Purpose of Corporations and Corporate Governance

This article studies the legal framework on corporate governance in India. This article also studies the role and purpose of corporation.
Estimated Reading Time: 11 minutes

Introduction

The term body corporate is used at numerous places in the Companies Act, 2013 (‘Act, 2013’). The Act, 2013 defines a body corporate in section 2(11) of Act, 2013, the definition is however inclusive. The articles discusses purpose of corporation and the need for corporate governance.

Statutory Definition

Definition of ‘body corporate’ under Act, 2013 The Act, 2013 defines a body corporate or corporation as follows: “body corporate” or “corporation” includes a company incorporated outside India, but does not include—

  • a co-operative society registered under any law relating to co-operative societies
  • any other body corporate (not being a company as defined in this Act),[1]

Exhaustively- A corporation has a wide variety of constituents and it needs to relate to all of them; like investors, shareholders, customers, employees, suppliers, creditors, government, and finally the community.

Brief History of “Corporations”

In 1919 the Michigan Supreme Court declared that “a business corporation is organized and carried on primarily for the profit of the stockholders.” And during the middle decades of the century — from the 1940s to the 1970s, an era that now appears an economic golden age marked by widely shared prosperity and globally dominant American corporations – many argued otherwise.

Corporations appeared to have won such secure positions in the economy, and so many workforces and communities were dependent on giant corporations, that it no longer seemed right for corporations to be run just for shareholders—who, in an era of high retained earnings, no longer even provided the corporation capital. Increasingly popular was the vision of a corporation responsive to multiple groups. 

 In 1950, for instance, the management guru Peter Drucker urged that management be held responsible to the corporation itself, “rather than to anyone group:  owners, workers, or consumers.”   In 1957, Harvard economist Carl Kaysen wrote that management should see “itself as responsible to stockholders, employees, customers, the general public, and, perhaps most important, the firm itself as an institution.” Managers should govern the corporation to benefit shareholders, they believed, but not shareholders alone[2].

The image of the “business statesman” common in the 1950s disappeared. New business and legal theories also played a role, as management was reconceived as the “agent” of the corporation’s “owners”—its shareholders—and share price seen as the best measure of whether these agents were doing their job.

By the turn of the twenty-first century, the conventional wisdom was that the corporation existed for its shareholders’ benefit. So ingrained is this view today that businesspeople who aim to combine profit with the social mission have begun inventing new business entities to fulfil their visions, the low-profit limited liability company (LLC) and benefit corporation (B Corporate) being the two most notable recent developments. It is too early to tell whether these new legal forms will flourish, but they testify to the enduring desire for a business form with a purpose beyond shareholder enrichment.

Evolution of Purpose of a Corporation

The sole purpose of Corporation was to provide for capital formation because it carried economic privileges that protected investors and enabled them to externalize all kinds of risks and costs but the scope of the same has been changed now there is a paradigm shift in the purpose of the Corporation.

Corporate Governance and Corporations

Corporate governance is the system of rules, practices, and processes by which a firm is directed and controlled. Corporate governance essentially involves balancing the interests of a company’s many stakeholders, such as shareholders, senior management executives, customers, suppliers, financiers, the government, and the community. Since corporate governance also provides the framework for attaining a company’s objectives, it encompasses practically every sphere of management, from action plans and internal controls to performance measurement and corporate disclosure.

The Ever-changing Role of Corporate Governance

India’s biggest-ever corporate fraud and governance failure unearthed at Satyam Computer Services Limited, the concerns about good Corporate Governance has increased phenomenally.

Internationally, there has been a great deal of debate going on for quite some time. The famous Cadbury Committee defined “Corporate Governance” in its Report (Financial Aspects of Corporate Governance, published in 1992) as “the system by which companies are directed and controlled”.

The Organisation for Economic Cooperation and Development (OECD), which, in 1999, published its Principles of Corporate Governance gives a very comprehensive definition of corporate governance, as under:

“a set of relationships between a company’s management, its board, its shareholders, and other stakeholders. Corporate governance also provides the structure through which the objectives of the company are set, and the means of attaining those objectives and monitoring performance are determined. Good corporate governance should provide proper incentives for the board and management to pursue objectives that are in the interests of the company and shareholders, and should facilitate effective monitoring, thereby encouraging firms to use recourses more efficiently.”

Generally, Corporate Governance refers to practices by which organizations are controlled, directed, and governed. The fundamental concern of Corporate Governance is to ensure the conditions whereby the organisation’s directors and managers act in the interest of the organization and its stakeholders and to ensure how managers are held accountable to capital providers for the use of assets. To achieve the objectives of ensuring fair corporate governance, the Government of India has put in place a statutory framework.

Regulatory framework on corporate governance

The Indian statutory framework has, by and large, aligned with the international best practices of corporate governance. Broadly speaking, the corporate governance mechanism for companies in India is enumerated in the following enactments/ regulations/ guidelines/ listing agreement:

  1. The Companies Act, 2013 inter alia contains provisions relating to board constitution, board meetings, board processes, independent directors, general meetings, audit committees, related party transactions, disclosure requirements in financial statements, etc.
  2. Securities and Exchange Board of India (SEBI) Guidelines: SEBI is a regulatory authority having jurisdiction over listed companies and which issues regulations, rules, and guidelines to companies to ensure the protection of investors.
  3. Standard Listing Agreement of Stock Exchanges: For companies, whose shares are listed on the stock exchange.
  4. Accounting Standards issued by the Institute of Chartered Accountants of India (ICAI): ICAI is an autonomous body, which issues accounting standards providing guidelines for disclosures of financial information. Section 129 of the New Companies Act inter alia provides that the financial statements shall give a true and fair view of the state of affairs of the company or companies, comply with the accounting standards notified under sec. 133 of the New Companies Act. It is further provided that items contained in such financial statements shall be following the accounting standards.
  5. Secretarial Standards issued by the Institute of Company Secretaries of India (ICSI): ICSI is an autonomous body, which issues secretarial standards in terms of the provisions of the New Companies Act. So far, the ICSI has issued Secretarial Standard on “Meetings of the Board of Directors” (SS-1) and Secretarial Standards on “General Meetings” (SS-2). These Secretarial Standards have come into force w.e.f. July 1, 2015. Section 118(10) of the New Companies Act provides that every company (other than one-person company) shall observe Secretarial Standards specified as such by the ICSI concerning general and board meetings.

Key Legal Framework for Corporate Governance in India

The Companies Act, 2013

The Government of India has recently notified Companies Act, 2013 (“New Companies Act”), which replaces the erstwhile Companies Act, 1956. The New Act has a greater emphasis on corporate governance through the board and board processes. The New Act covers corporate governance through its following provisions:

  • New Companies Act introduces significant changes to the composition of the boards of directors.
  • Every company is required to appoint 1 (one) resident director on its board.
  • Nominee directors shall no longer be treated as independent directors.
  • Listed companies and specified classes of public companies are required to appoint independent directors and women directors on their boards.
  • New Companies Act for the first time codifies the duties of directors.
  • Listed companies and certain other public companies shall be required to appoint at least 1 (one) woman director on its board.
  • New Companies Act mandates following committees to be constituted by the board for the prescribed class of companies:
    • Audit committee
    • Nomination and remuneration committee
    • Stakeholders relationship committee
    • Corporate social responsibility committee

Listing agreement

SEBI has amended the Listing Agreement with effect from October 1, 2014, to align it with the New Companies Act.

Clause 49 of the Listing Agreement can be said to be a bold initiative towards strengthening corporate governance amongst the listed companies. This Clause intends to put a check over the activities of companies to save the interest of the shareholders. Broadly, cl 49 provides for the following:

  1. Board of Directors: The Board of Directors shall comprise of such number of minimum independent directors, as prescribed. In case where the Chairman of the Board is a non-executive director, at least one-third of the Board shall comprise of independent directors and where the Chairman of the Board is an executive director, at least half of the Board shall comprise of independent directors. A relative of a promoter or an executive director shall not be regarded as an independent director.
    1. Audit Committee: the Audit Committee to be set up shall comprise of minimum three directors as members, two-thirds of which shall be independent.
    1. Disclosure Requirements: Periodical disclosures relating to the financial and commercial transactions, remuneration of directors, etc, to ensure transparency.
    1. CEO/ CFO Certification: To certify to the Board that they have reviewed the financial statements and the same are fair and in compliance with the laws/ regulations and accept responsibility for internal control systems.
    1. Report and Compliance: A separate section in the annual report on compliance with Corporate Governance, quarterly compliance report to stock exchange signed by the compliance officer or CEO, company to disclose compliance with non-mandatory requirements in annual reports.
  2. Corporate governance is the structure of rules, practices, and processes used to direct and manage a company.
  3. A company’s board of directors is the primary force influencing corporate governance.
  4. Bad corporate governance can cast doubt on a company’s reliability, integrity, and transparency, which can impact its financial health[3].

Understanding Corporate Governance

Governance refers specifically to the set of rules, controls, policies, and resolutions put in place to dictate corporate behaviour. Proxy advisors and shareholders are important stakeholders who indirectly affect governance, but these are not examples of governance itself. The board of directors is pivotal in governance, and it can have major ramifications for equity valuation[4].

Role of Corporate Governance in Evolving Corporations

A company’s corporate governance is important to investors since it shows a company’s direction and business integrity. Good corporate governance helps companies build trust with investors and the community. As a result, corporate governance helps promote financial viability by creating a long-term investment opportunity for market participants[5].

  • Communicating a firm’s corporate governance is a key component of community and investor relations. On Apple Inc.’s investor relations site, for example, the firm outlines its corporate leadership—its executive team, its board of directors—and its corporate governance, including its committee charters and governance documents, such as bylaws, stock ownership guidelines and articles of incorporation.
  • Most companies strive to have a high level of corporate governance. For many shareholders, it is not enough for a company to merely be profitable; it also needs to demonstrate good corporate citizenship through environmental awareness, ethical behaviour, and sound corporate governance practices. Good corporate governance creates a transparent set of rules and controls in which shareholders, directors, and officers have aligned incentives.
  • Corporate Governance and the Board of Directors -The board of directors is the primary direct stakeholder influencing corporate governance. Directors are elected by shareholders or appointed by other board members, and they represent shareholders of the company. The board is tasked with making important decisions, such as corporate officer appointments, executive compensation, and dividend policy. In some instances, board obligations stretch beyond financial optimization, as when shareholder resolutions call for certain social or environmental concerns to be prioritized. Boards are often made up of inside and independent members. Insiders are major shareholders, founders, and executives. Independent directors do not share the ties of the insiders, but they are chosen because of their experience managing or directing other large companies. Independents are considered helpful for governance because they dilute the concentration of power and help align shareholder interest with those of the insiders. The board of directors must ensure that the company’s corporate governance policies incorporate the corporate strategy, risk management, accountability, transparency, and ethical business practices.
  • The influence of Bad Corporate Governance-Bad corporate governance can cast doubt on a company’s reliability, integrity, or obligation to shareholders—all of which can have implications on the firm’s financial health. Tolerance or support of illegal activities can create scandals like the one that rocked Volkswagen AG starting in September 2015.
  • Types of bad governance practices include:
  • Companies do not cooperate sufficiently with auditors or do not select auditors with the appropriate scale, resulting in the publication of spurious or noncompliant financial documents.
  • Bad executive compensation packages fail to create an optimal incentive for corporate officers.
  • Poorly structured boards make it too difficult for shareholders to oust ineffective incumbents

Conclusion

The focus is now which is to provide profitable solutions to problems of people and planet, while not causing harm. The Business Roundtable has articulated a fundamental commitment of corporations to deliver value to all stakeholders, each of whom is essential to the corporation’s success. Each of the major US-based index funds has also expressed their views about the purpose of the corporations in which they invest, which, considered collectively, can be summarized as the pursuit of sustainable business strategies that take into account ESG factors to drive long-term value creation.

At present times, a corporation’s purpose is to benefit its shareholders – academics speak of the “shareholder primacy norm,” and many talks of corporate managers’ task as “shareholder wealth maximization.” Even apparently selfless corporate acts, such as charitable donations, are justified as ultimately benefiting shareholders by producing a favourable image and so consumer goodwill.The ever-changing imperatives have to lead to a simple formulation of corporate purpose.

The purpose of a corporation is to conduct a lawful, ethical, profitable and sustainable business to create value over the long-term, which requires consideration of the stakeholders that are critical to its success (shareholders, employees, customers, suppliers, creditors, and communities), as determined by the corporation and the board of directors using its business judgment and with regular engagement with shareholders, who are essential partners in supporting the corporation’s pursuit of this mission.

This conception of purpose is broad enough to apply to every business entity but at the same time supplies clear principles for action and engagement. The basic objective of sustainable profitability recognizes that the purpose of for-profit corporations is to create value for investors. The requirement of lawful and ethical conduct ensures minimum standards of corporate social compliance. Going further, the broader mandate to take into account corporate stakeholders—including communities, which is not limited to local communities, but comprises society and the economy at large—directs boards to exercise their business judgment within the scope of this broader responsibility.

The requirement of regular shareholder engagement acknowledges accountability to investors, but also shared responsibility with shareholders for responsible long-term corporate stewardship.


[1] Sec 2(11) Companies Act 2013

[2]The purpose of a Corporation: Brief History available at https://www2.law.temple.edu/10q/purpose-corporation-brief-  history/  by Harwell Wells.

[3] Corporate Governance Framework in India available at https://www.mondaq.com/india/shareholders/456460/corporate-governance-framework-in-india by Vaish Associates, 8 January,2016.

[4] Key Takeaways of Corporate Governance available at https://www.investopedia.com/terms/c/corporategovernance.asp

[5] Corporate Governance-definition available at https://www.investopedia.com/terms/c/corporategovernance.asp by James Chen, 12th April 2020

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