Corporate Disclosure and Transparency

National Conference On Disclosure, Transparency & Governance

Improving Standards

There is no gainsaying of the importance of corporate governance at a time when stock market interests have clambered up on to a much higher perch as compared to some years ago. In fact, the turmoil in global financial markets can be partly traced to poor corporate governance, with many reputed global financial institutions keeping shareholders in the dark regarding their precise financial standing.

Back home, there is no denying that the Government, share market regulator, SEBI, and corporate India have been pushing themselves hard to raise the bar for corporate governance. But the question is has corporate governance standards have improved to the desired levels.

As well said by Salman khurshid, Ministry of State (I/C) for Corporate Affairs, “The Ministry of Corporate Affairs has been working towards strengthening of the corporate governance framework through a two pronged strategy. Some aspects which needed to be incorporated in the law have been included in the Companies Bill, 2009 now under examination by Parliament. However, keeping in view the objective of encouraging the use of better practices through voluntary adoption, the Ministry has decided to draft a set of voluntary guidelines which not only serve as a benchmark for the corporate sector but also help them in achieving the highest standard of corporate governance.”

What is corporate governance? Broadly, it refers to the set of systems, principles and processes by which a company is governed. It can be defined as the relationship of a company to its shareholders, going beyond just legal compliance.

In other words, corporate governance encompasses a broad spectrum of elements, ranging from the role and powers of the Board, legislation, Board independence, code of conduct to financial and operational reporting, audit committees and risk management.

Pledging Of Shares

More recently, SEBI, in an attempt to further enhance transparency in corporate corridors, had made it mandatory for promoters to announce their pledged shares for the public.

Pledging of promoters shares has been commonplace in the history of corporate India and, as it was not earlier mandatory on them to disclose the amount of shares pledged, shareholders were left guessing.

Now that this disclosure has been made mandatory, shareholders will have a better idea of the financial stability and ownership status of the companies they invested in.

Comprehensive Laws

India, indeed, has an elaborate system of laws governing corporate governance. To start with, the Companies Act, 1956 covers corporate governance widely through a string of provisions such as constitution of audit committee, fixing of a ceiling on remuneration for directors and directors’ responsibility statement.

It was the Confederation of Indian Industry (CII) that came out with the first comprehensive code on corporate governance in 1998, which was followed by the recommendations of the Kumar Mangalam Birla Committee on Corporate Governance, appointed by SEBI.

The recommendations were embedded into the Clause 49 of the Listing Agreement on Indian stock exchanges.

At that time, the issue of corporate guidelines had come into focus in the wake of huge foreign investments flowing into the country — these investors wanted assurance that the companies they were investing in will be managed well.

And to further enhance their confidence and to safeguard retail investors, SEBI had revised Clause 49 of its “listing agreement”, which stipulated that at least one-third of the directors on the boards of the companies should be independent professionals.

These directors should in no way be connected to the interests of promoters. The revised Clause 49 was made effective from January 1, 2006.

Major changes were also made to the definition of ‘independent directors’, strengthening of the responsibilities of audit committee and improving the quality of financial disclosure.

The board, as a whole, was assigned the task of adoption of a formal code of conduct for senior management and the certification of financial statements issued by the CEO/CFO.

It is, however, no secret that many companies are yet to fully comply with the Clause 49 norms. It is thus time for SEBI to get stricter with such companies to protect shareholders interests. Apart from all this SEBI is providing special guidance to investors for the protection of their interest and spreading more awareness about the process involved in securities matters with transparency.

As per the basic objective of guidelines issued by the ministry of corporate affairs “Good corporate governance practices enhance companies’ value and stakeholders’ trust resulting into robust development of capital market, the economy and also help in the evolution of a vibrant and constructive shareholders’ activism.”. It suggested many others measure and requirements through which good corporate governance can be achieved

Auditors Role

Apart from independent directors, the role of auditors also came into focus.

The question that began to do the rounds in investors’ circles in the immediate aftermath of the Satyam scandal was whether shareholders and other stakeholders could take any action against the auditors.

Ms Namrata Mehta, Corporate Lawyer, Economic Laws Practice (ELP), a law firm that advises and litigates in areas of Direct and Indirect Tax, says “how an Indian Court will view the liability of the auditors of Satyam will depend upon the extent to which the Court is convinced about a claim for negligence.”

She further points out that regardless of the final outcome, auditors must be “reading their professional indemnity insurance contracts with a microscope and wishing that the Limited Liability Partnership Act was passed a few months earlier.”

As well observed by Kalbers and Fogarty “the formal empowerment of the audit committee appears to be designed for the consumption of external parties with some interest in the adherence to adequate forms of corporate control… changes in the structure of corporate governance pay be primarily symbolic…”

A new dimension of Secretarial audit has been introduced to make compliance with the transparency norms setup by the ministry of corporate affairs. As per the secretarial audit “Since the Board has the overarching responsibility of ensuring transparent, ethical and responsible governance of the company, it is important that the Board processes and compliance mechanisms of the company are robust. To ensure this, the companies may get the Secretarial Audit conducted by a competent professional. The Board should give its comments on the Secretarial Audit in its report to the shareholders.”

Institutional Investors

Experts feel that institutional investors can play a greater role in ensuring effective corporate governance standards, as they have a clout to extract information and play an activist role. This was best exemplified in the Satyam scam.

As for retail investors, it is important that they take all possible precautions before making investments.

Whatever may be the denouement of the Satyam fiasco, it is pertinent that corporate houses take this black chapter of India’s corporate history as a lesson in poor corporate governance practices and collectively map out a stricter structure that will protect the interests of all stakeholders.

Weak Links

However, despite these measures, there still exists some weak links in the system.

For example, experts say, the Satyam episode did bring to the fore once again the role of independent directors, who are supposed to protect shareholder interests.

“Independent directors should also be held accountable for board decisions and audit-related compliance practices,” said an analyst on corporate governance.

Satyam: The Truth At Last!

This, despite the fact that the Indian regulatory mechanism is widely seen as being among the world’s most stringent. The problem is that there are too many regulators in the market RBI, SEBI, FMC, IRDA, PFRDA and, of course, the Ministry of Finance, to name a few. If there is a pension’s problem, for instance, only the PFRDA is in the loop; never mind that the problem could spill over to the mutual fund space.

Since there is no umbrella organization (other than the Ministry of Finance, if you will) to oversee the activities of individual regulators, it leads to scams and frauds on a large scale. The result ? Small investors suffer when companies or specific sectors are found guilty. A few years ago, the Securities and Exchange Board of India, the stock market regulator, introduced Clause 49 of the Listing Agreement to ensure that the companies adhered to good corporate governance practices in the best interests of the market.

Unfortunately, most of the companies consider Clause 49 merely as additional paper work. However, there are a few like Prithvi Haldea, chairman and managing director, Prime Database, and independent director, Nucleus Software, who says, “Our role is to protect the interests of minority shareholders when decisions are taken by the management or the board.”

Satyam’s Six Deadly Sins

Haldea acknowledges that finding the right independent directors is a challenge, but one that will pay off. To help, he has generated a database of those interested in being independent directors (www.primedirectors. com); of the 13,643 profiles hosted on his Website, 3,920 are those of chartered accountants, 1,586 of company secretaries, 649 of cost accountants and 464 of retired civil servants.

Such efforts will help only if the companies are interested in finding the right people for the job. However, as Chamary says, “Independent directors are more like an old boys’ club and the Satyam board is an example of how, despite the presence of the best minds, investor interest did not reflect in the actions.”

An independent director is expected to stand up for the minority shareholders who are not represented on the company boards. Says Omkar Goswami, chairman, CERG Advisory, a research and consulting organization and an independent director: “In the long term, independent directors need to increase the shareholder’s value, ensure that the rights of minority shareholders are not in any way diluted, and monitor companies so that they act in a legal and ethical manner.” But as most companies are run by promoters, members of the board are picked by them.

And as a substantial amount of money is paid to independent directors, they are more than happy to toe the promoter’s line instead of holding out for the investors’ interests. “The Companies Act only has a negative list of the kind of people who can’t be independent directors,” says Haldea.

Ramalinga Raju: From Hero To Zero

If the regulators cannot tackle the relatively small problem of independent directors, how can they hope to ensure that small investors do not pay the price for large-scale fraud? Ved Jain, president of ICAI, the statutory body that regulates auditors and accountants, does not agree that the regulators have failed in this regard.

“(ICAI) has a strict code for its members and those found involved in malpractices have been suspended and action has been taken against them,” he says.

However, a look at the abysmal record of the institute in punishing errant members tells a different story. The offenders are punished by a disciplinary committee and are invariably let off with a fine of not more than Rs 5 lakh.

Corporate Frauds That Shook The World!

There are other problems as well. Multiple regulators and a turf war have hobbled commodities futures trading on the two national stock exchanges.

A year ago, the then finance minister P. Chidambaram had said, “The job of a regulator is to ensure that the market is well-regulated. In such a market, there will be periods of volatility. But I think responsible and mature market players will accordingly adjust their activities in the market in order to reduce volatility.”

For this to happen, there needs to be a clear, effective regulatory mechanism that has sufficient powers to penalize dissidents. This involves opening up questions about mandate and a need for better harmonization of principles of regulation across various regulators. Will this happen? We definitely hope so. The problem is in overcoming bureaucracy and the tendency to cling to old ways. Perhaps the latest shake-up, thanks to Satyam, will be the catalyst for change.

Checks

If the fraud funds runs into hundreds of crores, severance of punishment for fraudsters (such as the CEO, directors and auditors) including death sentences for the chief who commits fraud to be invoked and life imprisonment for frauds committed by others and for less serious crimes. Both the IPC (Indian Penal Code) and the Companies Act need to be amended for the purpose. More powers and exposure to the audit committee besides fixing responsibility for accounting frauds is also to be done to stop such frauds. Although measures like checklist on audit committee as given in Clause 49(II) controls the independence audit committee so that more transparent results can be obtained without any biasness and manipulation.

Future Of Investors

Frauds such as that happened with Satyam may increase investor nervousness about weak corporate governance and oversight in emerging markets, which are still reeling from the global financial crisis. Besides that it is a big shock to IT industry as well as to all the investors who were relying on such IT companies. The confidence of the investors on other IT majors will also have a similar look at the same time every company is not badly governed company. However, the confidence of the NRI investors and overseas investors was affected and it will not only impact the IT companies but also the capital market in general in the coming years.

Corporate frauds are not new to India or to the world. At every corner of the world unscrupulous individuals and institutions are involved in committing fraud. Fraudsters knowing them to be so commit frauds. Corporate frauds do not happen in isolation but happens in an organized form with the team of management and the auditing firm. India has witnessed various lapses that have happened in the past with several companies. Satyam was the biggest ever in the list with a huge amount of accounting fraud committed. In its case, the corporate governance lapses have been overlooked by PwC in connivance with the management of Satyam while auditing. Certainly an inflated cash balance to the tune of Rs.5, 040 crore could not have escaped the eye of the auditor.

The World Bank’s annual World Governance Indicators rate U.S. regulatory quality at 90.8 out of 100. India is rated 46.1 — below South Korea (78.6), Malaysia (67.0) and Thailand (56.3) but above China (45.6), Indonesia (43.7) and Vietnam (35.9). To such an extent the quality of governance of companies in India has rotten up. As rightly pointed out by Shri Domodaran, former chairman of SEBI, the case of Satyam Computer is neither the first nor the last corporate fraud to have hit India. In India the conviction rate in such cases of corporate fraud is dreadful constituting 5 per cent, as per parliamentary records. In India there are few instances of conviction on corporate frauds. One of the earliest cases of serious corporate fraud where the promoter was convicted was that of Ramakrishna Dalmia in 1956. After that an important convictions made was on Harshad Mehta in 1992 and Ketan Parikh in 2001. Yet another conviction on Dinesh Dalmia in 2004, who had alleged made a wrongful gain of Rs. 594 crore is yet to get a conviction from the courts.

Corporate Governance Challenges For India In Listed Companies

• In October 2004, SEBI has incorporated many elements of the Narayan Murthy Committee recommendations in its Listing Agreements, taking Indian business a few steps further on the road to good governance.
• The current institutional framework places the oversight of listed companies partly with the Department of Company Affairs (DCA), partly with the Securities and Exchange Board of India (SEBI) and partly with the stock exchanges. This fragmented structure gives rise to regulatory overlap and weakens enforcement. A streamlined regulatory structure would help improve accountability and market discipline.
• The corporate governance standard is a crucial factor for ensuring investors confidence. While the Company Law can take care of the basic requirement of the form of corporate governance structure, SEBI could be concerned with the corporate governance practices on on-going basis.
• With the SEBI trying to bring some discipline in the stock market especially in terms of greater transparency and disclosure norms, corporate governance in the Indian context at least seems to focus primarily and rightly on the issue of transparency. If corporate governance is concerned with better ethics and principles, it is only natural that the focus should be on transparency. One method of course is the code and another would be the regulatory authorities like SEBI, RBI etc. laying down guidelines so that a certain degree of transparency is automatically ensured. Generally two committees, the ethics committee as well as audit committee, of the board seem to be the instruments by which the board can keep a watch over the actual practices of the enterprise and ensure that the right values are observed and the principles of corporate governance are not violated.
• The challenge for regulators is to enhance market integrity by enforcing rules and regulations in a professional, timely, transparent and consistent fashion. Regulators should ensure that sanctions and enforcement are credible deterrents to help align business practices with the legal and regulatory framework, in particular with respect to related party transactions and insider trading. This would greatly improve confidence of investors and other stakeholders in the financial markets. v Corporate governance rules would make sense, if the regulator demonstrates its ability to book and punish powerful companies that break the laws. New registration requirements make sense if they help the regulator nail fraudsters and market manipulators. And complex disclosure norms for Initial Public Offerings (IPOs) would work if they actually weed out dubious issues. v The JPC report of 2002 specifically mentions 15 companies suspected of colluding with Ketan Parekh and other scamsters. SEBI did not even bother to investigate them. v One of the biggest weaknesses in SEBI’s investigation process is its failure to ‘follow the money’ to get to the root of market-related fraud. For this, the regulator would need to have access to all the bank accounts where proceeds of market related transactions are deposited and to follow the trail of money when it moves out of those accounts. If the Tax Information Network were able to chip in with income information, it would eliminate the brazen trades through dummy entities as is rampant in regional exchanges. v In order to track these shenanigans or to stop them, SEBI needs to enlist RBI’s cooperation in its surveillance effort. An insider says that despite repeated requests from SEBI, the RBI has ‘steadfastly refused’ to nominate a person to the SEBI constituted surveillance committee that meets every Monday and assesses market developments.
• A key missing ingredient in India today is a strong focus on director professionalism. Directors are expected to know their duties of care and loyalty to the company and all shareholders. However, as that is not always the case, we believe that the law or other regulations should clearly spell out the responsibilities of directors and they themselves should engage in the formulation of their tasks and work procedures.
• Corporate Governance in Listed companies – Recommendation of K.M Birla Committee

1. Board of Directors: The board of a company provides leadership and strategic guidance, objective judgement independent of management to the company and exercises control over the company, while remaining at all times accountable to the shareholders. The measure of the board is not simply whether it fulfils its legal requirements but more importantly, the board’s attitude and the manner it translates its awareness and understanding of its responsibilities. An effective corporate governance system is one, which allows the board to perform these dual functions efficiently.
2. Composition of the Board of Directors: The board of a company must have an optimum combination of executive and non-executive directors with not less than fifty percent of the board comprising the non-executive directors. The number of independent directors would dependent on the nature of the chairman of the board. In case a company has a non-executive chairman, at least one-third of board should comprise of independent directors and in case a company has an executive chairman, at least half of board should be independent.
3. Nominee Directors: Institutions should appoint nominees on the boards of companies only on a selective basis where such appointment is pursuant to a right under loan agreements or where such appointment is considered necessary to protect the interest of the institution. When a nominee of the institutions is appointed as a director of the company, he should have the same responsibility, be subject to the same discipline and be accountable to the shareholders in the same manner as any other director of the company. In particular, if he reports to any department of the institutions on the affairs of the company, the institution should ensure that there exist Chinese walls between such department and other departments which may be dealing in the shares of the company in the stock market.
4. Chairman of the Board: The role of Chairman is to ensure that the board meetings are conducted in a manner which secures the effective participation of all directors, executive and non-executive alike, and encourages all to make an effective contribution, maintain a balance of power in the board, make certain that all directors receive adequate information, well in time and that the executive directors look beyond their executive duties and accept full share of the responsibilities of governance.
5. Audit Committee: The need for having an audit committee grows from the recognition of the audit committee’s position in the larger mosaic of the governance process, as it relates to the oversight of financial reporting. A proper and well functioning system exists therefore, when the three main groups responsible for financial reporting – the board, the internal auditor and the outside auditors – form the three-legged stool that supports responsible financial disclosure and active and participatory oversight. The audit committee has an important role to play in this process, since the audit committee is a sub-group of the full board and hence the monitor of the process. The committee’s job is clearly one of oversight and monitoring and in carrying out this job it relies on senior financial management and the outside auditors.
6. Remuneration Committee of the Board: The board should set up are remuneration committee to determine on their behalf and on behalf of the shareholders with agreed terms of reference, the company’s policy on specific remuneration packages for executive directors including pension rights and any compensation payment.
7. Disclosures of Remuneration Package: All elements of remuneration package of all the directors i.e. salary, benefits, bonuses, stock options, pension etc. has to be disclosed to shareholders.
8. Accounting Standards and Financial Reporting: reporting on accounting based on accounting standards. Reporting should include consolidated accounts in respect of all its subsidiaries in which they hold 51 % or more of the share capital. Segment reporting is a must where a company has multiple lines of business. It is important that financial reporting in respect of each product segment should be available to shareholders and the market to obtain a complete financial picture of the company.
9. Management: The management is subservient to the board of directors and must operate within the boundaries and the policy framework laid down by the board.
10. Responsibilities of shareholders: The General Body Meetings provide an opportunity to the shareholders to address their concerns to the board of directors and comment on and demand any explanation on the annual report or on the overall functioning of the company. It is important that the shareholders use the forum of general body meetings for ensuring that the company is being properly stewarded for maximizing the interests of the shareholders.
11. Shareholders’ rights: Half-yearly declaration of financial performance including summary of the significant events in last six-months, should be sent to each household of shareholders. A board committee under the chairmanship of a non-executive director should be formed to specifically look into the redressing of shareholder complaints like transfer of shares, non-receipt of balance sheet, non-receipt of declared dividends etc. The Committee believes that the formation of such a committee will help focus the attention of the company on shareholders’ grievances and sensitize the management to redressal of their grievances. To expedite the process of share transfers the board of the company should delegate the power of share transfer to an officer, or a committee or to the registrar and share transfer agents. The delegated authority should attend to share transfer formalities at least once in a fortnight.
12. Institutional shareholders: The institutional shareholders take active interest in the composition of the Board of Directors, be vigilant, maintain regular and systematic contact at senior level for exchange of views on management, strategy, performance and the quality of management, ensure that voting intentions are translated into practice and evaluate the corporate governance performance of the company.

Recent Findings About Corporate Governance In India

Of late, a burgeoning empirical literature has begun to document important features of corporate governance in India. We summarize some of the major findings in this section, beginning with research examining corporate board composition.

Jayati Sarkar and Subrata Sarkar show that corporate boards of large companies in India in 2003 were slightly smaller than those in the United States (in 1991), with 9.46 members on average in India compared to 11.45 in America. While the percentage of inside directors was roughly comparable (25.38% compared to 26% in the U.S.), Indian boards had relatively fewer independent directors, (just over 54% compared to 60% in the U.S.) and relatively more affiliated outside directors (over 20% versus 14% in the U.S.). 41% of Indian companies had a promoter on the board, and in over 30% of cases a promoter served as an Executive Director. There is evidence that larger boards lead to poorer performance (market-based as well as in accounting terms), both in India and in the United States.

The median director in large Indian companies held 4.28 directorships in 2003, and this number is considerably (and statistically significantly) higher for directors in group-affiliated companies (4.85 versus 3.09 for non-affiliated companies). The figures were similar for inside directors, being 4.34, 4.95 and 3.06 for large companies, group affiliates, and non-affiliated companies, respectively. As for independent directors, however, the median number of positions held was 4.59, with no major differences between group and stand-alone companies. Interestingly, independent directors with multiple directorships are associated with higher firm value in India while busier inside directors are correlated negatively with firm performance. Busier independent directors are also more conscientious in terms of attending board meetings than their counterparts with fewer positions. As for inside directors, it seems that the pressure of serving on multiple boards (due largely to the prevalence of family owned business groups) does take a toll on the directors’ performance.

However, busy independent directors also appear to be correlated with a greater degree of earnings management as measured by discretionary accruals. Multiple positions and non-attendance of board meetings by independent directors seem to be associated with higher discretionary accruals in firms. After controlling for these characteristics of independent directors, board independence (measured by the proportion of independent directors) does not seem to affect the degree of earnings management. However, CEO-duality, where the top executive also chairs the board and the presence of controlling shareholders as inside directors are related, perhaps unsurprisingly, to greater earnings management.

A recent study finds that, during 1997-2002, the average (of a sample of 462 manufacturing firms) board compensation in India has been around Rs. 5.3 million (approximately USD 120,000), with wide variation across firm size. The average board compensation is Rs. 7.6 million (USD 171,000) for large firms and Rs. 2.5 million (USD 56,000) for small firms. The board compensation also appears to be higher, on average, at Rs. 6.9 million (USD 155,500) if the CEO is related to the founding family. Both board and CEO compensation depend on current performance, and CEO pay depends on past-year performance as well. Diversified companies also pay their boards more.

Given that almost two-thirds of the top 500 Indian companies are group-affiliated, issues relating to corporate governance in business groups are naturally very important. Tunneling, or “the transfer of assets and profits out of firms for the benefit of those who control them” is a major concern in business groups with pyramidal ownership structure and inter-firm cash flows. Marianne Bertrand and her coauthors estimate that an industry shock leads to a 30% lower earnings increase for business group firms compared to stand-alone firms in the same industry. They find that firms farther down the pyramidal structure are less affected by industry-specific shocks than those nearer the top, suggesting that positive shocks in the former are siphoned off to the latter, benefiting the controlling shareholders but hurting the minority shareholders. However, Bernard Black and Vikramaditya Khanna question how this logic would make them less sensitive to negative shocks. There is also some evidence that firms associated with business groups have superior performance than stand-alone firms.