The fundamental theoretical basis of corporate governance is agency costs. Shareholders are the owners of any joint-stock, limited liability company, and are the principals. By virtue of their ownership, the principals define the objectives of a company. The management, directly or indirectly selected by shareholders to pursue such objectives, are the agents. While the principals might wishfully assume that the agents will invariably do their bidding, it is often not so. In many instances, the objectives of managers are quite different from those of the shareholders. Such misalignment of objectives is called the agency problem; and the cost inflicted by such dissonance is the agency cost. The core of corporate governance is designing and putting in place disclosures, monitoring, oversight and corrective systems that can align the objectives of the two sets of players as closely as possible and, hence, minimise agency costs.

Corporate history suggests that there are two types of agency costs, and both relate to the basic concept of separation. The first is the separation of ownership from management, and is based largely on the examples of large US and British listed companies up to the mid-1980s. Vast Anglo-American corporations were characterised by very widely dispersed shareholding coupled with little or no managerial ownership of shares. Hence, managers had little incentive to align many of their decisions in line with those desired by the shareholders. Until the late-1980s, such differences were abetted by widely held share ownership, and the absence of powerful pension and mutual funds which could have used their relatively concentrated stockholdings to demand greater shareholder value. Such huge, and de facto uncontrolled managerial playing fields led to wrong investment decisions, unconnected diversification and taking of excessive risks with shareholders' funds - which often resulted in falling efficiency and declining long -term corporate value. In the US, such agency costs had their denouement in the spate of hostile takeovers from the late 1970s right up to the late 1980s. Although the modern champion of this corporate efficiency aspect of agency cost is Michael Jensen of the Harvard Business School, the essence of this concept was highlighted as early as in 1776, when Adam Smith wrote:

"The directors [managers] of such companies, however, being managers of other people's money than their own, it cannot well be expected that they should watch over it with the same anxious vigilance with which the partners in a private co-partnery frequently watch over their own… Negligence and profusion, therefore, must always prevail more or less in the management of the affairs of such a company."
[Adam Smith, An Inquiry into The Nature and Causes of The Wealth of Nations, p.31.]

There is, however, a second dimension to agency costs - which also has to do with separation. This form of agency cost does not adversely affect corporate efficiency as it does minority shareholder rights. Consider, for instance, the three dominant characteristics of South-East and East Asian conglomerates. First, relative to their size, most Asian companies have low equity. This was traditionally facilitated by highly geared, credit and term-lending driven growth. Secondly, given the low equity base, the promoters found it relatively cheap to own majority shares. This is still true for many companies in Hong Kong, Indonesia, Malaysia, Philippines, Thailand and China, where the entrepreneur and his family own up to 75% of the equity, which thwarts all possibilities of equity-triggered take-overs. Thirdly, equity ownership was camouflaged through complex cross-holdings.

None of this conforms to the model of the modern Anglo-American corporation, with its large equity base, dispersed shareholding and profound separation of ownership from management. However, that doesn't reduce the importance of agency costs. A promoter who controls management and directly or beneficially owns over 75% of a company's equity is not expected to perform in a value-destroying manner like many US corporate managers and boards did up to the late-1980s. However, he can do a great many things that deprive minority shareholders of their de jure ownership rights, without adversely affecting pre- or post-tax profits. These involve fixing the election of board members, packing the boards with crony directors, ensuring that key shareholder resolutions are vaguely worded and inadequately discussed at shareholders' meetings, fobbing off minority shareholder complaints, issuing preferential equity allotments to the promoters and their allies at discounts, transferring shares through private bought-out deals at prices well below those in the secondary market, and the like.

In the Indian context not only a large number of retail investors, but also several creditors, especially financial institutions, will echo this sentiment. Sharp practices may, on their own, add to agency costs, and the consequent depletion of shareholder value. Stakeholders almost seem to believe that this is a necessary evil that they will have to live with, especially if returns on their investment are perceived by them to be higher than the market average. However, in India a lot more has happened. Vanishing companies are a down right fraud, where shareholder money has simply disappeared. There have been subtler frauds too, such as the promoter-manager of a listed company utilising shareholder money to buy small private companies at exorbitant prices with every likelihood of the promoter-manager having a beneficial interest in such private companies; or, that of the promoter-manager using shareholder money to artificially raise the price of the company's shares, to induce existing investors to invest more, and new investors to invest anew. Even where frauds have not been committed, and promoter-managers have not actually destroyed share value, it can be safely said that more often than not wealth has not been fully or fairly been shared; in fact, such promoter-managers seem to have fine-tuned their ability to keep returns just above expectations of the shareholders. , to a fine art.

It will take much more research before one can definitively apportion agency cost effects between efficiency and expropriation. However, the point to recognise is that poor corporate governance is not only about destroying shareholder value through managerial inefficiency arising out of the disjunction between share- ownership and corporate control. Efficiently run firms that consistently outperform the competition and earn returns that exceed the opportunity cost of capital can also have poor corporate governance. And this can manifest itself in a steady expropriation of minority shareholder rights.

Two broad instruments that reduce agency costs and hence, improve corporate governance, are financial and non-financial disclosures and independent oversight of management. A company that discloses nothing can do anything. Improving the quality of financial and non-financial disclosures not only ensures corporate transparency among a wide group of investors, analysts and the informed intelligentsia, but also persuades companies to minimise value- destroying deviant behaviour. This is precisely why law insists that companies prepare their audited annual accounts, and that these be provided to all shareholders and be deposited with the Registrar of Companies (ROC). This is also why a good deal of effort in global corporate governance reform has been directed to improving the quality and frequency of disclosures.

Independent oversight of management comprises two aspects. The first relates to the role of the independent, statutory auditors - who are appointed by shareholders to audit a company's accounts and present a 'true and fair' view of the financial health of the corporation. Indeed, the quality and independence of the statutory auditors are fundamental to corporate oversight. While it is the job of management to prepare the accounts, it is the fundamental responsibility of the statutory auditors to scrutinise such accounts, raise queries and objections (if the need arises), arrive at a true and fair view of the financial position of the company, and report their independent findings to the board of directors and, through them, to the shareholders and investors of the company. No doubt, auditors have the skills to scrutinise complex accounts of today's multi-divisional, multi-segmental corporations, but these skills would come to nought if an auditing firm did not have a strict, arm's length independent relationship with the management of the companies they audit.

The second aspect of independent oversight is the board of directors of a company. A joint-stock company is owned by the shareholders, who appoint directors to supervise management and ensure that it does all that is necessary by legal and ethical means to make the business grow and maximise long term corporate value.

The point to note is that the board is appointed by the shareholders and are, therefore, accountable to them. Directors are fiduciaries of the shareholders, not of the management. That doesn't mean an adversarial or a non-collegial board. However, where the objectives of management differ from those of the wide body of shareholders, the non-executive directors on the board must be able to speak in the interest of the ultimate owners, discharge their fiduciary oversight functions, and stand up and be counted. This is precisely the reason why 'independence' has become such a critical issue to determining the composition of any board

Clearly, a board packed with executive directors or friends and cronies of the promoter or CEO cannot be normally expected to exercise independent oversight judgement at times when it is most needed. The failure of many large corporations in recent times, be these Japanese keiretsus, Korean chaebols, Indonesian empires, Indian groups or US conglomerates, has much to do with the poor quality of boards and the lack of independent oversight. Part of this failure is related to inadequate disclosure of key corporate information to boards as well as shareholders and other stakeholders - an issue that will be addressed in the course of this report. But much has to do with poor board composition where directors, due to their close business and social relationships with promoters, did not feel the necessity of asking the right questions when occasions demanded much more detailed scrutiny and debate. They were, as US observers picturesquely put it, "parsley on the fish" - meant for decoration and little else. Structure of the Report