Indian Corporate Governance - Evolution & Evaluation
February 18, 2016
“To han the gouernance of hous and land”
The word ‘Governance’ is probably as old as English literature. Chaucer described the word governance at the cosmic level as the relationship between God and Nature and Nature and sublunary creation. Corporate governance is a relatively newer term underpinned by Company law and has been practiced for as long as there have been corporate entities. It was in the late 18th century, Adam Smith observed:
“The directors of companies, 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 company frequently watch over their own.”
This observation is reflective of the fact that even prior to the knowledge about the term “corporate governance”, it was well comprehended. Yet, the underlying ideas and concepts of corporate governance have been surprisingly slow to evolve. Corporate governance acquired its distinctive significance only in the 20th Century i.e. when ‘Strategic Management’ saw a massive growth along with serious management thought. The 1970s saw two major significant developments in corporate governance thinking. These were the United States realizing the importance of independent outside directors and further introducing audit committees and the promotion of two-tier board systems in the European Union. The conventional wisdom with regard to corporate governance developed as a result of various company collapses and constant pressure on the board of directors (BoD) from various sources such as the institutional investors, investigative media etc. Sir Adrian Cadbury’s report popularly known as the Cadbury Report (1992) was the first report on corporate governance that reflected on the financial aspects of corporate governance in the UK and emphasized upon the importance of independent non-executive directors, “independent of management and free from any business or other relationship which could materially interfere with the exercise of independent judgment, apart from their fees and share-holding”.
An original member of the British Empire (‘the jewel in the crown’), India benefited from the codified body of company law backed by a reliable judiciary. Post independence, public sector undertakings and large-scale state and central government owned enterprises dominated the economy. In the wake of liberalization, corporate governance gained its prominence in India. The need for India to develop its business infrastructure and attract capital was recognized. It was in April 1997 at the National Conference and Annual Session of Confederation of Indian Industry (CII) that the National Task Force presented the draft guidelines and the code of Corporate Governance for the very first time. On the basis of these draft guidelines a voluntary code called ‘Desirable Corporate Governance Code’ was published in April 1998. With prima facie focus on regulating listed companies the code called for “independent non-executive directors” to constitute “at least 30 % of the board, if the chairman is a non-executive director and at least 50% when the chairman and the managing director were the same person.”
Although a few progressive companies adopted the aforementioned code voluntarily, the Birla Committee in its report felt that “under Indian conditions a statutory rather than a voluntary code would be far more purposive and meaningful, at least in respect of essential features of corporate governance.” Birla Committee in the said report, made certain recommendations, which pertained to board representation and independence. These key recommendations were accepted and approved by SEBI who codified a mandatory Clause 49 of the listing agreement of the stock exchanges, which made adherence to corporate governance norms mandatory. In August 2002, another committee was appointed by the Department of Company Affairs under the Ministry of Finance and Company Affairs, which submitted its report in December 2002 that made recommendations such as, “financial and non-financial disclosures, independent auditing, board oversight of management, grounds for disqualifying auditors from assignments, type of non-audit services that auditors should be prohibited from performing and the need for compulsory rotation of audit partners.” In furtherance, the Murthy Committee, set up by SEBI, reviewed clause 49 and in furtherance suggested measures to improve corporate governance standards by focusing on the role and structure of corporate boards, director independence particularly to address the role of insiders on Indian boards.
However, the said formation of committees generated more enthusiasm than the application of their recommendations as with the Satyam Computer Services scandal in January 2009 a re-assessment of the country’s progress in corporate governance was necessitated. This led to CII again putting forth certain recommendations that attempted to strike a balance between regulation and promotion of strong corporate governance norms by recommending a series of voluntary reforms. Vide its voluntary corporate governance guidelines, released in late 2009, the MCA laid emphasis on independence of BoD, strengthening the audit committee and encouraging whistle blowing.
The codification of a Code for Independent Directors, enacting guidelines of professional conduct including assistance to the company in implementing the best corporate governance practices and further mandating disclosures in the BoD’s report under the heading “Corporate Governance” in the newly incorporated the Act. This reflects the efforts of MCA to codify and consolidate corporate governance norms into the Act. As the focus swings to the legitimacy and the effectiveness of the wielding of power over corporate entities worldwide, 21st century promises to be the century of governance. With the entrenched corruption in government administration of India, which has lead to a high government distrust, the Ministry of Corporate Affairs and SEBI needs to adopt stringent measures in order to increase investor trust for further encouraging rapid economic growth.
Through this article, we shall try to understand the meaning attached to corporate governance, current corporate governance regimes prevalent in India and their evaluation and the steps that could be undertaken to encourage stringent application of corporate governance norms in India.
“The system by which companies are directed and controlled.”
Over the years several attempts have been made to define corporate governance. Ken Olisa OBE, Director Institute of Directors, Chairman of the Advisory Panel stated that, “It’s hard to define because governance is all about behaviours; and behaviours – whether individual or collective – are hard to reduce to a coherent framework connecting a small number of factors.” However, over the years some efforts have been made to define corporate governance. Corporate Governance: An International Review defines corporate governance as, “the exercise of power over corporate entities so as to increase the value provided to the organization’s various stakeholders.” While everyone perceives value differently, corporates need to ensure that all stakeholders, whether directly or indirectly should benefit from it.
The Organization for Economic Co-operation and Development in the year 2001 observed:
“Corporate governance refers to the private and public institutions, including laws, regulations and public institutions, which together govern the relationship, in a market economy, between corporate managers and entrepreneurs, on the one hand, and those who invest resources in corporations on the other.”
The Kumar Mangalam Birla Committee constituted by SEBI observed:
“Strong corporate governance is indispensable to resilient and vibrant capital markets and is an important instrument of investor protection. It is the blood that fills the veins of transparent corporate disclosure and high quality accounting practices. It is the muscle that moves a viable and accessible financial reporting structure.”
In addition to the above, the N.R. Narayana Murthy Committee observed:
“Corporate Governance is the acceptance by management, of the inalienable rights of the shareholders as the true owners of the corporation and of their own role as trustees on behalf of the shareholders. It is about commitment to values, about ethical business conduct and about making a distinction between personal and corporate funds in the management of a company.”
Simply put, corporate governance refers to an economic, legal and institutional environment that allows companies to diversify, grow and restructure to maximize long-term shareholder value. Corporate governance is a system by which corporations are directed and controlled. The corporate governance structure specifies the distribution of rights and responsibilities among different participants in the corporation and other stakeholders and spells out rules and procedures for making decisions on corporate affairs. By doing this, it also provides a structure through which the company objectives are set and the means of attaining those objectives and monitoring performance.
It is the process and structure, which directs and manages the affairs of the company and seeks to enhance long-term shareholder value, by encouraging corporate transparency and accountability, while paying due consideration to the interests of other stakeholders. Key aspects of good corporate governance includes:
“a) Transparency of corporate structures and operations;
b) Accountability of managers and the boards to shareholders; and
c) Corporate responsibility towards stakeholders.”
EVALUATION OF THE INDIAN CORPORATE GOVERNANCE REGIME
Good governance and good corporate governance have been clearly distinguished by the Supreme Court. In ‘Ashoka Smokeless Coal Ind.P.Ltd. and Ors. v. Union of India (UOI) and Ors.’, 2006 (13) SCALE 102, the Apex Court inter alia observed, “Whereas good governance would mean protection of the weaker sections of the people; so far as good corporate governance is concerned, the same may not be of much relevance.” Good governance is an essential prerequisite for sustainable success. Likewise, good corporate governance provides direction for a company, which describes structures and procedures to direct and control companies, to increase the BoDs’ accountability to shareholders, promote effective risk management, encourage discipline, transparency, social responsibility and eventually building investor trust. Mr.G.N. Bajpai, ex-chairman of SEBI was of the view that “Good governance, over and beyond its process aspects, is fundamentally a sustainability issue - good governance could result in the creation and fair distribution of tangible benefits.”
During recent times, corporate governance has gained significant attention and focus worldwide. India too has made commendable regulatory efforts for the very high maturity levels of corporate governance. We shall now analyze some of these regulatory efforts.
1.The Companies Act, 2013
The newly enacted Companies Act, 2013 (The Act) seeks to imbibe corporate governance within its domain by making certain good governance requisites mandatory. For achieving this objective, this Act seeks to lay greater emphasis on governance through the board and its processes. With significant changes to board compositions, the newly formed act seeks to ensure transparency in the corporate governance mechanisms by entrusting greater responsibility and obligation on the BoD and Management in Indian companies. These include:
(a) Appointment of Independent Directors
In terms of Section 149(4) of the Act, every listed public company is required to have at least one-third of the total number of directors as independent directors, whereas in case of any class or classes of public companies the Central Government may prescribe the minimum number of such directors. Such a director shall be a director other than a managing, whole time or a nominee director. Being independent of the operations of a Company enables independent directors in evaluating the performance of the board, scrutinize the performance of the management of a company, safeguard and balance the conflicting interests of the stakeholders and satisfy themselves on the integrity of financial information in a better manner. Stringent liabilities imposed by the Act increases accountability and discourages acceptance of this post by persons seeking personal favours. Independent directors are the enhancers of corporate governance and with a proper system of checks and balances provided by the Act, it is made sure that such extensive powers are not exercised in a rampant manner.
(b) Duties of the Directors
Section 166 of the Act, stipulates certain duties and liabilities upon the directors of a company. These include:
(1) To act in accordance with the articles of the company.
(2) To 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 interests of the
company, its employees, the shareholders, the community and for the protection of environment.
(3) Exercise his duties with due and reasonable care, skill and diligence and shall exercise independent judgment.
(4) Not to involve in a situation in which he may have a direct or indirect interest that conflicts, or possibly may conflict, with the interest of the company.
(5) Not to achieve or attempt to achieve any undue gain or advantage either to himself or to his relatives, partners, or associates and if such director is found guilty of making any undue gain, he shall be liable to pay an amount equal to that gain to the company.
(6) Not assign his office and any assignment so made shall be void.
(7) Any contravention of the provisions of this section shall be punishable with fine, which shall not be less than one lakh rupees but which may extend to five lakh rupees.
Enumerating the aforesaid duties and determining liabilities for acting in contravention to the aforesaid provisions, further seeks to ensure that the directors maintain high corporate governance standards. Penal consequences corroborate effective discharge of duties as they enable a person handling responsibility to work more diligently.
(c) Establishment of Committees
For corroborating adequate mechanisms that enable transparency and effective discharge of duties by corporations and in turn ensuring good governance, the Act has established certain committees. These include:
(i) Audit Committee: Section 177 of the Act requires the BoD of every listed company and certain other public companies to constitute an audit committee consisting of a minimum of 3 (three) directors, with the independent directors forming a majority. It emphasizes on the fact that majority of the members of the audit committee shall be persons with ability to understand financial statement. Audit Committees improve financial practices by constantly monitoring and reporting internal control measures, with a specialist department dedicated to auditing, it enables the creation of effective anti-fraud programs, ensures heightened credibility among stakeholders and eventually enhances internal audit function. With such extensive scrutiny over the financial mechanisms of the company and also self-evaluation to determine their own effectiveness, the audit committee assures continuous update and upgrade of the corporate governance standards of a company.
(ii) Nomination and Remuneration Committee: Section 178 of the Act necessitates the BoD to constitute a nomination and remuneration committee consisting three or more non-executive directors, one half of which shall be independent directors. As the name suggests the committee has been entrusted with the responsibility to determine the qualifications of not only directors but also persons who can be appointed in senior management. They therefore ensure that the background of a prospective director and other prospects shall in no way hamper the discharge of their duties as and when so appointed. This Committee also makes remuneration recommendation, which shall strike a balance between fixed and incentive pay. Disclosures with regard to remunerations including salary, bonuses, stock options, pension and other benefits have to be made in the Director’s annual report. These background checks before nominations ensure that effective persons capable of handling responsibilities are being hired and that qualified persons are advanced and paid accordingly. Remuneration disclosures also refrain hidden benefits that may be extracted by the persons in power. Therefore, through these operations Nomination and Remuneration Committee further good governance and successful organizations.
(iii) Stakeholders Relationship Committee: In furtherance to above, Section 178 (5) of the Act entails every company having more than one thousand shareholders, debenture-holders, deposit-holders and any other security holders at any time during a financial year to constitute a stakeholders relationship committee to resolve the grievances of security holders of the company. Stakeholder relationships are key to sustainable enterprises. Better relations with stakeholders help companies’ progress and recover faster. Better stakeholder relationships imply more trust on a companies actions, which increases transparency, better decision making and as such enable further investments. Dedicating a separate committee for stakeholders shall enable better understanding of their grievances, swift resolution and help organizations maintain high ethical standards.
(iv) Corporate Social Responsibility Committee (CSRC): Section 135 of the Act, requires every company having net worth of rupees five hundred crore or more, or turnover of rupees one thousand crore or more or a net profit of rupees five crore or more, to constitute a CSRC. The CSRC shall formulate and recommend to the BoD external activities that may be included in the social responsibilities of the corporations. The committee is also required to prepare a report detailing the CSR activities undertaken and if not, the reasons for failure to comply. CSR is the one thing that helps in winning over consumers and encourages strong loyalty amongst the consumers. In the modern day era, consumers are well aware of the global social issues. Any step by corporation towards society and its cause could make a positive image before consumers. Broad categories of social responsibility include responsibility towards environment, philanthropy and ethical labor practices. The CSRC handles these operations of a company, chalks out a proper policy, recommends expenditure and monitors the effective execution of these operations by a company. Corporate governance concerns itself to holding a balance between economic and social goals. Therefore, eventually the company gains more reputation with higher CSR standards and CSRC ensures that these standards are maintained.
Each of the committees would act as a “check and balance” on the powers of the board, by ensuring greater transparency and accountability in it’s functioning.
2. SEBI’s Corporate Governance Norms
Vide Circular No. CIR/CFD/POLICY CELL/2/2014 dated 17.04.2014; SEBI amended the clauses 35B and 49 of the Equity Listing Agreement. These amendments were made applicable to all listed companies with effect from 01.10.2014. Some of the key highlights of this circular include:
• Devising a mandatory whistle blower mechanism in a company enabling the stakeholders, including individual employees and their representative bodies, to freely communicate their concerns about illegal or unethical practices.
• Combination of executive and non-executive directors (50% of BoD) with at least one woman director.
• Maximum tenure of independent directors to be five consecutive years.
• Performance evaluation of Independent directors – to b