1. Workshop on Corporate Governance
Presented at the
ALB In-House Legal Summit
October 14, 2004
Mohit Saraf B.D. Ushir
(Partner) (Partner)
Luthra & Luthra Law Offices
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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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3. 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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4. Section II Conceptualizing 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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5. 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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6. 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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7. 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 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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8. Luthra & Luthra Law Offices
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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9. Luthra & Luthra Law Offices
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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10. Luthra & Luthra Law Offices
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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11. 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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12. 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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13. 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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14. Luthra & Luthra Law Offices
Major Areas of Debate
Directors
Independent Directors
Audit Committees
Auditors
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15. Section IV Director: 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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16. WHO DO DIRECTORS OWE A DUTY TO?
SHAREHOLDERS
COMPANY
EMPLOYEES
PUBLIC
CREDITORS
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17. 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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18. Luthra & Luthra Law Offices
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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19. 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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20. Duty of Care and Skill (Contd.)
Exercise reasonable care, skill and diligence
Continuing knowledge of company’s business
Reliance on Co-directors and Power to delegate with supervision
Bona fide and good faith intention
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21. 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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22. 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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23. 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 company’s 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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24. Liabilities of Directors
Derivative Action
Statutory Liability
Contractual Liability
Tortuous Liability
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25. Luthra & Luthra Law Offices
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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26. Luthra & Luthra Law Offices
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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27. Director:Legal 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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28. 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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29. 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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30. 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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31. Who is an Independent Director?
Independence of judgement
No material relationship
No pecuniary relationship
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32. Luthra & Luthra Law Offices
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 director’s 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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33. What is Independence? (Contd.)
Clause 2(45), Draft Companies Bill
“Independent Director” means a non-executive director of a company who apart from receiving director’s 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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34. Independent Directors
External expert
Independent director: watchdog?
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35. Luthra & Luthra Law Offices
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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36. 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
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37. 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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38. Audit Committee (Contd.)
Audit committees- Efficacy?
Chairman of Enron’s 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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39. Section V Auditors: 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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40. Section V Auditors: 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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41. Luthra & Luthra Law Offices
Auditor’s Liability
Basis of Liability
Contractual and Fiduciary
Company
Shareholders as a body
Tortuous
“Holding out”
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42. Auditor’s 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 ( )
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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43. 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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44. 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 auditor’s liability as set out in the Caparo Industries case?
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45. 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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46. 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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47. 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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48. Luthra & Luthra Law Offices
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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49. Section VI Reinventing 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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50. 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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51. 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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52. Luthra & Luthra Law Offices
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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Our Contact Details
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Mumbai Office Delhi Office
, 7th Floor, , Ashoka Estate,
Embassy Center, Nariman Point, 24, Barakhamba Road,
Mumbai – New Delhi
Tel : (91) (22) Tel: (91) (11)
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