The author would like to acknowledge the contributions of
Vaibhav Parikh, Janak Pandya and Parveen Nagree
While the concept of corporate governance has been around for a
considerable period of time, the maturing of the concept has been
seen only in the last decade. This was inevitable given the
fundamental link of corporate governance to issues of corporate
theory and corporate responsibility, transparency in corporate
decision-making, a practical revolution in business organizational
studies and an increasing focus on wealth maximization. In India,
corporate governance has been implemented through provisions of the
Companies Act, 1956 ("Companies Act"), recent amendments to the
listing agreements ("Listing Agreement Amendments") companies enter
into with stock exchanges and miscellaneous regulations prescribed
by the Securities and Exchange Board of India ("SEBI"). At the very
outset, it must be pointed out that the Listing Agreement
Amendments were based on recommendations of the Kumaramangalam
Birla Committee, an independent committee appointed by SEBI.
Corporate governance in India
The corporate governance in India for listed entities can be
examined under through the following broad headsaspects:
- emphasis on disclosure requirements;
- improving the quality of the board of directors;
- responsibility of the board of directors; and
- shareholder meetings.
It may be mentioned that many of these requirements are also
applicable to unlisted companies.
Emphasis on disclosure requirements
Disclosure requirements (for companies making an offer to the
public) are set out in detail in the Companies Act and guidelines
prescribed by SEBI. Mis-statements in a prospectus or offer
document could have civil as well as criminal consequences for the
directors and promoters. Continuous and ongoing disclosure by
publicly traded companies is mandatory through the following:
- publication of an annual report that would include a report
by the directors;
- detailed report on corporate governance that would form
part of the annual report; and
- management and discussion analysis report, which would need
to include details on the industry structure and developments,
risks and concerns, segment wise and product wise performance,
internal control systems and their adequacy etc. Incidentally,
management would include the chief executive of the company,
the executive directors and the key managers of the
company.
Improving the quality of the board of directors
In order to ensure quality of the board of directors, the
following norms have been stipulated:
- directors are ordinarily appointed by a majority of the
shareholders in general meeting and can be removed by the
shareholders in general meeting;
- not less than half of the directors of the company should
be non-executive directors, i.e directors not in the employment
of the company;
- companies with an executive chairperson need at least half
the board to be composed of independent directors; otherwise
the number of independent directors can be equivalent to
one-third of the board. Independent directors refers to
directors who, apart from their remuneration, have no material
pecuniary relationship with the company, its promoters, its
management, or its subsidiaries, which in the opinion of the
board may affect their independence of judgement;
- the board of directors is to be supplied with the
following: annual operating plans and budgets, capital budgets,
quarterly results, significant impending litigation, fatal or
serious accidents, dangerous occurrences, material effluents or
pollution problems, material defaults in financial obligations
to and from the company, product liability claims, significant
labour problems, intellectual property issues, details of
mergers and acquisitions, joint ventures and certain
investments;
- issues of non-compliance with any regulatory or statutory
issues have to be brought to the notice of the board of
directors;
- directors are prohibited from membership of more than 10
committees or from being the chairperson of more than 5
committees across all companies in which they are
directors;
- sellf-regulation through the appointment of an audit
committee of the board with a minimum of three members, all
being non-executive with the majority being independent
directors. The functions of the audit committee include:
oversight of the company's financial reporting process and the
disclosure of its financial information to ensure that the
financial statement are correct, sufficient, and credible;
recommending the appointment and removal of the statutory
auditor of the company; reviewing with management the financial
statements of the company prior to submission to the board;
reviewing the internal audit function; review of the findings
of the statutory auditor; pre-audit and post-audit discussions
with the statutory auditor; review of the company's financial
and risk management policies etc; and
- recommendation that companies regulate themselves by
appointing a remuneration committee and a shareholders'
grievance committee.
Responsibility of the board of directors
In exercising their powers on behalf of the company, the law
seeks to ensure that the board and management are accountable
through a variety of mechanisms:
- sensitive corporate transactions need shareholder approval
(through the passing of either ordinary resolutions or special
resolutions). Other important corporate decisions can be taken
only at full meetings of the board of directors;
- related-party transactions are regulated and require board
consent. Directors who are interested need to disclose their
interest and refrain from participating in the board
deliberations. Materially significant related- party
transactions need to be disclosed in the report on corporate
governance;
- regulations prohibiting insider trading and fraudulent
& unfair trade practices in the context of the securities
market;
- regulations with respect to market control mechanisms and
takeovers;
- remuneration details and employment terms of executive
directors need to be disclosed in the report on corporate
governance. Similarly, pecuniary relationships or transactions
of non-executive directors need to be disclosed;
- detailed provisions with respect to the criminal
responsibility of directors and top management exist in various
statutes;
- a mandatory director's responsibility statement with
respect to accounts needs to be provided;
- directors are cast with fiduciary responsibilities towards
the company and include: potential liability for breach of
trust; the duty to act honestly and exercise such degree of
skill and diligence as would amount to reasonable care, which
an ordinary man person would be expected to take; the duty to
disclose any personal interests of potential conflicts of
interest and the duty not to complete with the company;
and
- statutorily conferred remedies, which give shareholders
appropriate remedies with respect to minority protection and
mis-management of the company.
Shareholder meetings
A number of provisions pertaining to corporate governance at the
shareholder level exist:
- the implementation of many business decisions needs
shareholder consent through the holding of shareholder
meetings;
- some of these decisions can be passed by ordinary
resolutions (majority vote) while others require special
resolutions (three-fourths majority);
- the Companies Act was recently amended, making it
obligatory for companies to seek shareholder consent through
postal ballot for certain critical issues; and
- companies are required to hold an annual general meeting,
though additional meetings known as extraordinary general
meetings can also be held.
Corporate ecology: beyond corporate governance
India's attempts to introduce corporate governance systems have
partly been a catch-up exercise with other countries. However, it
is obvious that further steps need to be taken. The government's
Department of Company Affairs, appointed a study group to examine
how to operationalise the concept of corporate governance on a
sustained basis, to sharpen India's global competitive edge and to
further develop its corporate culture in the country. A task force
of the study group submitted a report entitled Corporate Excellence
through Governance ("Corporate Excellence Report").
Clearly, there exists an opportunity for India to make a
contribution in the development of corporate governance norms –
through the development of corporate ecology norms. Ecology in a
company, as in the ecosystem, refers to the pattern of relations
between the various parts/organisms that form the whole ecosystem.
Corporate ecology consequently would refer to the pattern of
relations between the "organisms" forming part of the company. From
the a legal standpoint, there are several practical steps that can
go a long way in contributing to this effort in making a company
ecologically sound. The importance of the corporate ecology can
best be understood through an examination of three broad
contributions India can make to the global debate on corporate
governance. These contributions are examined under the following
heads:
- Beyond Shareholder Value
- Beyond Procedural Corporate Governance
- Beyond Law and Regulation
Beyond shareholder value
The single most important issue in corporate governance
literature has been the question: "To whom are the directors of a
company responsible?" Indian law is consistent with the
multi-stakeholder model, rather than the shareholder primacy model.
The multi-stakeholder model examines the relationships between the
company and its dominant shareholders, small investors, employees,
creditors, suppliers, customers and the public at large. It also
examines the relationships between these stakeholders, in effect
articulating a system of accountability on the part of the board of
directors and management in relation to each of the stakeholders.
The reasons for the inconsistency with the shareholder primacry
model are as follows:
- statutory and regulatory law protects the interest of all
the stakeholders in different ways. For example, within the
"public interest" framework, the legal system protects the
interests of different stakeholders through a variety of
methods. These would include consumer protection statutes,
product liability laws, mechanisms to protect consumers from
manipulation of markets and prices, measures in relation to the
concentration of economic power and monopolization of the
market, food adulteration laws etc. These methods are likely to
be strengthened in the coming years;.
- the Birla Report acknowledged the multi-stakeholder
conception of the company by stating that the fundamental
objective of corporate governance is the enhancement of
long-term shareholder value while simultaneously protecting the
interests of the other stakeholders viz: suppliers, customers,
creditors, bankers, employees, the government and the society
at large;
- the Companies Act has detailed provisions where
governmental and quasi-judicial bodies can intervene to ensure
that the interests of the various stakeholders are taken into
consideration in the management of the company. It must be
added though that these provisions are rarely enforced;
- the Supreme Court has held that the term company would take
into its fold not just the shareholders and employees, but the
public interest as well;
- company law does not obligate directors to do what
shareholders tell them to do. Directors enjoy considerable
freedom from shareholder command and control, except where the
shareholders are in a dominant position and are in control of
the company. On the contrary, directors have the discretion and
freedom to take into consideration the interests of other
stakeholders of the company in their decision-making; and
- some steps have already been taken by the judiciary to
develop a "human rights jurisprudence" within the framework of
corporate India. Companies, for example, are required to set in
place internal systems as recommended by the Supreme Court to
prevent sexual harassment at the workplace.
It is this symbiotic relationship between the various
stakeholders that, which forms the first component of corporate
ecology – a relationship depicted in the Figure 1 below (with some
examples of the legal mechanisms for protecting the interests of
each stakeholder).
|
Multistakeholder
approach
|
|
With examples of protection
mechanisms for each stakeholder
|
 |
The need to balance the interests of different stakeholders
poses the greatest challenge of corporate ecology and needs further
analysis within the Indian context. Examples of the friction
between the various stakeholders already exist in India. Dominant
shareholders, management and creditors have worked together to
reduce the bargaining position of employees. The government has
committed itself to an ambitious agenda of privatizsation of a
number of public sector units, raising the shackles of the trade
unions. At the same time, dominant shareholders, management and
employees are at loggerheads with the right of the financial
institutions (the main creditors) to appoint nominee directors,
albeit for different reasons. The dominant shareholders and
management are opposed to the concept of nominee directors due to a
potential "conflict of interest". In addition, their presence is
thought to restrict the decision-making capacity of the board of
directors. Employees, however, believe that nominee directors have
a responsibility to all the stakeholders as financial institutions
lend public money, – and that nominee directors have failed to
discharge this responsibility.
Beyond procedural corporate governance
The second component of corporate ecology views corporate
governance not as a "procedural issue" (with just a focus on the
appointment of directors, appointment of board committees and
disclosures in an annual report) but as a "substantive issue",
which affects the way companies' function legally. It is important
to consider the impact the legal system has in the development of
good governance practices, in ensuring that corporate governance
finds a place in the organizsational structure and day-to-day
functioning of the company and in board reform.
Consequently, substantive corporate governance would address
itself to issues like risk management, legal compliance and
liability issues. In effect, corporate governance would take within
its fold systems to ensure legal compliance. For example, (as
pointed out earlier) the Listing Agreement Amendments require that
all examples of legal non-compliance must be brought to the notice
of the board. Many Indian statutes cast criminal responsibility on
the directors and management for criminal acts of the company.
Directors and management can defend themselves if they can
establish that they had taken due care or did not have any
knowledge. Since all issues of non-compliance would now be brought
to the notice of the directors, the efficacy of this defence is
compromised, thereby casting a greater responsibility on
directors.
The movement towards substantive corporate governance norms
would require the implementation of some of the recommendations set
out in the Corporate Excellence Report:
- a clear demarcation between the concepts of direction
(which is the responsibility of the board) and management
(which is the responsibility of executive management, including
executive directors). Despite language supporting such a
distinction in the Companies Act, the concepts are often
confused and not perceived as clearly as they ought to be;
- further strengthening of the concept of independent
directors by clearly articulating that they should be free from
any business or other relationship which could materially
interfere with the exercise of their independent judgement,
apart from their fees and shareholding;
- possible introduction of a Governance and Nominations
Committee of the board, charged with the responsibility of
scanning potential candidates for board membership when the
opportunity arises. Only independent directors would be members
of this committee with and would have a clear legal
responsibility of making recommendations in the interests of
the company. This would ensure that directorials appointees
would be free from any sense of false loyalty or obligation and
thus be able to perform their role;
- clear articulation of the rights, responsibilities and
liabilities of directors;
- consideration of the concept of "interested shareholders"
who would be legally bound to abstain from voting on certain
critical resolutions. This proposal would be interesting and
would need further debate in India. Well aware of the
consequences of such a proposal, the Corporate Excellence
Report sets out the need for stalemate provisions in the event
of a vested interest minority overrriding the beneficial
interests of the company;
- listed companies could have shareholder communication
sessions once every year at locations where at least 10% of
shareholders (by number) reside. These meetings would result in
greater communication of company policies and greater
involvement of minority shareholders; and
- annual shareholder meetings should be held in a location
where the largest proportions of shareholders (by numbers) are
resident and not necessarily at the registered office as is
currently the case. Video-conferencing facilities where at
least 5% of shareholders are resident should be put in
place.
Beyond law and regulation
It is no coincidence that some of the companies considered to be
the best managed and with significant market values are those that
have effective corporate governance mechanisms to protect the
interests of all the stakeholders. In this context, the blurring of
the differences between stakeholders has been significant. For
example, the walls between the various stakeholders are being
broken with stakeholders like employees and suppliers becoming
shareholders (through stock option and stock purchase schemes). The
challenge, however, is much greater since corporate governance and
company law itself needs to adapt and change with the changing
nature of business and the corporate world. This need for constant
change is the third dimension of corporate ecology; where
responsiveness to the environment in which the company functions is
essential.
The world has seen a focus on information, communication and
automation technologies – and it is important that companies use
information technology as a tool to minimize risk, manage liability
and ensure transparency. Management and directors would therefore
need to have greater technical insight. Knowledge and human capital
have become the most important factors of production. Capital
markets of around the world are integrated like never before, with
a proliferation of financial instruments and hybrid securities.
Methods of evaluating investment risk and disclosure norms differ
across the world. Institutional investors who who are shareholders,
and could therefore could be viewed as the principals of companies,
are themselves acting as agents for others, leading to significant
conflicts of interests. It is increasingly difficult to evaluate
and measure the quality of work of individuals. All of this
significantly challenges traditional approaches to corporate
governance – a challenge made increasingly difficult by the pace of
change in business organizsational structures and the rejection of
hierarchies in companies.
Similarly important is the global trend towards the creation of
independent specializsed regulators, who in turn have a
responsibility towards the community and to all stakeholders. There
is a proliferation of legislation to protect the interests of
various stakeholders, with different regulators or judicial bodies
looking after the interests of different stakeholders. India is
very much part of this movement towards regulatory structures. For
example, SEBI has a responsibility towards the investor and not
towards corporate India. Consumer courts look after the interests
of consumers. Labour courts look after the interests of the
workforce of companies.
In addition, corporate governance in India would need to take
into account constitutional principles. The Supreme Court has laid
down (in very few cases) guidelines that need to be complied with
and followed by not just the state but also private organisations.
If these developments were to enter the realm of corporate law (a
possibility that cannot be ignored given the activism shown by the
Indian judiciary), the result could be a totally different approach
to corporate governance.
Conclusion
Globally, corporate governance systems have evolved in different
countries based on domestic cultural, business and legal realities.
While there does seem to be a movement towards a convergence in
corporate governance norms, differences persist. These differences
have strong links with the nature of the legal systems (including
domestic regulation) and the markets themselves. Some authors
broadly differentiate between the outsider systems and the insider
systems,. – the former prevailing in countries such as the US and
UK, while the latter been seen in continental Europe and many Asian
countries.
Outsider systems typical in the US and UK are characterizsed by
an active and liquid stock market, separation of ownership and
control, institutional investment looking at the return in the
short and medium term, stringent disclosure norms aimed at ensuring
that investors can make their own informed decisions etc. Insider
systems typical in continental Europe and some Asian countries and
are characterizsed by concentrated ownership or voting power and a
multiplicity of inter-firm relationships and corporate holdings,
greater emphasis on stakeholder issues, institutional investment
based on strong links with the company and so on.
What cannot be denied however, is that both of these systems are
making a contribution in the development of uniform corporate
governance systems worldwide. The increasing globalizsation of
capital markets and the liberalizsation of international trade seem
to be creating an environment in which differences in corporate
governance systems have become less severe. Countries like India
combine features of both the outsider system and the insider
system. Many Indian companies seeking to list themselves abroad
have already felt the difference in approach and the differences in
corporate governance standards and approach, and this has resulted
in improved corporate governance standards incorporating the best
of different systems. Corporate ecology (as a concept beyond
corporate governance) and its ability to integrate practices around
the world could be an excellent framework for the convergence in
corporate governance standards.
Nishith Desai Associates (www.nishithdesai.com)
is a research based multi-disciplinary Indian law firm with
offices at Mumbai and Palo Alto, California. The firm
specialises in corporate, tax and technology laws. The firm has
been awarded 'The Indian Law Firm of the Year 2000' title by
IFLR - Editor
Nishith Desai Associates
93-B Mittal Court
Nariman Point
Mumbai 400 021
India
Tel: +91 22 282 0609
Fax: +91 22 287 5792
Internet:
www.nishithdesai.com