. However, it is mandatory to disclose information regarding the remuneration of directors in the annual report.

The remuneration committee performs the following tasks:

• Ensures that the remuneration of executive directors is not set up by themselves
  
  
• Ensures that the remuneration committee is staffed by non-executive directors only
  
  
• Takes consideration of other companies before offering monetary benefits to directors
  
  
• Considers the relevant attribute for setting up remuneration offered to BODs
  
  
• Decides which kind of disclosures should be made by the remuneration committee in the accounts section pertaining to corporate governance

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What is Whistle-blowing?

The word whistle-blowing was derived from the practice of English policemen, who used to blow their whistles to alert people of any danger or mishappening. There are several ways to define whistle-blowing. In the organisational context, whistle-blowing is an act of reporting or raising a concern over wrongdoing within an organisation to internal or external parties.

Internal whistle-blowing happens when a matter is reported internally to an authority within an organisation, while external whistle-blowing happens when a whistle blower spreads the information outside the organisation; for instance, to media. An individual who takes the responsibility of raising voice against wrong is called a whistle-blower.

Whenever a concern is raised by an employee, it needs to be communicated to the ombudsman who can either be a personal legal advisor, or a member of the audit committee or a compliance officer. This would help to initiate an enquiry, which can either be accepted or dismissed if the complaint is frivolous or insignificant.

In case of genuine complaints, an enquiry committee needs to be appointed which may take the investigation further and based on the results of the enquiry, an appropriate action may be taken against the wrongdoer.

Most whistle blowers are the productive, valued and highly committed members of the organisation. They have a high sense of responsibility towards their organisation’s ethics and goals. Such employees feel perturbed whenever they are confronted with moral or ethical dilemmas.

Whistle-blowing is an act of self-sacrifice as whistle-blowers are threatened by the authority structure within the organisation for reporting wrongdoing. Sometimes, whistle-blowers are either fired or humiliated. It can be said that they put themselves at risk willingly in order to achieve the common good of the organisation.

In the era of globalisation where personal and economic motives surpass all virtues, values and traditions, it becomes more important to protect the public interest from great corporate scandals. An effective whistle-blower policy has hence been recognised as an important feature of corporate governance norms adopted by most of the countries across the globe.

In India, a report given by the Murthy Committee suggested that a whistle-blower policy is mandatory but it was made a non-mandatory recommendation due to the lobbying of Indian corporations.

The concept of whistle-blower came into existence in 2002 after the two of the biggest known corporate scandals: Enron and WorldCom. Sherron Watkins (Vice President of Enron) and Cynthia Cooper (Accountant at WorldCom) have been recognised as the two gutsiest women of this century.

Both of them uncovered fraud and misrepresentation of statements in the accounts of two well-known corporations of the US. In India, Satyendra Dubey was murdered in 2003 as he wrote a letter to the then Prime Minister to expose corruption in the Golden Quadrilateral Highway Construction Project. In India, the idea of protecting the interest of whistle blowers gained attention afterwards.

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Non-executive Directors and Their Roles

Non-executive directors are the members of an organisation’s BoDs. However, they neither belong to the executive team nor are involved in the day-to-day running of the organisation. They may even have full-time jobs elsewhere or they may be prominent individuals from the public.

Usually, non-executive directors are hired on a fixed contract and paid a flat fee for their services. The main role of non-executive directors is to minimise the conflicts of interests in the organisation.

However, according to the Higgs Report, published in 2003, their role can be summarised as follows:

• Contributing to the strategic plan
  
  
• Scrutinising the performance of EDs
  
  
• Providing an external perspective on risk management
  
  
• Dealing with issues, such as the future shape of the board and resolution of conflicts

According to various codes of corporate governance, non-executive directors should be independent, i.e., they should not have any material or pecuniary relationship with the organisation. As per the Cadbury Report, non-executive directors are in the best position to monitor the performance of the board and the CEO.

They are responsible for providing direction to the company and bringing in their experience, technical expertise, independent judgement and new ideas to the board. Non-executive directors must also maintain adequate control systems to safeguard the organisation’s interests as well as the interests of all stakeholders.

In the eyes of law, there is no difference between executive and non-executive directors, i.e., they have the same fiduciary duties as that of other directors. Hence, these outside directors have the power to demand information from the management or exercise their votes.

Non-executive directors must maintain high levels of integrity and act ethically. They need to monitor the conduct of the executive team by demonstrating a willingness to listen, question, debate and challenge while avoiding friction.

Having more non-executive directors than EDs is now recognised as a best practice in public organisations. For example, Tesco PLC has five executive directors and eight independent non-executive directors; Swire Pacific Limited has eight EDs and ten non-executive directors.

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One.Tel’s Collapse: a Case of Weak Internal Corporate Governance

One.Tel, an Australia-based telecommunications company, was established in 1995. It was Australia’s fourth largest telecommunications provider at the time of its collapse. As per as agreement with Optus (the second largest telecommunications company in Australia), One.Tel received SIM cards, customer call details and network services from Optus.

One.Tel had to pay Optus for the call charges and a monthly access fee for each of its subscribers. Thus, the gross profit of One.Tel was the excess of the amount billed to its customers over the amount paid to Optus.

It used to attract customers by providing cheap mobile calling rates and selling profitable long distance and international call service to them. However, in July 1996, disagreements between One.Tel and Optus increased on the issues of competition and promotion campaigns.

Thereafter, One.Tel signed an agreement with Global One in July 1997. It started providing discounted national and international calls to its customers carried on Global One’s network. One.Tel was listed on the Australian Securities Exchange on 12 November 1997.

One.Tel’s growth was very rapid with regards to the number of customers and sales revenue. Stats showed that the company’s operating profit after tax was A$3.7 million in 1996–97. In 1998, One.Tel expanded its operations to Europe and the US. In February 1999, News Ltd. and PBL were One.Tel’s primary shareholders as these companies invested about one billion Australian dollars.

Soon after being ranked as the 30th largest listed company in Australia with a market capitalisation of A$3.8 billion on 23 November 1999, One.Tel suffered a record operating loss of A$291 million for 1999–2000 fiscal year as per August 2000 data, despite the doubling of sales revenue from the previous year to A$654 million. Further, in February 2001, One.Tel reported a loss of A$132 million for July-December 2000, and by April 2001, its cash balance had reduced to A$25 million.

On the final trading day of 25 May 2001, One.Tel shares closed at Australian 16 cents, and it went into receivership on 30 May 2001. The creditors of the company voted to close its operations on 24 July 2001.

The One.Tel collapse is a classic case of weak internal corporate governance, failed expectations, incorrect pricing policy, unbridled growth and strategic mistakes. According to Hambrick and D’Aveni (1992), corporate collapses are usually preceded by corporate deteriorations because of strategic errors of senior management.

One.Tel senior management also made such strategic errors and had wrong pricing policy. It had very expensive customer acquisition campaigns. Moreover, the customers failed to contribute to the revenues and the cash flow the company desperately required to continue its operations.

In addition, One. Tel was involved in expansion into new markets through its aggressive strategies without consolidating its position in the local and existing markets. All along, the company was involved in disagreements with its suppliers, i.e., Optus and Telstra, and its network builder, Lucent Technologies. One.Tel also paid an excessive amount to obtain telecommunication licences to position itself in the market.

One.Tel had poor financial reporting quality along with poor earnings quality. It was only able to report small positive earnings in its initial years because of non-conservative accounting policy choices and large positive accruals. The company had weak internal controls, discrepancies in record keeping and poor audit quality. It regularly obtained an unqualified audit opinion despite serious breaches of the Corporations Act, principle accounting and auditing standards in 1998.

Despite the company’s deteriorating operating cash deficits, cash collection issues and losses concealed by non-conservative accounting policies, its auditor did not place any ‘going concern’ opinion.

There were serious issues of diversity among its board members, and the senior management failed to make full disclosure to the board regarding the performance and solvency of the company. Besides, the non-executive directors failed to analyse the functioning of the senior management effectively.

Weak internal corporate governance was further evident from the fact that there was very poor linkage between executive pay and performance at the company. The senior management at One.Tel received hefty performance bonuses during the times of deteriorating performance of the company.

One-Tel had major problems with its cash balance, creditors, earnings and debtors. The management communications to the board only reflected EBITDA (Earnings before Interest, Taxes, Depreciation and Amortisation) and gross margin but not net profit. Further, the board was rarely apprised of different creditor and debtor issues. Its cash balances reported in the board papers often neglected unpresented cheques. There were no well-defined responsibilities between the board and the management.

One of the two joint CEOs of One.Tel was of very dominant nature in the board who was appointed without any proper election and chaired various board meetings. Although One-Tel had set up an audit committee, a remuneration committee and a corporate governance committee, all these committees’ duties and responsibilities were performed by two non-executive directors. Thus, these committees never had any impact on One.Tel’s governance.

As per Haleblian and Finkelstein (1993), firms with dominant CEOs tend to perform poorly in a difficult environment. As late as 30 March 2001, One.Tel board members were notified that ‘everything was fine.’ Later, on 1 May 2001, the company’s cash crisis was simply termed ‘timing issue’. There was also major information asymmetry between One.Tel’s senior management and shareholders during 2000 – 2001.

The dominance of the CEO and poor monitoring of the management by the board negated chances for the company’s survival. This also hampered the functioning of the board and affected leadership renewal. Further, excessive reliance of the company’s shareholders on the CEOs enabled them to conceal the crisis situation of the company. All these factors led to the collapse of One.Tel.