full text of the report produced by a 12-member CII task force headed by Rahul Bajaj, past president of CII and
chairman and managing director of Bajaj Auto Ltd.
Although corporate governance still remains an ambiguous and misunderstood phrase, three aspects are becoming evident.
First, there is no unique structure of corporate governance in the developed world; nor is one particular type unambiguously better than others. Thus, one cannot design a code of corporate governance for Indian companies by mechanically importing one form or another.
Second, Indian companies, banks and financial institutions (FIs) can no longer afford to ignore better corporate practices. As India gets integrated in the world market, Indian as well as international investors will demand greater disclosure, more transparent explanation for major decisions and better corporate value.
Third, corporate governance goes far beyond the company law. The quantity, quality and frequency of financial and managerial disclosure, the extent to which the board of directors exercise their fiduciary responsibilities towards shareholders, the quality of information that the management share with their boards, and the commitment to run transparent companies that maximise long term shareholder value cannot be legislated at any level of detail. Instead, these evolve due to the catalytic role played by the more progressive elements within the corporate sector and enhance corporate law.
A minimal definition
Corporate governance deals with laws, procedures, practices and implicit rules that determine a companys ability to take managerial decisions vis-a-vis its claimants- in particular, its shareholders, creditors, the state and employees. There is a global consensus about the objective of `good corporate governance: maximising long-term shareholder value. Since shareholders are residual claimants, this objective follows from a premise that, in well performing capital and financial markets, whatever maximises shareholder value must necessarily maximise corporate value, and best satisfy the claims of creditors, employees and the state.
For a corporate governance code to have real meaning, it must first focus on listed companies. These are financed largely by public money (be it equity or debt) and, hence, need to follow codes that make them more accountable and value-oriented to their investing public. There is a diversity of opinion regarding beneficiaries of corporate governance. The Anglo-American system tends to focus on shareholders and various classes of creditors. Continental Europe, Japan and South Korea believe that companies should also discharge their obligations towards employees, local communities, suppliers, ancillary units, and so on. In the first instance, it is useful to limit the claimants to shareholders and various types of creditors. There are two reasons for this preference.
The corpus of Indian labour laws are strong enough to protect the interest of workers in the organised sector, and employees as well as trade unions are well aware of their legal rights. In contrast, there is very little in terms of the implementation of law and of corporate practices that protects the rights of creditors and shareholders.
There is much to recommend in law, procedures and practices to make companies more attuned to the needs of properly servicing debt and equity. If most companies in India appreciate the importance of creditors and shareholders, then we will have come a long way. Irrespective of differences between various forms of corporate governance, all recognise that good practices must - at the very least satisfy two sets of claimants: creditors and shareholders. In the developed world, company managers must perform to satisfy creditors dues because of the disciplining device of debt, which carries with it the credible threat of management change via bankruptcy. Analogously, managers have to look after the right of shareholders to dividends and capital gains because if they do not do so over time, they face the real risk of takeover. An economic and legal environment that puts a brake on the threat of bankruptcy and prevents takeovers is a recipe for systematic corporate mis governance.
Board of directors
The key to good corporate governance is a well functioning board of directors. The board should have a core group of excellent, professionally acclaimed non-executive directors who understand their dual role: of appreciating the issues put forward by management, and of honestly discharging their fiduciary responsibilities towards the companys shareholders as well as creditors.
Recommendation I: There is no need to adopt the German system of two-tier boards to ensure desirable corporate governance. A single board, if it performs well, can maximise long-term shareholder value just as well as a two or multi-tiered board. Conversely, there is nothing to suggest that a two-tier board, per se, is the panacea to all corporate problems.
However, the full board should meet a minimum of six times a year, preferably at an interval of two months, and each meeting should have agenda items that require at least half a days discussion.
It has been proved time and again in the US, Great Britain, Germany and many other OECD countries that the quality of the board - and, hence, corporate governance - improves with the induction of outside professionals as non-executive directors. As a recent article put it:
Obviously not all well governed companies do well in the market place. Nor do the badly governed ones always sink. But even the best performers risk stumbling some day if they lack strong and independent boards of directors.
-Business Week, November 25, 1996. 84
Securing the services of good, professionally competent, independent no-executive directors does not necessarily require the institutionalising of nomination committees or search committees. However, it does require a code that specifies a minimal thumb-rule. This leads to the second recommendation.
Recommendation II: Any listed companies with a turnover of Rs 100 crore and above should have professionally competent and acclaimed non-executive directors, who should constitute
at least 30 per cent of the board if the chairman of the company is a non-executive director, or
at least 50 per cent of the board if the chairman and managing director is the same person.
Getting the right type of professionals on the board is only one way of ensuring diligence. It has to be buttressed by the concept of limitation: one cannot hold non-executive directorships in a plethora of companies, and yet be expected to discharge ones obligations and duties. This yields the third recommendation.
Recommendation III: No single person should hold directorships in more than 10 companies. This ceiling excludes directorships in subsidiaries (where the group has over 50 per cent equity stake) or associate companies (where the group has over 25 per cent but no more than 50 per cent equity stake).
As of now, section 275 of the Companies Act allows a person to hold up to 20 directorships. The Report of the Working Group on the Companies Act (February 1997) has kept the number unchanged. It is extremely difficult -almost inconceivable - for someone to hold 20 directorships and yet discharge his fiduciary responsibilities towards all. In this context, it is useful to give the trend in the USA. According to a recent survey of over 1,000 directors and chairmen of US corporations, the directors themselves felt that no one should serve on more than an average of 2.6 Boards. On 12 November 1996, a special panel of 30 corporate governance experts co-opted by the National Association of Corporate Directors of the USA recommended that Senior executives should sit on no more than 3 boards, including their own. Retired executives and professional non-executive directors should serve on no more than 6.
Recommendation IV: For non-executive directors to play an important role in maximising long-term shareholder value, they need to
Become active participants in boards, not passive advisors;
Have clearly defined responsibilities within the board; and
Know how to read a balance sheet, profit and loss account, cash flow statements and financial ratios and have some knowledge of various company laws. This, of course, excludes those who are invited to join boards as experts in other fields such as science and technology.
This brings one to remuneration of non-executive directors. At present, most non-executive directors. At present, most non-executive directors receive a sitting fee which cannot exceed Rs 2,000 per meeting. The Working Group on the Companies Act has recommended that this limit should be raised to Rs 5,000. Although this is better than Rs 2,000, it is hardly sufficient to induce serious effort by the non-executive directors.
Recommendation V: To secure better effort from non-executive directors, companies should:
Pay a commission over and above the sitting fees for the use of the professional inputs. The present commission of 1 per cent of net profits (if the company has a managing director), or 3 per cent (if there is no managing director) is sufficient.
Consider offering stock options, so as to relate rewards to performance. Commissions are rewards on current profits. Stock options are rewards contingent upon future appreciation of corporate value. An appropriate mix of the two can align a non-executive director towards keeping an eye on short-term profits as well as longer term shareholder value. The above recommendation can be easily achieved without the necessity of any formalised remuneration committee of the board. To ensure that non-executive directors properly discharge their fiduciary obligations, it is, however, necessary to give a record of their attendance to the shareholders.
Recommendation VI: While re-appointing members of the board, companies should give the attendance record of the concerned directors. If a director has not been present (absent with or without leave) for 50 per cent or more meetings, then this should be explicitly stated in the resolution that is put to vote. As a general practice, one should not re-appoint any non-executive director who has not had the time to attend even one half of the meetings.
It is important to recognise that, under usual circumstances, non-executive directors suffer from informational asymmetry. Simply put, the extent to which non-executive directors can play their role is determined by the quality of disclosures that are made by the management to the board. In the interest of good governance, certain key information must be placed before the board, and must form part of the agenda papers.
Recommendation VII: Key information that must be reported to, and placed before, the board must contain:
Annual operating plans and budgets, together with up-dated long term plans.
Capital budgets, manpower and overhead budgets.
Quarterly results for the company as a whole and its operating divisions or business segments.
Internal audit reports, including case of theft and dishonesty of a material nature.
Show cause, demand and prosecution notices received from revenue authorities which are considered to be materially important. (Material nature is any exposure that exceeds 1 percent of the companys net worth).
Fatal or serious accidents, dangerous occurrences, and any effluent or pollution problems.
Default in payment of interest or non-payment of the principal on any public deposit, and/or to any secured creditor or FI.
Defaults such as non-payment of inter-corporate deposits by or to the company, or materially substantial non-payment for goods sold by the company.
Any issue which involves possible public or product liability claims of a substantial nature, including any judgment or order which may have either passed strictures on the conduct of the company, or taken an adverse view regarding another enterprise that can have negative implications for the company.
Details of any joint venture or collaboration agreement.
Transactions that involve substantial payment towards goodwill, brand equity, or intellectual property.
Recruitment and remuneration of senior officers just below the board level, including appointment or removal of the Chief Financial Officer and the company secretary.
Recruitment and remuneration of senior officers just below the board level, including appointment or removal of the Chief Financial Officer and the Company Secretary.
Labour problems and their proposed solutions.
Quarterly details of foreign exchange exposure and the steps taken by management to limit the risks of adverse exchange rate movement, if material.
The Report of the Working Group on the Companies Act was in favour of Audit Committees, but recommended that these be set up voluntarily with the industry associations playing a catalytic role [p.23]. The Group felt that legislating in favour of Audit Committees would be counter-productive, and could lead to a situation where such committees would be often constituted to meet the letter - and not the spirit- of the law. Nevertheless, there is a clear need for Audit Committees, which yields the next recommendation.
Recommendation VIII:
Listed companies with either a turnover of over Rs 100 crore or a paid-up capital of Rs 20 crorewhichever is less should set up Audit Committees within tow years.
Audit Committees should consist of at least three members, all drawn from a companys non-executive directors, who should have adequate knowledge of finance, accounts and basic elements of company law.
To be effective, members of Audit Committees must be willing to spend more time on the companys work vis-a-vis other non-executive directors.
Audit Committees should assist the board in fulfilling its relating to corporate accounting and reporting practices, financial and accounting controls, and financial statements and proposals that accompany the public issue of any security- and thus provide effective supervision of the financial reporting process.
Audit Committees should periodically interact with the statutory auditors and the internal auditors to ascertain the quality and veracity of the companys accounts as well as the capability of the auditors themselves.
For Audit Committees to discharge their fiduciary responsibilities with due diligence, it must be incumbent upon management to ensure that members of the committee have full access to financial data of the company, its subsidiary and associated companies, including data on contingent liabilities, debt exposure, current liabilities, loans and investments.
By the fiscal year 1998-99, listed companies satisfying criterion (1) should have in place a strong in place a strong internal audit department, or an external auditor to do internal audits; without this, any Audit Committee will be toothless.
Why should the management of most Indian companies bother about giving such information to their Audit Committees? The answer is straightforward. Over time, they will have to, for there will be a clear-cut signalling effect. Better companies will choose professional non-executive directors and form independent Audit Committees. Others will either have to follow suit, or get branded as the corporate laggards. Moreover, once there is an established correlation between Audit Committees on the one hand, and the quality of financial disclosure on the other, investors will vote with their feet. The last two years have seen domestic investors escape from equity in favour of debt, particularly bonds issued by public financial institutions. If the corporate sector wants to create a comeback for equity, it can only do so through greater transparency. Audit Committees ensure long term goodwill through transparency.
Desirable disclosure
Our corporate disclosure norms are inadequate. With the growth of the financial press and equity researchers, the days of having opaque accounting standards and disclosures are rapidly coming to an end. As a country which wishes to be a global player, we cannot hope to tap the GDR market with inadequate financial disclosures; it will not be credible to present one set of accounts to investors in New York and Washington DC, and a completely different one to the shareholders in Mumbai and Chennai. So, what is the minimum level of disclosure that Indian companies ought to be aiming for ?
The working Group on the Companies Act have recommended many financial as well as non-financial disclosures. It is worth recapitulating the more important ones.
Non-financial disclosures recommended by the working group on the Companies Act:
Comprehensive report on the relatives of directors either as employees or Board membersto be an integral part of the Directors Report of all public limited companies.
Companies have to maintain a register which discloses interests of directors in any contract or arrangement of company. The existence of such a register and the fact that it open for inspection by any shareholder of the company should be explicitly stated in the notice of the AGM of all public limited companies.
Similarly, the existence of the directors shareholding register and the fact that it can be inspected by members in any AGM should be explicitly stated in the notice of the AGM of all public ltd companies.
Details of loans to directors should be disclosed as an annex to the Directors Report in addition to being a part of the schedules of the financial statements. Moreover, such loans should be limited to only three categorieshousing, medical assistance, and education for family members and be available only to full time directors. The loans should not exceed five times the annual remuneration of the whole time director, and would need shareholders approval in a general meeting.
Appointment of sole selling agents for India will require prior approval of a special resolution in a general meeting of shareholders. The board may approve the appointment of sole selling agents in foreign markets, but the information must be divulged to shareholders as a part of the Directors Report accompanying the annual audited accounts. In either case, if the sole selling agent is related to any director or director having interest, this fact has to not only be stated in the special resolution but also divulged as a separate item in the Directors Report.
Subject to certain exceptions, there should be a Secretarial Compliance Certificate forming a part of the Annual Returns that is filed with the Registrar of Companies which would certify, in prescribed format, that the secretarial requirements under the Companies Act have been adhered to.
Financial disclosures recommended by the working group on the Companies Act.
A tabular form containing details of each directors remuneration and commission should form a part of the Directors Report, in addition to the usual practice of having it is a note to the profit and loss account.
Costs incurred, if any, in using the services of a Group Resources Company must be clearly and separately disclosed in the financial statement of the user company.
A listed public limited company must give certain key information on its divisions of business segments as a part of the Directors Report in the Annual Report. This should encompass (i) the share in total turnover, (ii) review of operations during the year in question, (iii) market conditions, and (iv) future prospects. For the present, the cut-off may be 10% of total turnover.
Where a company has raised funds from the public by issuing shares, debentures or other securities, it would have to give a separate statement showing the end-use of such funds, namely: how much was raised versus the stated and actual project cost; how much has been utilised in the project up to the end of the financial year; and where are the residual funds, if any, invested and in what form. This disclosure would be in the balance sheet of the company as a separate note forming a part of accounts.
The disclosure on debt exposure of the company should be strengthened.
In addition to the present level of disclosure on foreign exchange earnings and outflow, there should also be a note containing separate data on of foreign currency transactions that are germane in todays context:(i) foreign holding in the share capital of the company, and (ii) loans, debentures, or other securities raised by the company in foreign exchange.
There are often differences in assets and liabilities between the end of the financial year and the date on which the board approves the balance sheet and profit and loss account. These disclosures and profit and loss account. These disclosures appear in the Directors Report. In addition, such differences should be clearly stated under the relevant sub-heads, and presented as a note forming a part of the accounts.
If any fixed asset acquired through or given out on lease is not reported under appropriate sub-heads, then full disclosure would need to be made as a note to the balance sheet. This should give details of the type of asset, its total value, and the future obligations of the company under the lease agreement.
Any inappropriate treatment of an item in the balance sheet or profit and loss account should not be allowed to be explained away either through disclosure of accounting policies or via notes forming a part of accounts.
The threshold remuneration of those employees whose details have to divulged under section 217(2A) should be raised to Rs 5 lakh per year, and this disclosure of Companies and not form a part of the Directors Report. The statement should be made available for inspection of shareholders at the AGM. However, if there are any directors relatives who receive remuneration, full details of such cases should be given.
While the disclosures recommended by the Working Group in its report as well as in the modified Schedule VI that would accompany the Draft Bill go far beyond existing levels, more needs to be done outside the framework of law, particularly (i) a model of voluntary disclosure in the current context, and (ii) consolidation of accounts.
All other things being equal, greater the quality of disclosure, the more loyal are a companys shareholders. Besides, there is something very inequitable about of present disclosure standards: we have one norm for the foreigners when we go in for GDRs or private placement with foreign portfolio investors, and a very different one for our more loyal Indian shareholders. This should not continue. The suggestions given below partly rectify this imbalance.
Recommendation IX: Under Additional Shareholders Information, listed public companies should give data on:
High and low monthly averages of share prices in all the Stock Exchanges where the company is listed for the reporting year.
Statement on value added, which is total income minus the cost of all inputs and administrative expenses.
Greater detail on business segments or divisions, up to 5% of turnover, giving share in sales revenue, share in contribution, review of operations, analysis of markets and future prospects.
The Working Group on the Companies Act has recommended that consolidation should be optional, not mandatory. There were two reasons: (i) first, that the Income Tax Department does not accept the concept of group accounts for tax purposes and the Report of the Working Group on the Income Tax Act does not suggest any difference, and (ii) the public sector term lending institutions do not allow leveraging on the basis of group assets. Thus:
Recommendation X:
Consolidation of group acco- unts should be optional and subject to:
the FIs allowing companies to leverage on the basis of the groups assets, and
the Income Tax Department using the group concept in assessing corporate Income Tax.
If a company chooses to voluntarily consolidate, it should not be necessary to annex the accounts of its subsidiary companies under section 212 of the Companies Act.
However, if a company consolidates, then the minimal definition of group should include the parent company and its subsidiaries (where the reporting company owns over 50% of voting stake)
One of the most appealing features of the Cadbury Committee Report (Committee on the Financial Aspects of Corporate Governance) is the Compliance Certificate that has to accompany the annual reports of all companies listed in the London Stock Exchange. This alone has created a far more healthy milieu for corporate governance despite the cosy, club-like atmosphere of British board-rooms. it is essential that a variant of this be adopted in India.
Recommendation XI: Major Indian Stock Exchanges should gradually insist upon a compliance certificate, signed by the CEO and the CFO, which clearly states that :
The management is responsible for the preparation, integrity and fair presentation of the financial statements and other information in the Annual Report, and which also suggest that the company will continue in business in the course of the following year.
The accounting policies and principles conform to standard practice, and where they do not, full disclosure has been made of any material departures.
The board has overseen the companys system of internal accounting and administrative controls systems either through its Audit Committee (for companies with a turnover of Rs.100 crores or paid up Capital of Rs 20 crore, whichever is less) or directly.
As mentioned earlier, there is something inequitable about a company declaring disclosing sub-stantially more for its GDR issue compared to its domestic issue. This treats Indian shareholders as if they are children of a lesser God.
Recommendation XII: For all companies with paid-up capital of Rs 20 crore or more, the quality and quantity of disclosure that accompanies a GDR issue should be the norm for any domestic issue.
Capital market issues
Since take-over is immediately associated with raider, it is considered an unethical act of corporate hostility. The bulk of historical evidence shows otherwise. Growth of industry and business in most developed economies have been aided and accompanied by take-overs, mergers and strategic acquisitions.
International data shows that takeovers usually serve three purposes:
