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Corporate Governance: Precepts and Practices-II

S. B. Mathur

WHAT EXACTLY IS CORPORATE GOVERNANCE?

Corporate governance is an evolving subject. Everyday, you keep hearing about it in the media. So many debates, conferences, seminars are taking place. What was relevant yesterday may not be relevant today. What is relevant today may not be relevant tomorrow. But to ensure that we are on the same wavelength, let me first start with what is corporate governance. Generally speaking, it is a process by which companies are directed and controlled, and it is a field in economics where separation of ownership and control is the focus along with the issues that arise thereafter. It is all about promoting corporate fairness, integrity, transparency, accountability and responsibility. Objectives have very clearly been stated. It is to enhance and protect the interest of the stakeholders through efficient performance, transparency and greater accountability. It builds an environment of trust, encourages full disclosure, stays clear of conflicting interest and shows absolute transparency, encouraging ethical behaviour and goes beyond compliance of laws that you call regulatory guidelines. A lot of thought has gone into evolving the present structure of corporate governance. A lot of committees and government bodies have gone into it. But basically, two main committees or acts that we often refer to were in the UK: The Cadbury Committee, which I consider to be the Bible of corporate governance and one of the earlier works on this subject was in the US, we had the Blue Ribbon Committee, which led to the Sarbanes-Oxley Act, popularly known as the SOX.

When it comes to India, the Kumar Mangalam Birla Committee was one of the earliest committees to go into it on the basis of which the corporate governance structure has been drawn, and now of course, we have Clause 49. There are various other committees in India and globally that are looked into and I have drawn from these too.

WHAT CONSTITUTES CORPORATE GOVERNANCE?

Basically, these four committees provide the basic guidelines, basic structure. Before we look at corporate governance, we have to look at various facts, various aspects that constitute or lead to corporate governance. The first and foremost is of course the top management: the board directors and the CEO. You look at Clause 49, look at various other things, most of it is directed towards how a board should be formed, how it should be structured, how it should function, what information should come to it and this is critical. Corporations may comply with laws, they may file returns, make disclosure, but unless the board of directors, the CEO and the top management are serious that corporate governance compliance, disclosure and democratic working is necessary, corporate governance cannot be a success. Second, as was mentioned earlier, the whole edifice of corporate governance is based on the two factors, namely disclosure and transparency. If you look at Infosys’ statement of philosophy of corporate governance, they accept that the strong financial disclosure is the core philosophy, and they say, when in doubt, disclose. If you are not sure whether it is to be disclosed or not, if there is any confusion, disclose. This is the kind of approach towards disclosure and transparency called for. And then the third equally important factor is independent financial scrutiny. Financial statements have to be vetted by auditors. They have to make a quarterly statement, they have to make limited review, they have to certify that all accounting standards have been complied with; no accounting changes have taken place in accounting policy. All this has to be certified; even compliance with corporate governance norm of Clause 49. Auditors have to make a separate certification over and above their normal statutory requirements. This independent financial statement is to be stressed because over a period of time, from the corporate failures in US, and some of the cases taking place in India earlier, one lesson we have learnt is that we cannot trust all corporate managements, who have, at times, made had conflicted interests. I don't make it as a statement applicable to all corporations, but the general perception is that financial statement has to be an independent material. It cannot be fraud; it can be ignorance, lack of a sense of awareness of the urgency of things. So, independent financial statements are very important and they make corporate governance popular. I think we should ensure that ethical behaviour goes beyond the letter of the law.

THE ROLE OF THE BOARD IN ENSURING CORPORATE GOVERNANCE

I would now mainly concentrate on the word management since corporate governance is practiced through the board and the committee. I feel that for corporate governance to be in place a strong commitment of the board of directors is very crucial. I would like to state that we tend to rely heavily on global experience. At times, we practice what is written or practised abroad. If we look at the shareholding patterns of the company, we find that in India there are only two big corporations where the largest shareholder has less than 15 per cent shares. There is concentrated shareholding among individual promoters. Whereas, if you look at the shareholding pattern in the US, you will find that in no large corporate, does a single person or individual own more than 10 per cent shares. There are only 17 corporations where the largest shareholder has less than 5 per cent shares. So, blindly imitating what is happening in the US or other countries is very dangerous. We may have to keep that in mind before we go ahead to ensure good corporate governance. The board of directors basically develops the model for corporate governance, which aligns values of participation and periodically evaluates the efficacy of the model that has been put in place. As I said before, what is relevant today is not relevant tomorrow. Thus, they have to constantly monitor what module they have put in practice. A commitment from the board of directors towards a module is important and it is also important that they monitor the need to amend this module. The size and composition of the board of directors becomes important because of this criticality.

I will come to it later, but there are views about the size of the board whether we should have one member, two members or three members apart from statutory limits that could be very broad. So, the number of board members should not be too small because many of them bring varied skills to the board and that availability of that skill set will be there if there are a number of people bringing different kinds of manpower, and to bring more and more transparency to help the process. Guidelines say that if the chairman of the board is fulltime or functional, then minimum 50 per cent of the board should be independent otherwise, the floor limit is one third of the members. This is to ensure that the internal skill level is present, but outsiders are there to bring skills and experience of different industries, companies and countries. Now in more and more corporations you find board members travelling from abroad to attend board meetings or teleconferencing and now the whole market is getting united globally. Thus, we have the international experience also. The latest consensus that is developing now is that we should have an independent person as chairman in the position of CEO. I will come to that later when we look at some of the issues that we have. Splitting helps in meaningful and frank discussions with the board.

SELECTION OF INDEPENDENT DIRECTORS

Then independent directors that we just talked about are very critical to the concept of corporate governance. The definition of independent directors also keeps changing. Already on the Web site of Securities and Exchange Board of India (SEBI), there are provisions which affect the definition of independent directors. But basically independent directors are those who do not have any pecuniary relationship or who do not have any transaction and dealings with the company other than the incentives or whatever is approved by the board. How do we select independent directors? Normally, directors are proposed by the chairman, CEO or the dominant group of shareholders. And then it will go to the board, they will look at the person's background and approve. Now with the selection becoming a difficult and specialized issue, the nomination committees are being formed to go through the resume of the person to recommend to the board and ultimately to the general body so they can give their approval to take the director.

HOW TO ENSURE THAT THE BOARD PERFORMS ITS ASSIGNED TASK?

Now, you can have a structure, you can have a board in place, but how to ensure that the board actually, genuinely works regularly. So, there are stipulations that there should be four board meetings in a year, and the gap between two meetings should not exceed two months. Then to get the director's full attention, and involvement in the working of the company, to ensure that they are not occupied by too many things outside for other companies so that they don't give, what I would like to call, enough ‘mind time’ to the company, there is a restriction that a person cannot be on the boards of more than 15 companies. It is also prescribed as to what minimum information to be placed before the board that has to be considered by the board. Matters like operating plans, capital expenditure, budget, quantitative results and any penalties, levies, details of fatal accidents, frauds, then minutes of the board committees, minutes of the subsidiary committees, all of these have to be placed before the board to ensure the management this information, it is presented on time, because the meetings are not too distant in time, in terms of time, and this helps. Then another feature that has been introduced in addition to the usual report is that the board of directors has to present a management discussion analysis report that goes to the shareholder annual report. This report contains a lot of important information that is placed before the company and includes the internal control system adequacy, financial performance, risk analysis, opportunities, threats, and segment-wise performance.

THE NEED FOR THE CREATION OF UBCOMMITTEES IN THE BOARD

The complexities of corporate working are increasing day by day. In case of large corporations the multiunit, multifunctional areas of working are becoming more and more common these days. Under these circumstances, to expect board members to devote full attention to the working of the company is difficult. Therefore, there is a provision in the rules that there should be subcommittees in the board. And perhaps the most critical of these committees are the audit committee and the shareholders grievance committee. These are the two statutory committees. There are also the remuneration committee and nomination committee; and these are non-mandatory committees. Now these committees are becoming more and more important and they give specialized attention to various areas of the board is working and make recommendations. The audit committee should have three directors as members, two of whom should be independent. And all members should be financially literate and one member should have accounting and financial management experience. In fact, this committee goes through a lot of financial information, reviews the quarterly results, examines the internal control system, appoints auditors, determines their remuneration, briefs them before the audit as to what are the aspects the members would particularly like to know and when the final report comes, it goes through it and makes recommendations to the board. Audit committee members, who are prescribed, should be financially literate. In fact, this is one area which has gained a lot of importance in the last two decades or so; ever since the Enron and WorldCom scandals broke out in the US. The Forbes data published sometime in 2004 said that out of all the directors appointed by the US 500 top corporations 15 per cent were with financial background, whereas it used to be only 1 per cent in 1998. This data refers to year 2003; in five years, the percentage of independent directors appointed with financial background has shot up from 1 per cent to 15 per cent. I feel it is something that should gladden the hearts of people like me and you who have the financial background; there are lots of opportunities for us. It is also prescribed that the chairman of the audit committee should be present in the annual general meeting to answer shareholders’ questions clearly and also the committee has the power to invite other members and the CFO and head of internal audit to the AGM. These are all the aspects that the committee should look after.

ISSUES DEALT WITH BY THE SUBCOMMITTEES

Then the second important mandatory committee is shareholders’ grievance committee. It is based on the principle that equal treatment should be given to all shareholders. So there is a board committee formed under the chairmanship of an independent director to look into the redressals of shareholders’ or investors’ complaints. There should be a minimum of two meetings in a year, and the data on complaints received but awaiting resolution is to be given in the annual report. Then we look at some of the other non-mandatory committees such as the remuneration committee. It's a voluntary committee under Clause 49 and it's formed to determine company policy on remuneration packages for executive directors on behalf of board and shareholders. The committee may have the minimum of three independent directors as members. The chairman of the committee is to be an independent director. All members present are to construct and constitute a core representation and the chairman of remuneration committee could be invited to the AGM, but it is not mandatory to answer shareholders’ queries.

Even for independent directors, remuneration is decided by the board and then by practice, the remuneration committee also looks into that. Then again, the committee members are required to make in-depth examination of the issues that are put up to the committee. They should have full involvement of the directors who are members. To ensure that, there is a provision that no member director could be member of 10 committees across all companies and he or she should not be chairman of more than five companies. There are similar provisions about the audit committee, also that there should be four meetings in a year, the gap between two meetings should not be more than four months, and quorum should be one-third of the members. But the minimum number of independent directors to be present in the audit committee must be two, just to ensure the functioning of the audit committee and other committees.

ASSESSMENT OF DIRECTORS' PERFORMANCE

What happens after the shareholder appoints the board of directors to conduct the business of the company to lay out the policies, strategies and how do the shareholders evaluate the performance of the directors? What happens in the board? What are the shareholder's rights? That basically means that directors’ appointment and reappointment is done by the shareholders in general body meeting. When the issues come up regarding the appointment, or reappoint-ment, of directors, the directors place their resumes that give the background details of their shareholdings, other directorship, their interests, membership of committees and other things. They also disclose the remuneration paid to them, performance incentives, sitting fees as well as the employee stock ownership plans (ESOPs) granted to them and exercised by them. All this information is given and ultimately shareholders approve that. They will also review, in the annual report, all the various meetings that a director attended—how many board meetings, how many committee meetings, whether the concerned director was regular and so on. All this data is presented by the AGM in the annual report where the shareholders can review the performance. There are also certain voluntary provisions in Clause 49 that go towards the assessment of directors’ performance; one is that to acquire a larger skill they should be given training in the business model of the company, the risk profile of the company, what are the risks, and what are the threats so that they are better equipped to participate in the working of the whole and make greater contribution to the company. So far as the evaluation is concerned, there is a process where the peers evaluate the performance of the director, that is all the directors, independent of the director being evaluated, give their views about the performance of the concerned director and that could be the basis for the board as a whole to decide whether to reappoint a particular director or decide against it.

OTHER ISSUES CRITICAL TO ENSURE CORPORATE GOVERNANCE

This entire process holds to show how the board functions and how critical it is for it to make the corporate governance a success. As regards independent scrutiny, we have basically the examination by chartered accountants, certification of the accounts, and corporate governance. The other issues that are very critical, and for which there are various norms laid down, are that there should be rotation of auditors. If the auditing firm is not changed, the lead partner should be changed; the same partner should not sign the account for more than three consecutive years. There are restrictions on auditors taking up other assignments. All those things are there and, of course, the ethics we have talked about emphasize that there should be ethical behaviour and that compliances should be not only in letter. In practice, there are various issues that come up,especially in the field of board of management; board of directors, their size, composition, chairmanship and the like.

THE APPROPRIATE SIZE OF THE BOARD

The first thing that needs to be considered is what should be the size of the board? There are companies which have very small board, there are companies with large board, and both are equally successful, but what should be the norm? In fact, if we look at top 50 Indian companies, only two companies have a board size of more than 50, and four have 15 members. If we look at the Indian companies as a whole, 44 per cent companies have more than 12 members. If you look at the scenario in the US, among S&P 500 top companies, 66 per cent companies have more than 12 members and the average size of an S&P company in 2003 was 11. This has come down from 14 in 1993. One could say that this is not a very positive indication, but then the focus on the board membership has shifted to independent directors from functional directors. That would account for the change. In 25 per cent of US S&P companies, they had eight or nine directors and only five had just three directors and this process is changing because more and more independent directors are being taken in. In fact, 80 per cent of directors on S&P company boards were independent directors and the process of taking more and more such directors is gaining momentum. In 2002 and 2003, these 500 companies appointed about 800 new directors, and that means within a year 1.6 new directors were added. The size of the board is relevant only when you look at it from the point of view of the operations of the company. If the operations of the company are small or medium sized, not too complicated, not too many units, not multidimensional, then there could be a small board, but otherwise, people feel that there should be at least 10 to 12 members who could bring varying sets of skills to the board.

SEPARATION OF THE CHAIRMANSHIP AND CEO UNCTIONS

Then we have another issue of the chairmanship. Greater and greater consensus now appears to be that the position of chairman and CEO should be separate. Indian companies have shown a lead in this area. In fact, 60 per cent of Indian companies have independent chairmen, and the chairman and CEO positions are separate; only 40 per cent of the remaining companies have a combined position, but out of these 40 per cent, half are from the public sector. In the public sector units (PSUs), there is the system where the chairman cum MD or chairman who is full time functional is very common. In this regard, we are ahead of the US where 20 per cent companies have independent chairmen non-functional, non-executive chairmen. The Ganguly Committee—one of the committees appointed by the Reserve Bank of India—has recommended that in large banks the position of chairman and CEO should be split, and that in all public sector banks, it should be implemented. The Committee and the Reserve Bank seem to be quiet inclined towards this view. But you look at the working of some of the companies. In fact, I just had a look at the working of six companies, four are listed, two are unlisted and five are professionally managed and one is a family business. It is not Murugappa group. I just had a look at these companies; they all had combined CEOs and chairmen. The experiences of one manufacturing, multidimensional, multidivision large company is like this, there is too much of concentration of power and whatever the board's feelings, these do not always come out and, therefore, the position could be construed to be working against the democratic or collective thinking. In a family-run company, there is no discussion on major issues; people may talk, independent directors may have their objections, but ultimately the chairman says for one reason or the other very politely, ‘It’s a matter of Rs 20 crore; we have large resources of Rs 500 crore, what difference does Rs 20 crore make?’ There are the discussions, the objections are put forward, but normally the management mind is made up. However, there are other companies that work differently. I know of one in manufacturing sector. Out of the six that I know of, three companies were bold, very positive, in spite of the board being the chairman-cum-CEO. They often listen to the opinions and sometimes not. One manufacturing company, a very large manufacturing company, into infrastructure, construction and other divisions, they have a small subsidiary, a financial services subsidiary. The services company wanted to acquire a much bigger financial services company and contributing only 5 per cent to 10 per cent of the group's turnover, or maybe even less in profits. They did all the due diligence, participated in the bidding and all other procedures. When the matter came up to the board, the independent directors said, ‘You are a manufacturing company, your core competency is in manufacturing, why do you want to go in to financial services?’ And in spite of all the efforts and labour put in, the proposal was dropped. It was a combined chairman-cum-CEO. The same thing happened in another professionally managed financial services company. So, basically, it is the commitment of the CEO and the board that applies. Just because the position is split, it may help, but it does not necessarily mean the combined CEO and Chairman position cannot be an example in corporate governance in carrying out group discussion.

THE ISSUE OF COMPETENCE OF DIRECTORS

Then comes the issue of the competence of directors. As we have seen, the directors play a very critical role and if a company has to be successful, they must have competent members on the board. In fact, there is a dilemma whether to go in for a new blood, new director or go in for experienced directors, and availability of such persons would become more and more difficult since all companies want to acquire men with experience. The way they are going about elsewhere is to set up nomination committees for the board, let them scout for good people and talk to them, analyse their performance, go through their resumes and then recommend to them, but in India this practice is not there. Only nine out of the top 50 companies had nomination committees in place, whereas in the US practically every company has a nomination committee in place. This is going to be very critical in times to come.

THE MATTER CONCERNING CORPORATE COMPENSATION

Then another issue which Mr Alagappan also mentioned is that of corporate compensation. When you expect so much from the directors, employees, functional directors and others, you need to pay them for the ever increasing work load, more and more responsibility. Then there is the question of director's liability. The directors are exposed to all sorts of liability. It could be loss of reputation, it could be penalty, it could be fine, it could be that they may be debarred from being directors of the board of other companies and there are some provisions in the company law that also provide for imprisonment. There are whole lots of liabilities coming up. Also, reward them for additional risk, award them for the contribution companies expect them to make. Remuneration is becoming very critical. Their liability is being taken care of at least by going in for director's liability insurance, which is becoming very common. But for remuneration, a separate remuneration committee is being put in place to ensure that there is proper evaluation made on the contribution of the directors, and they are properly rewarded. This is going to be very critical in times to come.

SEBI'S LATEST GUIDELINES ON ISSUES RELATING TO CLAUSE 49

I'll just mention the latest guidelines of SEBI, about which changes are put in Clause 49 on the SEBI's Web site. It has invited comments on these guidelines. I think the last date is 2 April. It talks of directors and independent chairman. If he is related to the director, the promoter or the top management, which means one level below the board, then that director, not saying in so many words, will be deemed to be not independent. In the sense that, that company will have to provide at least 50 per cent of board members as independent. Then there is the talk of age, qualification of directors. In business concerns especially, you often see that a person, a family member, the moment he crosses 18, he is put as a director on the board of the company. So, SEBI has said the minimum age of director is proposed to be changed to 21 and another thing that they say is earlier directors nominated by institutions on the board of directors are deemed to be independent, now they are changing it, that these directors are not deemed to be independent, so they will not constitute part of 33 per cent, 50 per cent of the independent directors. It is difficult to provide a guideline for the minimum qualification of directors since there are all sorts of companies, small companies, big companies, medium-sized companies, in different lines of businesses. But somewhere regulators have prescribed not the qualification but the recommended area of expertise where directors should come from. Banking companies do talk of certain disciplines where members can have those kinds of disciplines. Even the Indian Regulatory Development Authority (IRDA) recommends such things. It says that the actuary, the appointed actuary, in-house or from outside, has to be a member of the board. That kind of thing is there but the post changes in Clause 49 do not speak of any provision, any qualification as to the proper age. Finally, for corporations who are reluctant to go for corporate governance, there are provisions. If a director resigns, then the new director has to be appointed within 90 days, since without this provision, corporations would say that they couldn't find a suitable replacement for the director who has resigned. To deal with this kind of contingencies, it is made a mandatory requirement.

COMPLIANCE COMES WITH A COST

Compliance would become a big issue. Everyday, new provisions are added. Compliance comes with a cost. It's not possible for every company, especially for smaller companies. If a company is raising money, say, less than Rs 200 crore then it gets its capital at very high cost. A time will come when corporate governance level would also govern the cost. So far, we are not at a stage where we should worry. But for the insurance and banking sector, it has become a major issue and compliance is becoming very costly. This is an evolving field and new things keep coming in and we have to have a progressive mindset, a kind of ethical behaviour that we expect from corporations, not different and distinct from the larger democracy we feel in the political arena.