Workshop on Corporate Governance

1
Workshop on Corporate Governance

• Presented at the
• ALB In-House Legal Summit
• October 14, 2004
• Mohit Saraf B.D. Ushir
• (Partner) (Partner)
• Luthra LuthraLaw Offices

2
Framework

• Section I The Need for Corporate Governance
• Section II Conceptualizing Corporate
  Governance
• Section III Evolution of Systems of
  Accountability
• Section IV Director The Fiduciary
• Section V Auditors The Watchful Eye
• Section VI Reinventing Corporate Governance

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Section I The Need for Corporate Governance

• Responsibility to Stakeholders
• Predictability
• Transparency
• Accountability
• Easier access to capital (FII, VCF)
• Efficiency (at the firm level) and Global
  Competitiveness (IPRs)

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Section IIConceptualizing Corporate Governance

• Narrow Definition
• - A set of relationships between the company and
  shareholders, directors and management.
• Broad Definition
• - Going beyond and looking to the implicit and
  explicit relationships of the company with
  employees, creditors, consumers, distributors,
  local communities.

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Conceptualizing Corporate Governance (Contd.)

• OECD Definition
• System by which corporations are directed and
  controlled.
• Spells out the rules / procedures for making
  decisions on corporate affairs.
• Provide the structure through which the company
  objectives are set, and the means of attaining
  those objectives and monitoring performance
• Specifies the distribution of rights and
  responsibilities among different participants in
  the corporation, such as, the board, managers,
  shareholders and other stakeholders
• World Bank Definition
• Corporate governance is about promoting corporate
  fairness, transparency and accountability

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Conceptualizing Corporate Governance (Contd.)

• What constitutes shareholders interest?
  sustainable profitability versus profitability
• Need for external regulation
• FOR
• Conflict of interest b/w Management/Promoters and
  other constituencies
• To protect small investors
• To account for Externalities
• AGAINST
• Risk of excessive policing (time cost of
  compliance)
• Increase costs
• Check the box approach

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Section III Evolution of Systems of
Accountability Indian Initiatives

• In December 1995, CII set up a task force to
  design a voluntary code of corporate governance
• In April 1998, the Desirable Corporate
  Governance A Code, was released
• SEBI set up the Kumar Mangalam Birla Committee in
  1999 to design a mandatory-cum-recommendatory
  code for listed companies (Clause 49)
• DCA set up the Naresh Chandra Committee Report in
  2002. The key recommendation related to financial
  and non-financial disclosures and independent
  auditing and board oversight of management (Draft
  Companies Bill)
• The Narayana Murthy Committee was set up by SEBI
  in 2002 to review clause 49 and suggest measures
  to improve corporate governance standards
  (Proposed Clause 49)

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Developments in the U.S

• ENRON
• Bankruptcy filing in 2001 (largest in US history)
  
• Accounting techniques involving unconsolidated
  partnerships and special purpose entities to
  hide losses from financial statements conceal
  indebtedness.
• Issues regarding independence of auditors,
  provision of non audit services conflict of
  interest
• Independence of directors
• SARBANES OXLEY ACT, 2002 (SOX)
• Signed into law July 30, 2002
• Enhances reporting obligations of public
  companies to prevent securities fraud other
  abuses

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SOX

• Applicable to
• Companies listed or traded in the U.S (including
  non U.S Companies)
• Subsidiaries of U.S Companies in India (provided
  they have a business connection in the U.S)
• Foreign accounting firms that prepare or furnish
  audit report for an issuer
• Sometimes compliance expected by U.S Companies
  from business partners in India (implications for
  BPO sector)

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SOX-Brief Overview

• CEO CFO certification in SEC Reports (Ss 302
  906)
• Compliance with Securities Exchange Act, 1934
• Financial statements represent the true financial
  condition of the Company operations
• Financial results contain no untrue statement
  /omission of material fact
• Company has complied with Disclosure norms
• Management have disclosed significant
  deficiencies, changes, fraud to auditors audit
  committee
• Ban on loans to executive officers and directors
• Accelerated filings of periodic reports
• Filing of change of beneficial ownership within 2
  days

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SOX-Brief Overview (Contd.)

• Reimbursement by CEO/CFO upon restatement of
  financial statements due to misconduct
• Bonus/other incentive based compensation
• Profits from sale of securities
• Independence of Board of Directors/ Committees
• Enhanced Criminal Penalties (upto 5 million fine
  for individuals, 25 million for entities, prison
  terms upto 20 years)
• Strict Reporting of illegal or unethical behavior

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SOX-Brief Overview (Contd.)

• Audit Committee
• Independent
• Financial Literacy of members
• At least one financial expert
• Responsible for appointment, compensation
  oversight of auditor approval of audit/non
  audit services
• Create compliant mechanism regarding accounting
  and auditing
• Approve all related party transactions
• Implementation of a Whistleblower policy

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SOX-Brief Overview (Contd.)

• Additional Disclosures
• Off Balance Sheet Items transactions that may
  have material current/future effect on financial
  condition/results of operations
• Pro forma Information must conform to financials
  prepared under GAAP - No untruth/omission
• All fees billed by auditors in annual report
• Audit Partner Rotation
• Registration with Public Company Accounting
  Oversight Board (including foreign audit firms
  that audit Issuers)

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Major Areas of Debate

• Directors
• Independent Directors
• Audit Committees
• Auditors

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Section IVDirector The Fiduciary

• If directors act within their powers, if they
  act with such care as is reasonably to be
  expected from them, having regard to their
  knowledge and experience, and if they act
  honestly for the benefit of the company they
  represent, they discharge both their equitable as
  well as their legal duty to the company

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WHO DO DIRECTORS OWE A DUTY TO?
SHAREHOLDERS
COMPANY
EMPLOYEES
PUBLIC
CREDITORS
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General Duties of Directors

• Duty of care and skill
• Duty of loyalty disclosure
• Duty of disgorging profit in relation to
  corporate opportunity

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Duty of Care and Skill

• A director or officer has a duty to the
  corporation to perform his functions in good
  faith, and in a manner that he reasonably
  believes to be in the best interest of the
  corporation, and with a care that an ordinary
  prudent person would reasonably be expected to
  exercise in a like position and under similar
  circumstances

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Duty of Care and Skill (Contd.)

• Courts in UK and USA have held that directors in
  banks and financial institutions owe a higher
  degree of care
• The banking industry is involved in regular
  receipt of public cash and property and is thus
  more vulnerable than other businesses and
  therefore a greater care is required
• A director of a company (a bank) that has a large
  amount of liquid assets carries with him higher
  risks and temptation to which such assets give
  rise
• There are more legislative and regulatory
  monitoring and liability provisions pertaining to
  banking companies than any other company and such
  provisions may also extend to the director of the
  bank or financial institution.

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Duty of Care and Skill (Contd.)

• Exercise reasonable care, skill and diligence
• Continuing knowledge of companys business
• Reliance on Co-directors and Power to delegate
  with supervision
• Bona fide and good faith intention

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Duty of Loyalty Disclosure

• Section 299, Companies Act, 1956
• principal is based on the rudiments of law that
  the same person cannot act for himself/herself
  and at the same time, with respect to the same
  matter, act with another whose interests are
  conflicting
• Effect of disclosure
• Disclosure to whom
• How extensive should the disclosure be

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Duty in Relation to Corporate Opportunity

• By occupying a position of trust, a director
  must not make a profit which he can acquire only
  by use of his position and, if he does, he must
  account for the profit so made.

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Corporate Opportunity

• Any profit made by a Director through holding the
  office of such director must be accounted for.
  Therefore, a Director would be held accountable
  for personal profits made from
•  The sale of goods, materials or services earlier
  dealt with by Company for its business
• Forestalling the companys business opportunity
  unless the company has rejected such opportunity
• Requesting the customer to place orders for
  goods, materials and services with another
  company in which he has some interest
• Receiving Commission from another company,
  which has sold goods to the company

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Liabilities of Directors

• Derivative Action
• Statutory Liability
• Contractual Liability
• Tortuous Liability

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Derivative Action

• Resolutions by directors for transferring the
  controlling interest of the company wherein there
  is a complete changeover of the structure to the
  detriment of the company
• Sale of land to oneself at a discounted value
• Directors passing an ordinary resolution where
  the act in question would require a special
  resolution

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Statutory Liability

• Companies Act, 1956 Officers in default
• Banking Regulation Act, 1949
• Insurance Act, 1948
• Pollution Laws
• Income Tax Act, 1961

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DirectorLegal Provisions

• Restrictions on loans to directors or other
  specified entities (s. 295)
• Interest rate shall not be less than 4 above
  prevailing bank rate
• Quantum of loan to not exceed 25 times the gross
  salary
• No default on public deposit by the company
• Boards sanction for contracts in which directors
  are interested (s. 297)
• Consent by way of board resolution
• Prior to the contract or within three months
• Except contract between two public companies
• Prior approval of the central government for a
  contract where the company has paid up share
  capital of not less than Rs 1 crore

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Director Legal Provisions (Contd.)

• Disclosure of interest by directors (s. 299)
• Default ground for vacation under s. 283.
• Interested directors not to participate or vote
  in board proceedings (s. 300)
• Applicable only to public companies
• Maintenance of records of contracts, companies,
  firms in which directors are interested (s. 301)
• to be signed by all the directors present in the
  next board meeting
• kept at registered office and available for
  inspection
• Restriction on directors from holding office of
  profit (s. 314)
• Company can give consent by special resolution
• Does not apply to managing directors

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Issues for Consideration

• Should the directors be educated on the risk
  profile of the company and their duties as a
  director?
• Narayana Murthy Committee Report
• Should there be codified duties and
  responsibilities?
• Should the liability of the non-executive
  directors mirror the liability of the executive
  directors?

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Independent Directors

• No mention in the Companies Act
• Clause 49
• - Optimum combination of executive and
  non-executive directors
• - Not less that fifty per cent being
  non-executive
• - If non executive chairman, at least one third
  of the board should comprise of independent
  directors
• - If executive chairman, at least half of the
  board should comprise of independent directors
• Clause 63, Draft Companies Bill
• Every public company of prescribed paid up
  capital or turnover to have at least seven
  directors of which at least three or fifty
  percent, whichever is higher, to be independent
  directors
• Would include unlisted public companies also

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Who is an Independent Director?

• Independence of judgement
• No material relationship
• No pecuniary relationship

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What is Independence?

• The Cadbury Report defines independence as
• Apart from their directors fees and
  shareholdings, they should be independent of
  management and free from any business or other
  relationship which could materially interfere
  with the exercise of their independent judgement.
  
• Clause 49
• Independent defined as those directors who,
  apart from receiving directors remuneration do
  not have any other material pecuniary
  relationship or transactions with the company,
  its promoters, management or subsidiaries, which
  in the view of the board may affect independence
  of judgment

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What is Independence? (Contd.)

• Clause 2(45), Draft Companies Bill
• Independent Director means a non-executive
  director of a company who apart from receiving
  directors remuneration, does not have any
  material pecuniary relationship or transactions
  of such amount as may be prescribed, with the
  company , its promoters, managing director, whole
  time director, other directors, manager or its
  holding company and its subsidiaries apart from
  possessing such attributes for being treated as
  Independent director as may be prescribed by the
  Central Government from time to time.
• Excessively restrictive?

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Independent Directors

• External expert
• Independent director watchdog?

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Audit Committee

• Clause 49, Listing Agreement
• Minimum three members, all non-executive
  directors
• Majority independent, chairman independent
• At least one director having financial and
  accounting knowledge
• Must have at least three meetings per year

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Audit Committee (Contd.)

• Section 292A, Companies Act
• public companies
• minimum three directors
• two thirds other than managing or whole time
  directors
• no other qualifications prescribed
• recommendations relating to financial management
  binding
• reasons for not accepting any recommendation
• Auditors required to attend the meetings
• Clause 62, Draft Companies Bill
• not less than two independent directors
• no other qualifications prescribed

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Audit Committee (Contd.)

• Proposed Clause 49 (pursuant to N.M. Report)
• At least one member having financial and
  accounting expertise
• All members to be financially literate
• Expanded role- independent judgment
• Focusing on
• Quality of accounting policies
• Alternate accounting policies
• Internal control deficiencies
• Implementation of whistleblower policy

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Audit Committee (Contd.)

• Audit committees- Efficacy?
• Chairman of Enrons audit committee was a
  Stanford professor with 30 years experience in
  auditing and accounts
• Should the members of audit committee be
  financially literate?
• Should the scope of audit committee be decided by
  the Board of Directors?
• Is remuneration of members an issue?

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Section VAuditors The Watchful Eye

• Appointment regulated by the Companies Act
  (s.224)
• Maximum number of companies prescribed (20)
• Qualifications Disqualifications (s. 226)
• Person holding any security of that company (2000
  Amendment)
• Requirement to report on specific matters (s.
  227)
• ICAI Code of Conduct

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Section VAuditors The Watchful Eye

• Duties of Auditor
• Duty of Care (Re Kingston Cotton Mills Co.)
• Reasonable care and skill
• Auditor is the servant of the shareholder and
  whose duty is to examine the affairs of the
  company on their behalf at the end of a year and
  to report to them what he has found.
• The auditor is like a trustee for shareholders.
• Watchdog and not a bloodhound

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Auditors Liability

• Basis of Liability
• Contractual and Fiduciary
• Company
• Shareholders as a body
• Tortuous
• Holding out

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Auditors Liability (Contd.)

• Stage I (Upto 1963)
• Candler v. Crane
• Privity doctrine a third party not in privity
  with the auditor cannot recover damages for
  negligence
• Justice Denning gave a dissenting judgment
• it must be known to the advise42r that the advice
  would be communicated to the plaintiff in order
  to induce him to adopt a particular course of
  action
• the advice must be relied upon for the purpose of
  the particular transaction for which it was known
  to the advisers that the advice was required.
• Stage II (1964-1990)
• Hedley Byrne Co. v. Heller Partners
• Liability for a negligent misstatement made by
  one person to another, even in the absence of any
  contractual or fiduciary relationship causing
  financial loss

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• Caparo Industries Plc v. Dickman
• Stage III (Post 1990)
• Watered down in Caparo Industries case
• The three criteria for the imposition of a duty
  of care are
• foreseeability of damage
• proximity of relationship
• the reasonableness or otherwise of imposing a
  duty
• The auditor of a public company's accounts owed
  no duty
• of care to a member of the public at large, who
  relied on
• the accounts to buy shares in the company.
• An auditor owed no duty of care to an individual
  shareholder in the company who wished to buy more
  shares in the company
• The purpose for which accounts are prepared and
  audited is to enable the shareholders as a body
  to exercise informed control of the company

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Caparo Industries Plc v. Dickman

• Cadbury Committee on Caparo Industries
• the case exposed two widely held misconceptions
• audit report is a guarantee to the accuracy of
  the accounts, and perhaps even as to the
  soundness of the company
• that anyone (including investors and creditors)
  can rely on the audit, not only in a general
  sense but also very specifically by being able to
  sue the auditors if they are negligent
• In light of Enron is there a need to re-examine
  the issue of auditors liability as set out in
  the Caparo Industries case?

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Issues for Consideration

• Should statute set out the liability?
• Should breach of care be extended to any other
  group?
• Whether rules for auditors liability need to be
  codified and made stricter?
• Recommendations of Naresh Chandra Committee
  Report
• Should Audit committees evaluate independence of
  auditors?

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Similarities between US position Indian
Proposals

• SOX
• CEO/CFO Certification
• Reimbursement for misstatement
• Ban on loans to directors
• Code of Conduct/Ethics
• Independent Board/ Committee
• Disclosure of Off Balance Sheet/transactions that
  may have future impact

• Narayana Murthy Committee
• CEO/CFO Certification
• Reimbursement for misstatement
• Restriction on loan to directors
• Written/Public Code of Conduct
• Independent Board of Directors
• More limited disclosures-but left open for
  consideration

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Comparison between US Indian Position

• SOX
• Audit Partner Rotation
• Audit Committee
• Financial Literacy
• One financial expert
• Oversee auditor
• Approve related party transactions
• Whistleblowers policy

• Narayana Murthy Committee
• Audit Partner Rotation
• Audit Committee
• Financial Literacy
• One financial expert
• Oversee auditor
• Approve related party transactions
• Whistleblowers policy

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Proposed Amendments

• Proposed amendments to clause 49 and Draft
  Companies Bill address major issues
• Appointment of a Chief Accounting Officer by a
  Company
• Definition of related party transactions expanded
  and specific approval requirements introduced
• Disclosure of all contingent liabilities
• Timely communication of Risk Management
  activities
• CEO/ CFO certification requirements

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Section VIReinventing Corporate Governance in
India

• Super regulator v. Multiple regulators?
• - Efficiency
• - Cost of Compliance
• Transparency by the regulators?
• - Late trading and market timing investigations
• Enforcement by stock exchanges?

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Reinventing Corporate Governance in India (Contd.)

• Disclosure of voting agreements which impact
  governance of companies?
• Pro-active role by institutional investors?
• Mandatory Corporate Governance Ratings?
• - Will it lead to better corporate governance?

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Reinventing Corporate Governance in India (Contd.)

• How can whistle blowers be encouraged?
• - Narayana Murthy Report
• - Immunity for whistleblowers?
• Directors officers liability insurance?

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Conclusion

• Good corporate governance means to the end of
  sustainable wealth creation
• The positive side of adherence to most rigorous
  standards in governance for corporations
• Increased importance of corporate governance as
  an investment criteria among large investors
• Improved Equity Price Performance
• Higher Valuations
• Access to global markets
• Increased investor goodwill confidence
• Balance between enterprise and constraints

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