Article: Ethical Storm Brewing: Corporate Governance At a Crossroads

C-Suite

Ethical Storm Brewing: Corporate Governance At a Crossroads

While individual incidents like the telecom scam seem manageable from an economy standpoint, the larger india growth story is at risk with this dirty and globally unique alignment of shareholders and corrupt government interests
Ethical Storm Brewing: Corporate Governance At a Crossroads
 

Corporate Governance is now centered around how to deal with shareholder greed that ends in corruption

 

Publicly held firms in countries perceived as less corrupt are valued at bigger market premiums than those in places considered more corrupt

 

There are different degrees of greed, different forms of greed. Since the times of Enron, the concept of Corporate Governance and managerial ethics has concentrated on the role of management and of the board for protecting minority shareholder interests.
In India, this essence of corporate governance has been re-visited in 2008 & 2009, in the aftermath of the Satyam saga - with the underlying theme of how to guard the interests of minority shareholders from the wrongdoings of its promoters (read majority shareholders), who also manage the company. But the events of 2010 pose a new set of questions. With the playing out of the ugly telecom scam, the questions that confront us today are different – What happens when the interests of politicians, government officials, media, corporate managers, shareholders (majority and minority alike) – are aligned to loot the collective assets of a nation? Around this question does the debate on corporate governance and managerial ethics now revolve.
While individual incidents like the telecom scam seem manageable from an economy standpoint, the larger India growth story is at risk with this dirty and globally unique alignment of shareholder and corrupt government interests.

Ethics and Governance are downright boring topics. While we are all interested in the vicarious details of scam – how much money did so and so make, who was the go between, how was the physical cash handled, how pathetic that no one has been booked – few look into the origins of such behaviour and the possible mechanisms that could deter actions of the kind that have been exposed recently.
This story attempts to create a case for a new kind of Corporate Governance – one where the overriding principle of protecting the minority shareholder is replaced by a larger emphasis on behaviour within ethical boundaries. As compelling as it is to advocate ‘ethics for ethics sake’, the story tries to create a case for maintaining ethical behaviour to ensure long term economic growth and for managers to be the caretakers of such behaviour.

Protecting the small guy: From Enron to Satyam

The Enron scandal of 2001 created a new awareness in the failure of corporate governance involving the culpability and collusion of the company’s management, board, auditors and stock market analysts. The situation led to a widespread debate and discussion on the control and stretegic responsibilities of the board, on alignment of management compensation with long-term company objectives and on the flow of information from within the company to its shareholders – all with the aim to protect shareholder interests.
India had its share of corporate scandal with the Satyam saga, wherein the control failure of the board working closely with the company’s unscrupulous promoter-management led to a destruction of wealth for minority shareholders. The central theme in the post-debacle analysis was a re-examination of roles of the board, the management, the promoters, the auditors and market analysts – again with the purpose of protecting the interests of minority shareholders, a diffused entity with the least representation and with minimal access to information.

A new ethical dilemma

The last couple of years in India have demonstrated a different type of corporate scandal in sectors like telecom and mining – one where collusion between politicians, officials, media and promoters (with the aid of managers and the subtle nod of shareholders) has led to the siphoning of national resources on a scale hitherto unimagined. The gory economics of the telecom scam were made public by a CAG report and a subsequent media jamboree – including details like loss to exchequer, personalities / business houses involved and the nature of transactions publicized to an awestruck audience in the form of tapes. When it comes to the mining industry, such details are not so well known. A recent report by research house CLSA1, highlights some shocking facts in this sector:
While touching upon the Reddy brothers’ illegal mining scam in Karnataka, the POSCO debacle and the revoked permission for the Vedanta refinery, the CLSA report stated some shocking facts. In the past few years, besides Karnataka, there have been 3,200 illegal mining cases in Rajasthan, over 8,000 in Maharashtra, over 7,500 in Andhra Pradesh and over a thousand infringements in Chhattisgarh. A report by the Central Empowered Committee has noted also that over 60% of all mines in Orissa are illegal.2
There is a fundamental difference between the Enron-Satyam type of corporate scandals and the recent ones. The post-mortem of these recent scams is not centered around protecting the shareholder, not even the minority shareholder. Ironically, this analysis is centered around how to deal with shareholder greed that ends up in complex collusion – on how to save the system of capitalism from the capitalists.

Does bad ethics make for bad economics?

While most Indians are outraged by the unethical nature of such transactions, there is a common perception that such scams notwithstanding, the larger long term economic interests of the country remains intact – that the India growth story survives in spite of public-private corruption and will not be derailed by any such behaviour. What needs careful analysis here is if this belief is substaintiated and if not, how do such instances of collusion and corruption adversely affect long term economic growth. And, how managers should be incentivized to first conduct themselves ethically and then look to maximize shareholder value.
There exists a very strong case for transferring public assets at affordable prices from inefficient government control to private entrprise for the benefit of both consumer and shareholder. Telecom itself is a prime example of how transfer of airwaves at ridiculously low license fees has ultimately benefited the customer and spawned a communication revolution that now touches the poorest and gives access to scalable solutions for information and transaction in an otherwise access-starved economy.
Hence the question: Is corruption, even of epic proportions, a small price to pay for accelerating the process of transfer of assets from lazy-public-sector to efficient-private-sector? A process that has demonstrated benefit to every stakeholder, including the lowest common denominator and one that reinforces our faith in the Invisible Hand of capitalism. The larger question here is one on consequence - Is there a larger economic price to be paid for such unethical practises and hence, can long-term economic interest become the motive for enacting or regulating ethical behaviour? Or, are businesses destined to become the ‘new politicians’ – representing a class whose economic interests are rarely affected in spite of their most visible flouting of laws, rules, norms and ethics?

Reputation, Hot Money & Disparity

In spite of what most think, the primary negative effect of corruption is the damage it causes to the India Shining story - in terms of reduced long-term investment and reduced direct investment. This view was reflected by Deepak Parekh, chairman of HDFC, at an event recently organised by the Confederation of Indian Industry (CII). “Corruption has become synonymous with Indian society, as ethical lines are crossed in all professions on a regular basis, and as the country’s moral universe shrinks. While we should be celebrating India’s newfound confidence, we are in the throes of something that is eating India from within. Current concerns such as high inflation, and eternal woes such as lack of adequate infrastructure, all take a back seat today to India’s invasive vice, corruption. India’s growth story could be at risk due to the current environment of negativity”, Parekh said while addressing a session on corporate governance.
The reasoning is simple – unethical behaviour will make it difficult for companies to associate with investors, businesses and consumers in countries with strong policies for preventing dishonesty. A recent study by Charles M.C. Lee, an expert on markets and accounting at Stanford’s Graduate School of Business shows that ethical lapses matter in the market value of companies. Over the long run, publicly held firms in countries perceived as less corrupt are valued at bigger market premiums than those in places considered more corrupt, according to Lee. In his research, corruption was defined as the “misuse of public office for private gains.” This could include bribery of public officials, embezzlement of public money, and kickbacks in public procurement. Corruption isn’t just a matter of appearing “unsavoury”, Lee said during a public address. There is evidence, linking corruption to “social and economic ills” such as lower economic growth, less foreign direct investment, higher military spending, and worse health care and education, he added.
To most, it does not take research to re-iterate belief in “good karma”, but research such as Lee’s helps in an environment where even the most ethical are beginning to question if corrupt practises will ever be punished. And maybe it helps reinforce values in a younger generation that is starved for ethical role models - something that Parekh lamented in his recent talk, “Most troubling is that there is not even a sense of remorse from the people who are involved. It is difficult to tell the younger generation to be ethical, when the very preachers of morality are embroiled in controversy.”
Another long-term economic repercussion of a corrupt system is that of hot money flows, both inward and outward. A decent portion of proceeds from corruption in India has funded asset booms – like the one in real estate, taking prices and rentals beyond the reach of ordinary citizens. Simultaneously, a large portion of ‘corruption money’ leaves the country to havens abroad and is never deployed in the local economy. Estimates predict that between 2000 and 2008, India had a mindboggling USD 125 billion in cumulative illicit capital flight.
A different kind of hot money that follows corrupt practises in the transfer of state assets to private enterprise is that of short-term focused foreign (and domestic) investment. The expectation and immediate aftermath of companies receiving licenses/rights for a fraction of their ‘real value’ prompts speculative rallies and dramatic pullbacks much before such companies can actually demonstrate operational capability. This could well be one of the main contributors for the tremendous rise in telecom service provider stocks by early 2009 followed by a near 50% loss in market value over the period since. In the long run, such hot money flow (and flee) could have devastating effects – something our South East Asian neighbours witnessed a decade ago.
The final long-term impact of corrupt practices is the increased disparity in income and wealth levels between various sections of society. With the kind of collusion seen in the recent telecom scam and in various mining scams, the profiteers include the new ‘masters of the universe’ - politicians, officials, promoters of companies, media persons, senior corporate managers and ultimately, minority shareholders as well. Which leaves out the non-white-collared, non-shareholding class that comprises more than 90% of the legitimate populace. While this class does occasionally benefit as consumers, the question of increased wealth disparity between them and the new ‘masters of the universe’ is beyond debate.
The long-term costs of huge income and wealth disparities are slowly becoming clearer to all. The maoist naxal problem has its roots in this growing disparity caused by a simultaneous misappropriation of mining land by companies (with active government support) and the state’s inability (or lack of intent) to provide adequate relief, rehabilitation and skills to tribal populace. The investment community is slowly waking up to the potential ill effects of such massive problems – it is time for the management community as well.

The imperative for managers and b-schools

In an age of tremendous pressure for managers to deliver results and of sufficient compensation to justify such pressure, there is little to dissuade managers from indulging in unethical behaviour to deliver better results – except for ethical motivation from within and for peer pressure. And this is where HR and senior managers can make a difference by recruiting for the right ethical attitude. Author and management guru Gurcharan Das has a strong view on this, “Hiring the right people is extremely important - recruiting people with character; what the person knows or his intellect is not as relevant. Hiring people is one of the most important decisions for the organization; people you bring inside the organization will collectively determine the character of the organization. The time when people join the organization is the time when companies need to tell them what is right and what is not right and create the right habit. Of course, the management should behave as they say and may need to protect their employees for any business misjudgement but never for ethical lapses.”
There is a larger role for education, especially business education, in reinforcing ethics that is vital for business sustainability and for economic stability at large. Post-Enron, there was a huge emphasis on teaching ethics in American business schools. While the results of such initiatives are neither predictable nor easily measurable, Indian business schools could help in creating a better ethical base for tomorrow by emphasising on ethics.
Prof. M.J. Xavier, Director of IIM Ranchi is a firm believer in the role of holistic development of an individual as a part of business education. “Business education should be reformulated with the triple bottom-line approach - Profit, People and Planet. Currently management education is entirely focussed on the first P - profit. When it come to people, business should be relevant to the society in which it operates. Inclusive growth, ethical behaviour and regional development must form a key component of business education. The last P is increasingly becoming important as we are destroying mother earth very rapidly. Sustainability and green initiatives should also form a major part of business education”, he says.

Solutions galore

In the face of a large-scale collapse of ethics, most solutions seem either thin or impractical. Yet, ironically, there is widespread dismay at the current state of governance from people across professions and the call for systemic reform is uniform. Most of the experts polled point to systemic reforms in the reduction of discretionary powers with ministers that have increased with economic growth and with larger access to resources. Another pointer for systemic change is to increase the autonomy of investigating agencies and to fast track the judicial process that handles financial crimes, bolstered by laws that fine corporate entities breaking laws and make it difficult for companies to deflect blame on independently acting employees in the event of bribery. However, any such change would require political will and corresponding legislation – something that is completely missing and worse, is the biggest obstacle in the path of reform towards ethical behaviour.
At a corporate level, the role of a company’s board requires greater attention. While its role as shareholders’ representative has been scrutinized over the last decade, the board’s role as a company’s conscience keeper and strategic advisor has not been explored sufficiently. Also, an expansion of the Whistleblower Bill to include corporate whistleblowers (which the bill surprisingly omitted) could create a way for protecting employees willing to provide information on corrupt practises within the company.
A very interesting point here is one of creating sectoral and market regulators to oversee ethical behaviour and act in the public interest. The views of Sushil Tripathi, Former Secretary, Ministry of Petroleum and Gas might form the base for actionable ideas in this context. “At the corporate level, the role of Statutory Auditor and Independent Directors has to be emphasized- they should be chosen by management / shareholders only from a panel of names given by the sectoral regulator. These should all be professionals and public servants of high professional competence and unimpeachable integrity. Statutory as well as Internal Auditors should make quarterly presentation to the independent director about compliance of laws and Code of Ethics. In case the public shareholding in a company is 50% or more, the market regulator should appoint one of the independent directors as chairman of the board”, he says.
The consumer and the employee can also make a significant impact in forcing companies to behave ethically. When consumers and employees consciously begin to discriminate between brands from ethical and ‘unethical’ companies, companies will be forced to re-think their corporate decisions. Gurcharan Das is a believer in the balancing role of reputation within the capitalist system – “There is such drive for success and for self interest in companies, but brands are also measured by reputation. I am more likely to do business with a reputed company as opposed to one that uses unethical or illegal business means. So reputation is a very valuable asset. Many people believe that capitalism, as a system is efficient because there are very strong signals that make companies behave in a moral way”, he says. However, there are two obstacles to this consumer / employee preference for ethical companies. First, it frequently requires customers to buy more expensive products or for employees to go for lower compensation. Second, the notion of corporate reputation is a function of media inputs, something that is understood to be actively ‘managed’ by corporate interests.

Ethics in politics, anybody?

At the end of the day, however, none of these solutions would work without a general ethical awakening among the masses – a task for religious bodies, schools, media, NGOs and individuals alike. After all, the rot visible today should be a fair reflection of the drop in individual and community values. Reflecting this is Bikhchandani, who believes that it is the leader of an organization who dictates its ethical standing – “Corporate Governance needs to start in the promoters’ head first. Everything else is an add-on to strengthen that position – audits, audit committees, independent directors etc. If there isn’t the intent on adhering to good governance practices between the entrepreneurs, then none of the add-ons will help”, he articulates.
Finally, there is one critical issue on which few people have a favourable view – one of ethical behaviour among people occupying positions of power. At a time when ministers are appointed to ‘protect’ friendly business interests, when corruption in public office is an expected norm and when personal conflicts of interest in public office are no longer a hindrance to operate, faith in public officials and politicians is at an all-time low. While the media and corporate India are going through a period of intense reflection and soul-searching, the measures taken by government to curb such behaviour are cosmetic at best and largely non-existent. The need of the hour to solve this collective problem of “global warmingesque proportions” is one of serious structural reform and a visible return of propriety and ethics in public life. While that may sound logical and may be the only way ahead for governments, experience suggests that it might be too much to ask of our leaders.
 

Topics: C-Suite, Leadership

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