Post Satyam : Corportae Governance Structure in India

“Reputation is an idle and most false imposition: oft got without merit, and lost without deserving.[1]” Failed institutions, including Lehman Brothers, Enron, and Satyam, would stand a testimony to this fracas in a post-mortem analysis.

Corporate governance is perhaps the toughest part of corporate handling. It requires an ideal control system which can regulate both motivation and ability. At one end of the spectrum are the shareholders as owners of the business entity since they provide the ultimate risk capital. At the other end are the “managers” or the “executive directors” of the company who are in control of its day-to-day affairs. As the elected representatives of the shareholders it is the collective responsibility of the board of directors to direct operations of the company in a manner that is best suited to the interests of the company. As the owners of business, the shareholders are expected to monitor and evaluate operations of the company as well as the performance of the entire board of directors and in particular the effectiveness of the full time or executive directors.[2]

Corporate governance mechanisms differ between different countries. The governance mechanism in each country is shaped by its political, economic and social history. The governance practices adopted in any country reflect the national ethos and value systems adopted in that country over a long period of time.[3] In most of the countries the corporate form of organization did not evolve and emerge through a natural business process. Hence different countries have assimilated it their own way. The predominant form of corporate governance in India is much closer to the East Asian “insider” model where the promoters dominate governance in every possible way. A distinguishing feature of the Indian diaspora is the implicit acceptance that corporate entities belong to the “founding families” though they are necessarily considered to be their private properties.[4]

 Despite all the differences among shareholders philosophy across different countries in regard to corporate governance mechanisms there is no denying of the fact that good governance is the time need of changing world. While multilateral organizations like World Bank and ADB[5] have shown keen interest in the subject of corporate governance, the intellectual lead has been given by the OECD (Organization for Economic Cooperation and Development) in evolving a set of cogent principles of corporate governance. OECD has come out with a set of clearly defined principles, which it hopes, will be useful to all countries irrespective of their stages of development, legal systems, institutional frameworks and traditions. But roughly there is the requirement of some corporate governance control. It requires two types of corporate governance i.e. internal corporate governance and external corporate governance.

        In September 2008 the World Council for Corporate Governance honored the now-beleaguered Indian outsourcer Satyam with a “Golden Peacock Award” for global excellence in corporate governance. With its honoree now engulfed in scandal, the Council rushed to distance itself from the troubled company by rescinding the award, issuing a press release through the India-based Institute of Directors stating “the award was obtained as a result of non-disclosure of material facts.”

But a closer look at some of the “material facts” which Golden Peacock judges should have known about at the time of the award would have brought to the forefront a company whose governance standards were far from those of a global leader.[6] In fact, in public filings made several weeks prior to the award show, Satyam demonstrated woeful boardroom inadequacies and significant departures from commonly accepted “best practices” in governance. But Satyam won and painted itself in a self-congratulatory light by using Golden Peacock logos and references. Some of the most modest publicly traded companies are following governance practices far more laudable than those of this “global honoree.”[7]  

The great set back in Indian corporate world

Corporate India will never be the same again. What transpired in Satyam computers in January culminating into the historic confession letter of former chairman B. Ramalinga Raju, admitting a fraud of Rs 78 billion has caused the regulators and the investors everywhere to re-examine the corporate governance standards. The multibillion dollar scam is unprecedented and idiosyncratic for more than one reason. The fact that company which was audited by one of the most prestigious audit firms and adopted most advanced accounting and transparent IFRS accounting systems much ahead of time can penetrate such a colossal and a global fraud is clearly eye opening for corporate counsel worldwide. It was triggered with Satyam’s bid to acquire Maytas companies for US$ 1.6 billion.[8] This revealed the self aggrandizing policies of the promoters, which caused severe investor backlash.

While there are adequate levels of checks and balances in the system to prevent frauds, it is the slack attitude of each institution responsible for upholding corporate governance that made such a fraud possible. Unless heavy fines and strict liabilities are provided for, if not in the statute then in the internal code of conduct, each of these institutions, namely the internal audit committee, the independent directors and the external auditors could continue to remain “rubber stamps” approbating all management actions.[9] The Satyam scandal has reiterated the importance of checks on related party transactions.  Stringent checks and balances on these ought to be incorporated into the Indian corporate and securities laws to prevent transactions like Maytas in future. Pending statutory incorporation, companies can incorporate adequate checks and balances in their code of conduct as a measure of ensuring good corporate governance.  It is natural to expect an enhanced level of security of the financial and governance aspects of Indian companies, and to a lesser extent, any Asian-based companies. The role of corporate counsel will assume added pressures, with a higher emphasis on preventing frauds.

           In the area of securities regulation, SEBI has made numerous changes in recent years including: revising and strengthening Clause 49 in relation to independent directors and audit committees; revising Clause 41 of the Listing Agreement on interim and annual financial results; and amending other listing rules to protect the interests of minority shareholders, for example in mergers and acquisitions. SEBI brought out new rules in February 2009 requiring greater disclosure by promoters (i.e., controlling shareholders) of their shareholdings and any pledging of shares to third parties. And in November 2009 it announced it would be making some further changes to the Listing Agreement, including requiring listed companies to produce half yearly balance sheets.  More recently, in December 2009, the Ministry of Corporate Affairs (MCA) published a new set of “Corporate Governance Voluntary Guidelines 2009”, designed to encourage companies to adopt better practices in the running of boards and board committees, the appointment and rotation of external auditors, and creating a whistle blowing mechanism.[10]

             In the current corporate governance practices it is required to focus on particular corporate governance mechanisms.  There are two types of mechanism that resolve the conflicts among different corporate claim-holders, especially, the conflicts between owners and managers, and those between controlling shareholders and minority shareholders. The first type consists of various internal variables, e.g. (1) the ownership structure, (2) board of directors (3) executive compensation and (4) financial disclosure.[11] The second includes external mechanism with variables, e.g. (1) effective takeover market, (2) legal infrastructure and (3) product market competition.  “Good corporate governance practices are a sine qua non for sustainable business that aims at generating long term value to all its shareholders and other stakeholders”.[12]

A more comprehensive review of corporate governance regulation and practices is required in India. While the new “Voluntary Guidelines 2009” provide helpful and detailed guidance to companies interested in developing a more effective board of directors yet  lot of issues remain unattained ad unanswered. Nor will the new Companies Bill resolve these challenges.

Independent Directors

Nomination committee can be advisably established comprising solely of independent directors or a majority of independent directors empowered to appoint the board and evaluate its performance. Although evaluation of performance is not yet mandatory under the extent of corporate governance regime yet it might yield a better result and in further coarse of time it should be made compulsory.

There should be a fixed tenure beyond which an independent director should not be associated with a company.  An aggregate limit of nine years has been prescribed under clause 49 VII (ii) of the equity listing agreement, but such a requirement is not mandatory.[13]

Regarding the remuneration of the independent directors the pecuniary payouts are usually incommensurate with the onerous role they perform. Adequate remuneration may ensure that the directors discharge their duty with care and diligence rather than just playing an ornamental role in the organization.  Another step that might ensure a better working is that the independent directors should meet separately without any member in the management to discuss the affairs of the company. This would help them to make decisions on matters without being euphemistically ‘guided’ by the management.[14]

Limit on number of Directorships: In case an individual is a managing or whole-time director in a listed company, the number of companies at which such an individual can serve as non-executive director, be restricted to 10, and the number of listed companies at which such an individual can serve as a non-executive director, be restricted to 2. The maximum number of listed companies in which an individual can serve as a director is to be restricted to 7.[15]

Separation of roles of Chairman and CEO: There should be a clear demarcation of the roles and responsibilities of the Chairman of the Board and that of the Managing Director/ CEO. The Roles of Chairman and CEO should be separated to promote balance of power. A “comply or explain” approach should be adopted.[16]

 

 

Auditors

Compulsory rotation of auditors: Though there are views that periodic rotation of the audit firm may be enough to break the collusive links between the company and the auditors, The alternatives to rotation are joint audit, rotating of managing partners, harsh penalties for collusion and regulation will make it difficult for the companies to sack the auditors who insist on qualifying fudged accounts. SEBI released on September 14, 2009 on proposed changes to the Listing Agreement, one of the reforms suggested was the rotation of either audit firms or audit partners as a way to enhance their independence from clients.[17] SEBI felt that the independence of auditors should be reviewed because, as it said in its discussion paper: “The quality of financials reported by companies and the true and fair view of the financial statements submitted by listed entities to the stock exchanges have, of late, come into sharp focus.”[18]  Moreover, in India, there is no supervisory structure like the PCAOB[19] in US which is an independent body which supervises the audit of public firms…. a similar structure should be mandated for Indian audits.[20]

Secretarial Audit: Secretarial Audit should be made mandatory in respect of listed companies and certain other companies. The report on the audit of secretarial records shall be submitted by the secretarial auditor to the Corporate Compliance Committee of the Board of Directors of the company. The Secretarial Audit Report should form part of the Board’s Report.

Risk Management

Companies need to frame a strong risk management framework to systematically manage and regularly review the risk profile at a strategic, operational and functional level. Whistle blowers policy which is ingrained in the model code of conduct of a few corporations in India should be made mandatory for all the listed companies to encourage transparency.[21]

Listed companies must have a nominating/corporate governance committee composed entirely of independent board members. The committee must have a written charter that addresses its purpose and responsibilities, which include (i) identifying qualified individuals to become board member; (ii) selecting, or recommending that the board select, the director nominees for the next annual meeting of shareholders; (iii) developing and recommending to the board a set of corporate governance principles applicable to the company; (iv) overseeing the evaluation of the board and management; and (v) conducting an annual performance evaluation of the committee.[22]

Corporate Compliance Committee to be made mandatory: The constitution of Corporate Compliance Committee should be made mandatory in respect of all public limited companies having a paid-up capital of Rs.5 crores or more.[23]

Directors’ Responsibility Statement to include Statement on Compliances: Directors’ Responsibility Statement should include a statement that proper systems are in place to ensure compliance of all laws applicable to the company.

Constitution of Investor Relations Cell: Constitution of Investor Relations Cell should be made mandatory for Listed Companies. The Investor Relations meet after declaration of financial results should be compulsorily webcast in case of companies having a market capitalization of Rs.1000 Crores or more.[24]

        The Ministry of Corporate Affairs (MCA) based on Satyam fraud investigation has worked out new parameters for scrutiny of companies. In instructions to the Registrar of Companies (RoC), MCA has pointed to ‘cash at bank’ as a vital parameter for scrutiny.[25] Till now, the auditor’s certificate was sufficient. After the Satyam episode, it has been decided that the RoC should not only look at the balance sheet but also check the veracity of the certificates. This could be done either internally or in coordination with other regulators. The RoC will now not only verify cash at bank but also cross-check. In the case of Satyam, which had shown Rs 3,800 crore as cash at bank, the auditors had relied on a bank statement provided by the company. The auditors are required to confirm from the bank to verify the amount. It is important to check this parameter, as it indicates the financial health of the company, based on which company shareholders; analysts and other outsiders make an assessment. 

     Another important criterion for scrutiny is “related party transactions”. These are business transactions done by a company with companies or outfits owned by relatives of the promoters or own subsidiaries.  India’s rules on related-party transactions are sparse. In the Companies Act [26]there are only four sections 295[27], 297[28], 299[29] and 300[30] dealing with related party transaction. Clause 49 makes a number of references to related-party transactions, but all of them are brief and quite general. They contain no requirement for independent shareholder approval of significant transactions, nor much in the way of disclosure and reporting rules. The Bill restricts such transactions only for public companies but broadens the definition of related party to include managers of the company. The approval of shareholders, rather than the government is now required.[31]

         Various counter arguments are made in India against introducing stronger rules on related-party transactions. One is that allowing shareholders to vote on such transactions would interfere with the smooth operation of companies. Another is that since many promoters (i.e., controlling shareholders) have more than 50% of the voting rights in the company, the result of any vote would be a foregone conclusion. These objections miss the point: as rules in other markets show, related-party regulation does not require every single transaction to be voted on—only the largest and most material. Moreover, the second objection is not relevant, since connected shareholders would not be permitted to vote in a meeting of independent shareholders it is not just the voting power that is sought to be a check on related party transactions, when such a transactions require shareholder approval, then the board has to justify it to the shareholders. This is the bigger check. Even though they may have the required voting strength, other shareholders can still ask questions and the board will have to justify the deal. This will force the board not to enter into transactions that will bring it unwanted publicity.

     SEBI only recently published regulations in the Issue of Capital and Disclosure Requirements, 2009, which replaced the Disclosure and Investor Protection Guidelines, 2000. Whereas the earlier regulations made scant reference to related-party transactions (other than the fact that promoters/controlling shareholders should disclose them in their financial reports), the new regulations do devote a paragraph on how related-party transactions should be disclosed according to Accounting Standard 18.[32]

“If more than 50 per cent of business transactions by a company are with related parties, then the balance sheet should be scrutinized and adequate explanations should be sought from its officers. Under this, if a company is using more than half its funds in activities other than the stated objective in the memorandum of association (MoU) given to the registrar of companies, the balance sheet will be examined. These purposes could be loans to subsidiary companies, other companies, and investments in mutual funds or stock market, real estate or in foreign exchange transactions when the company does not have much business with foreign exchange exposure, etc.[33]  A comprehensive regulation of related-party transactions, including giving independent shareholders the powers to approve large transactions above a certain limit and enhancing disclosure requirements on other material transactions. Such regulation could be provided for in both the Listing Agreement and new SEBI regulations or guidelines. An independent financial advisor and an independent board committee should be appointed to determine whether material transactions are fair and reasonable to all shareholders. Independent directors are required to exercise their duties more diligently and protect the interests of minority shareholders, especially in cases where the majority shareholder is also the manager of the company.[34] Some degree of legal liability could be considered for directors in cases such as Satyam. Listed companies with numerous related transactions should set up a related-party transaction committee of their board. This would scrutinize such transactions, recommend to the board if shareholder approval should be sought, advise on disclosure and judge the fairness of transactions.

 

Corporate Disclosure

The scope, depth, timeliness, consistency and formatting of corporate financial disclosure in India could be greatly improved.  Certain reforms are needed to improve the quality and timeliness of corporate disclosure of most listed companies in India. Such reforms would provide investors with more useful information on which to make investment decisions and would strengthen the reputation of the Indian capital market.[35]

 All companies should, in effect, be required to produce audited annual results within three months of the year end and their full annual report within four, or at most five, months of the year end.  The format of quarterly P&L statements is to be reviewed to require additional details regarding revenues. Listed companies are to be encouraged to provide both cash flow statements and balance sheets with their quarterly reports.

 Corp Filing and EDIFAR[36] should be merged into one database, with the structure following the organisation of EDIFAR, but with further thought being given as to how information could be even more easily accessible.

On November 9, 2009, the SEBI Board announced that it would amend the Listing Agreement in relation to three of these issues, namely:

• Allowing the voluntary adoption of IFRS by listed entities with subsidiaries;

• Requiring half yearly disclosure of balance sheets (which must provide audited figures, or   non-audited figures with limited review); and

• Approving some of the new deadlines recommended by SCODA for the submission of financial results. (Namely, a more flexible requirement for the disclosure of quarterly results—45 days after the period end rather than the current 30 days—but a tighter deadline for the disclosure of audited annual results by companies that opt to produce “stand-alone” (i.e., unconsolidated) annual results instead of an unaudited fourth quarter report—reduced from 90 days to 60 days.)[37]

It is not clear, however, when these listing rule changes will take effect. Moreover, the changes to the disclosure deadlines still fail to address the problem of when a company should publish its audited annual results if it chooses to produce an unaudited fourth quarter report.[38]

 

Preferential Warrants

 

The scope for the misuse and abuse of warrants in India is considerable. Regulation of their issuance to promoters needs to be tightened. The issuance of preferential shares, warrants or other securities to promoters and other connected persons must be prohibited (as in other markets), except under the limited circumstances envisaged in markets such as Hong Kong (i.e., where the securities are part of a pro-rata entitlement made available to all shareholders on an equal basis, or as part of a shareholder-approved stock option scheme). [39]

Companies are required to seek shareholder approval at their annual general meetings for the issuance, over the subsequent 12 months, of any new shares at a discount to a limited group of (non-controlling) shareholders. Strict rules should govern the size and discount of such offerings. Listed companies should review the way they use warrants and limit their application to forming part of a wider issue of debt or equity securities (i.e., where warrants act as sweeteners for investors).

 

 

Conclusion
The Satyam incident, though unfortunate, exposed some big loopholes in the system. Just as the United States needed the Enron Scandal to clean up its act, perhaps India needed the Satyam fiasco to introduce sweeping changes in its own financial reporting system. It cannot be denied that the Satyam episode was a stark failure of the code of Corporate Governance in India. Corporate governance refers to an economic, legal and institutional environment that allows companies diversify, grow, restructure and exit, and do everything necessary to maximise long term shareholder value. It is not something which can be enforced by mere legislation; it is a way of life and has to imbibe itself into the very business culture the company operates in. Ultimately, following practices of good governance leads to all round benefits for all the parties concerned. The company’s reputation is boosted, the shareholders and creditors are empowered due to the transparency Corporate Governance brings in, the employees enjoy the improved systems of management and the community at large enjoys the fruits of better economic growth in a responsible way. The loyalty of a typical Indian investor is far greater than his counterparts in the USA or Britain.[40] But, our companies must not make the mistake of taking such loyalty as a given. To nurture and strengthen this loyalty, our companies need to give a clear-cut signal that the words “your company” have real meaning. That requires well functioning boards, greater disclosure, better management practices, and a more open, interactive and dynamic corporate governance environment. Quite simply, shareholders’ and creditors’ support are vital for the survival, growth and competitiveness of India’s companies. Such support requires us to tone up our act today.

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