19

Corporate Governance The Indian Scenario

• Introduction
• Emergence of Corporate Governance Issues in India
• Efforts to Initiate Corporate Governance in the Country
• Implementation of Recommendations of Birla Committee Report
• Pioneers in Good Governance Practices
• Need For Accounting Standards
• Corporate Governance Rating
• Corporate Governance in India—A Performance Appraisal
• The Future of Corporate Governance in India

Introduction

Corporate governance as a means of achieving equitable prosperity for the people of all nations has nowadays come to the centrestage because of two reasons: First, after the collapse of the Soviet Union at the end of cold war in 1990, it has become the conventional wisdom all over the world that market dynamics must prevail in economic matters. The concept of government controlling the commanding heights of the economy has been given up as being unproductive. This, in turn, has made the market the most decisive factor in settling economic issues. Second, it has also coincided with the thrust given to globalisation because of the establishment and administration of the World Trade Organisation and the member nations of the WTO trying to bring down the tariff barriers. Globalisation involves free movement of the four economic factors of production, namely, physical capital in terms of plant and machinery, financial capital in terms of money invested in capital markets or in FDI, technology and labour moving across national borders. The pace of movement of financial capital has become quicker because of the pervasive impact of information technology and the world having shrunk into a global village. When investments take place in emerging markets, investors want to be sure that not only the capital markets or enterprises in which they invest are run competently, but they also have good corporate governance. “Corporate governance represents the value framework, the ethical framework and the moral framework under which business decisions are taken.”¹ In other words, when investments take place across national borders, investors want to be sure that not only is their capital handled effectively and adds to the creation of wealth, but business decisions are also taken in a manner which is not illegal or involve moral hazards.

 

Why is Corporate Governance Important?

Corporate governance is important for a society due to many reasons as given below:

1. It lays down the framework for creating long-term trust between companies and the external providers of capital.
2. It improves strategic thinking at the top by inducting independent directors who bring in a wealth of experience and a host of new ideas.
3. It rationalises the management and monitoring of risks a firm faces globally.
4. It limits the liability of the top management and directors by carefully articulating the decision making process.
5. It ensures the integrity of financial reports.
6. It helps to provide a degree of confidence that is necessary for the proper funding of a market economy.

The Need for Corporate Governance in India

If corporate governance has to take root in a country it will, to a large extent, depend on the economic and business environment that has been created by public governance in the country; there cannot be good corporate governance if public governance is weak. The dramatic collapse of corporations like Enron has highlighted the reality of how companies, which were the darlings of the stock market and held up as models for vigorous and innovative growth, can ultimately fall like a pack of cards when fraud and dishonesty became their operational guide. The association of the accounting firm, Andersen has also raised a doubt about the credibility of even highly regarded global players. In the Indian context, the need for corporate governance has been highlighted because of the series of scams that had become an annual feature ever since the government liberalised the economy in 1991. Since then, there had been the Harshad Mehta scam, Ketan Parikh scam, the UTI scam, Vanishing Companies scam, Bhansali scam and so on. In the Indian corporate scene, it is very clear that unless we induct global governance standards, the scope for scams may rise in the years to come. To reduce it to the minimum, there is an urgent need to improve corporate governance in the country.

 

The legal and administrative environment in India provides greater scope for corrupt practices in business. For more than five decades since independence, lack of transparency and financial disclosures, corruption and mismanagement have been accepted as a way of life and taken in a stride in an insulated, licence-ridden and non-competitive economic environment. As a result, unless a management is committed to be honest and observes the principles of propriety, the atmosphere is too tempting not to observe good corporate governance in practice. We should approach the issue of corporate governance in India not merely from the point of view of the Companies Act or the SEBI guidelines or the codes evolved out of recommendations of committees such as the Kumar Mangalam Birla Committee or the Rahul Bajaj Committee, but look at the entire network of various rules and regulations impinging on business so that there is an integrated holistic system, created for ensuring that transparency and good corporate governance prevail.

Ethics and Values in Corporate Governance

No discussion on public affairs will be complete without a reference to ethics and values. The quality of corporate governance is also determined by the manner in which top management, particularly the board of directors, allocates the financial resources of the company between themselves and other interested groups such as employees, customers, government, etc. The basic qualities invariably expected in this regard are trust, honesty, integrity, transparency and compliance with the laws of the land. There is an increasing body of public opinion that would expect a business enterprise not only to be a mere economic unit but also to be a good corporate citizen. For this, its corporate governance must be based on a genuine respect for business ethics and values. But unfortunately the business environment in India is replete with unethical situations such as bribery, corruption, insider trading and malpractices of various kinds that—“insiders” do not think foul of siphoning off funds that ought legitimately to belong to “outsiders” and stakeholders. However, it is heartening to note that things are slowly moving for the better mainly because of the opening of the economy to global players.

The ethical climate in any business or capital market depends on three factors: (i) the individual’s sense of value, (ii) the social values accepted by business and industry. When Harshad Mehta scam took place, it was claimed that the manner in which the bank receipts were being treated was the prevailing norm. Perhaps a similar argument would have been given to the Ketan Parikh scam. In other words, practices, which are later on found to be highly objectionable, became acceptable because that was the prevailing market practice. Social values will depend upon the standards set up by professional bodies such as the Institute of Chartered Accountants of India or the Institute of Cost and Works Accountants of India and so on. (iii) The third and perhaps the most decisive factor is the system. It is here we face the main challenge. Our system encourages lack of corporate governance. If those who violate the norms are effectively punished, then the fear of punishment will make the violators adhere to the principles of corporate governance. What we lack in India today, which comes in the way of corporate governance, is presumption that violators may not be detected, and even if detected, they could go scot free with their wrongdoings. If we want to usher in an era of better corporate governance in the country, the focus has to be turned effectively on creating a proper climate of public governance and making changes in the various regulations impinging on the working of an enterprise or a body like the capital market.

The Companies Act, the Harbinger of Corporate Governance

In India, until recently company legislation has been the main instrument to promote corporate governance. Tracing its origins to the mid-nineteenth century, and thereafter closely following similar developments in the United Kingdom, the Companies Act 1956 was a consolidating legislation with far reaching impact that significantly altered the structure of corporate management in India. Subsequently, incorporating recommendations of the Bhabha Committee, this Act legislated, inter alia, the abolition of the system of managing agents, an institution that had served the country truly and well during the early days of corporatisation and more significantly industrialisation, but fallen into disrepute through abuse and malpractice in its application by its latter day exponents. With this, a pernicious vehicle for siphoning off corporate wealth for the benefit of a few dominant and controlling shareholders was sought to be destroyed. Subsequent amendments in the later part of the twentieth century essentially built upon the basic 1956 edifice, and usually attempted to plug observed loopholes in practice. A completely revised, updated, and in-tune-with-the-times, abridged version of the legislation was introduced in the parliament some years ago, but more urgent and necessary revisions to meet the requirements of a changing business environment were enacted through an amendment in 1999. Another amending bill introduced in the late 1999 and modified in 2000 has already been approved by the parliament. This offers further inputs for improving standards of corporate governance in the country.

 

The Emergence of Corporate Governance Issues in India

The Stock Exchange of London appointed, as discussed earlier, the famous Cadbury Committee which submitted its report in 1992 that included the “Code of Best Practices” to be practised by listed companies. Sir Cadbury Report was implemented by the London Stock Exchange as part of its Listing Agreement with its member companies. The Cadbury Report is generally considered to be the foundation stone of corporate governance.

In India, the real history of corporate governance dates back to the year 1992, following efforts made in many countries of the world to put in place a system suggested by the Cadbury Committee. The Confederation of Indian Industry framed a voluntary code of corporate governance for listed companies in 1998. This was followed by the recommendations of the Kumar Mangalam Birla Committee set up in 1999 by SEBI culminating in the introduction of Clause 49 of the standard Listing Agreement to be complied with all the listed companies in stipulated phases. The Kumar Mangalam Birla Committee divided its recommendations into mandatory and non-mandatory. Mandatory recommendations included such issues as the composition of the board, appointment and structure of audit committees, remuneration of directors, board procedures, additional information regarding management, discussion and analysis as a part of the annual report, disclosure of directors’ interest, shareholders’ rights and the compliance level of corporate governance in the annual report. Its non-mandatory recommendations included issues concerning the chairman of the board, setting up of remuneration committee, half yearly information to the shareholders, use of postal ballots for certain key decisions, appointment of nominee directors and obligations of institutional shareholders.

Efforts to Initiate Corporate Governance in the Country

The Companies Amendment Act, 2000

Many provisions relating to corporate governance such as additional ground of disqualification of directors in certain cases, setting up of audit committees, directors’ responsibility statement in the directors’ report, etc. were introduced by the Companies (Amendment) Act, 2000. Corporate governance was also introspected in 2001 by the advisory group constituted by the standing committee on International Finance Standards and Codes of the Reserve Bank of India under the chairmanship of Dr. Y. V. Reddy, the then Deputy Governor.

The Enron debacle of 2001 involving the hand-in-glove relationship between the auditor and the corporate client, the scam involving the fall of the corporate giants in the US like the WorldCom, Qwest, Global Crossing, Xerox and the consequent enactment of the stringent Sarbanes-Oxley Act were some important factors which prompted the Indian government to do something to put in place proper governance mechanism in the structure and system of administration of listed public limited companies.

 

Naresh Chandra Committee, 2002

In the year 2002, a high-level committee was appointed to examine and recommend drastic amendments to the law involving the auditor client relationships and the role of independent directors by the department of company affairs in the Ministry of Finance & Company Affairs under the chairmanship of Naresh Chandra. The committee was asked to examine various corporate governance issues and to recommend changes in diverse areas such as: (a) the statutory auditor-company relationship so as to further strengthen the professional nature of the interface; (b) the need, if any, for rotation of statutory audit firms or partners; (c) the procedure for appointment of auditors and determination of audit fees; (d) restrictions, if necessary, on non-audit functions; (e) independence of auditing functions; (f) measures required to ensure that the management and companies actually present “true and fair” statement of the financial affairs of companies; (g) the need to consider measures such as certification of accounts and financial statements by managements and directors; (h) the necessity of having a transparent system of random scrutiny of audited accounts; (i) adequacy of regulation of chartered accountants, company secretaries and other similar oversight functionaries; (j) advantages, if any, of setting up an independent regulator similar to the Public Company Accounting Oversight Board in the SOX Act, and if so, its constitution; and (k) the role of independent directors and how their independence and effectiveness can be ensured. We have already seen rather elaborately the recommendations of the Naresh Chandra Committee in the Chapter 3, “Landmarks in the Emergence of Corporate Governance.”

Narayana Murthy Committee, 2003

The Company Law Amendment Bill, 2003 envisaged many amendments on the basis of reports of the Naresh Chandra committee and the subsequently appointed N.R. Narayana Murthy committee. Both the committees have done an excellent job to promote corporate governance practices in India. The Company Law Amendment Bill, 2003 envisaged many amendments on the basis of reports of the Naresh Chandra Committee and the subsequently appointed N.R. Narayana Murthy Committee. Both the committees have done an excellent job to promote corporate governance practices in India. Both the committees have done an excellent job to promote corporate governance practices in India. The Narayana Murthy Committee’s report summed up the utility of the corporate governance in the following words: “Effectiveness of a system of corporate governance cannot be legislated by law nor can any system of corporate governance be static. In a dynamic environment, systems of corporate governance need to be continually evolved. The committee believes that its recommendations raise the standards of corporate governance in indian firms and make them attractive for domestic and global capital. These recommendations will also form the base for further evolution of the structure of corporate governance in consonance with the rapidly changing economic and industrial environment of the country in the new millennium.” Introduction of corporate governance norms consequent to the debacles of famous corporates was a good augury for the corporate world. Stakeholders, financial institutions, bankers, creditors, shareholders and the general public alike appreciated the measures taken by SEBI and the Ministry of Commerce in regulating corporates.

 

Legislative Changes

In the present global scenario, India’s corporate sector has not only to compete with business worldwide but also has to achieve levels of management and governance that inspire confidence in investors—both domestic and foreign. The legal and regulatory framework must provide comfort to investors, especially foreign investors.

Keeping this in view, the Department of Company Affairs (DCA) has taken several initiatives in the recent past. These include legislative changes and modernisation of services with the help of technology. The DCA, in consultation with experts in the field, as also the stakeholders, has ushered in several changes in the corporate law. The Companies Act, 1956, has been amended thrice since 1999 and some further amendments are under consideration to give effect to policy liberalisation. An ordinance was promulgated on 23 October 2001, for easier terms and conditions for buy-back of shares by companies. This was done keeping in view the continuing depression in the share market and also the recent developments in the US and elsewhere.

The government constituted a high-level committee to examine and make recommendations for the legislative framework to enable formation and conversion of cooperative business into companies. Based on the recommendations of this committee, a bill was introduced in the Lok Sabha in August 2001, and passed by both the Houses of Parliament in December 2002. This legislation is intended to provide “primary producers” an option to have a new kind of business organisation (called a producer company) to produce and market products in a modern and professional manner at par with other companies. It may enhance their efficiency and competitiveness in the present liberalised and globalised market and help for the betterment of “primary producer”.

Further, the government constituted a committee to examine the existing law relating to winding up of companies in order to remodel it in line with the latest developments and innovations in the corporate law and governance elsewhere. On the basis of the recommendations of the committee, a bill was introduced in Lok Sabha in August 2001, and was passed by both the Houses of Parliament. This bill ushers in a new era of insolvency laws and provides for constitution of a Company Law Tribunal. The jurisdiction and powers presently conferred on the Company Law Board will be vested in the proposed national tribunal. This will result in the dissolution of the Company Law Board. It also envisages replacement of the Board for Industrial and Financial Reconstruction (BIFR) by repealing the Sick Industries (Special Provision) Act, 1985, for accelerating the pace of revival.

Introduction of Regulations

Governance initiatives through regulation have also made significant strides in the country. The Securities and Exchange Board of India (SEBI) has an ongoing programme of reforming the primary and secondary capital markets. SEBI was set up by the government in 1992 to counter the shortcomings found in the functioning of stock exchanges such as long delays, lack of transparency in procedures and vulnerability to price rigging and insider trading, and to regulate the capital market. SEBI, which has been made into a statutory body is authorised to regulate all merchant banks on issue activity, lay guidelines, supervise and regulate the working of mutual funds and oversee the working of stock exchanges in the country. In consultation with the government, SEBI has initiated a number of steps to introduce improved practices and greater transparency in the capital markets in the interest of the investing public. The stock exchanges in the country also mandate several salutary requirements through their listing agreements that every publicly traded company has to comply with. On the insistence of SEBI, stock exchanges have amended listing agreements to ensure that a listed company furnishes them annual statements showing the variations between financial projections and projected utilisation of funds, which would enable shareholders to make comparisons between promises and performance.

 

Among the professions, the Institute of Chartered Accountants of India has emerged as a responsible body regulating the profession of public auditors, and counts among its achievements the issue of a number of accounting and auditing standards. Constitution of an independent National Advisory Committee on accounting standards has been legislated by the amended Companies’ Act of 1999. Other professional bodies such as the Institute of Cost and Works Accountants of India and the Institute of Company Secretaries of India have helped in promoting and regulating a well-trained and disciplined body of professionals who could add value to corporations in improving their management practices. The Institute of Company Secretaries of India has also taken a major initiative in constituting in 2001, a secretarial standards board comprising senior members of eminence to formulate secretarial standards and best secretarial practices and develop guidance notes in order to integrate, consolidate, harmonise and standardise the prevalent diverse practices with the ultimate objective of promoting better corporate practices and improved corporate governance. R. Ravi, the ICSI President, informed the press on 30 January 2005 that the institute has mooted a proposal to the government to make mandatory secretarial standards (SS) issued by it on the lines of accounting standards issued by the Institute of Charted Accountants of India. The ICSI has issued three SSs till now on board meetings, general meetings and payment of dividend, and one on registers and records is being finalised.

As mentioned earlier, with the interest generated in the corporate sector by the Cadbury Committee’s report, the issue of corporate governance was studied in depth and dealt with by the Confederation of Indian Industry (CII), the Associated Chambers of Commerce (ASSOCHAM) and the Securities and Exchange Board of India (SEBI). The corporate governance Code in India was first promoted by the Confederation of Indian Industry. Further, the Securities and Exchange Board of India constituted the Kumar Mangalam Birla Committee and adopted its report in mid-2000.

The Kumar Mangalam Birla Committee confined itself to submitting recommendations for good corporate governance and left it to SEBI to decide on the penalty provisions for non-compliance. In the absence of suitable penalty provisions, it has been difficult for the market regulator to establish good corporate governance. Some of the penalty provisions are not sufficient enough to discipline the corporates. For example, the penalty for non-compliance of the stipulated minimum of 50% in respect of the number of directors in the board that should be non-executive directors is delisting of shares of the company. This would hardly serve the purpose. In fact, this would be detrimental to the interest of the investors and to the effective functioning of the capital market.

Similarly, an audit committee, which is subservient to the board, may serve no purpose at all; and one which is in perpetual conflict with the board, may result in stalemates to the detriment of the company. If a company is to function smoothly, it should be made clear that the findings and recommendations of the audit committee need not necessarily have to be accepted by the board which is accountable to the shareholders for its performance and which, under Section 291 of the Companies Act, is entitled to “exercise all such powers, and do all such things as the company is authorised to exercise and do”.

However, some functional specialists are of the considered view that whenever there is a difference of opinion and the audit committee’s advice is ignored or over-ruled, the board should be required to place the facts before the general body of shareholders at their next meeting.

Implementation of the Recommendations of Birla Committee Report

Clause 49 of the Listing Agreement

What is Clause 49?

The Securities and Exchange Board of India monitors and regulates corporate governance of listed companies in India through Clause 49.² This Clause is incorporated in the listing agreement (LA) of stock exchanges with companies and it is compulsory for them to comply with its provisions. Stock exchanges endeavour to bring in corporate governance standards among companies by the introduction of Clause 49 in the listing agreement they enter into with them before they are being listed. SEBI issued Clause 49 in February 2000. All group A companies had to comply with its provisions by 31 March 2001. All other listed companies with a minimum paid-up capital of Rs. 10 crore and networth of Rs. 25 crore had to comply with its provisions by 31 March 2002, and the remaining listed companies with a minimum paid-up capital of Rs. 3 crore or net worth of Rs. 25 crore had to comply with them by 31 March 2003.

 

Subsequently, on 29 October 2004, SEBI amended the original Clause 49 and issued a new Clause 49. All existing listed companies will have to comply with the provisions of the new clause by 1 April 2005. However, it has already come into force for companies that have been listed on the stock exchange after 29 October 2004.

Provisions and Requirements of Clause 49

1. Composition of Board: The board should be composed of in the following manner: In case of full time chairman, 50% non-executive directors and 50 percent executive directors.
2. Constitution of the Audit Committee: The audit committee should have 3 independent directors with the chairman having sound financial background. The finance director and the head of the internal audit should be special invitees and a minimum of three meetings should be convened every year.
3. The Audit Committee: The audit committee is responsible for review of financial performance on half-yearly/annual basis; appointment/removal/remuneration of auditors; review of internal control systems and its adequacy.
4. Remuneration of Directors: Remuneration of non-executive directors is to be decided by the board. Details of remuneration package, stock options, performance incentives of directors should be disclosed to the shareholders.
5. Board procedures: The board should have at least four meetings a year. A director should not be a member of more than 10 committees and chairman of more than 5 committees across all companies.

   Management discussion and analysis report should include the following points:

   1. Industry structure and developments
   2. Opportunities and threats
   3. Segment-wise or product-wise performance
   4. Outlook on the business
   5. Risks and concerns
   6. Internal control systems and its adequacy
   7. Discussion on financial performance
   8. Disclosure by directors on material, financial and commercial transactions with the company
6. Shareholders information: The company should provide a brief resume of new or reappointed directors. Quarterly results should be submitted to stock exchanges, placed on the company web site, and presented to analysts.

   The shareholders’/investors’ grievance committee should have a minimum of 2 meetings a year, under the chairmanship of an independent director.

   A report on corporate governance and a certificate from auditors on compliance of provisions of corporate governance, as per Clause 49 in the listing agreement, should be provided.

Differences in the Key Provisions of the Original Clause and the New Clause

The new Clause 49 lays down tighter qualification criteria for independent directors. Unlike the original clause, the new clause disqualifies material suppliers and customers from being independent directors. It also disallows a shareholder with more than 2 percent stake in the company from being an independent director as well as a former executive who left the company less than 3 years ago.

Partners of current legal, audit, and consulting firms as well as partners of such firms that had worked in the company in the preceding 3 years, too, cannot be independent directors. A relative of a promoter, or an executive director or a senior executive one level below an executive director, too, cannot be an independent director.

Another important difference is that while the original clause gave the board freedom to decide whether a materially significant relationship between director and the company affected his independence, the new clause takes this discretionary power away from the board.

According to the original clause, the maximum time gap between two board meetings could be a maximum of 4 months. The new clause has reduced this time gap to 3 months.

The original clause had stipulated that the audit committee must meet at least three times a year and at least once every 6 months. The new clause makes it mandatory for the audit committee to meet a minimum of four times a year with a maximum time gap of 4 months.

Moreover, unlike the original clause which was silent on the qualifications of audit committee members, the new clause states that all members should be financially literate and at least one should have financial or accounting management expertise. The new clause gives a definition of “financially literate” and “accounting or related financial management expertise”. The new clause also strengthens and widens the role and responsibility of audit committees.

1.  Nominee directors considered to be independent directors: Nominees of institutions that have invested in or lent to the company are deemed independent directors.

2.  New provisions incorporated in the new Clause 49: The major new provisions included in the new Clause 49 are given below:

• The board will lay down a code of conduct for all board members and senior management of the company to follow compulsorily.
• The CEO and CFO will certify the financial statements and cash-flow statements of the company.
• At least one independent director of the holding company will be a member of the board of a material non-listed subsidiary.
• The audit committee of the listed company shall review the financial statements of the unlisted subsidiary, in particular its investments.

If while preparing financial statements, the company follows a treatment that is different from that prescribed in the accounting standards, it must disclose this in the financial statements, and the management should also provide an explanation for doing so in the corporate governance report of the annual report.

CEOs Accountable for Companies’ Risk Systems

Inspired by Sarbanes-Oxley Act, Clause 49 of listing agreement was scheduled to come into effect from 1 April 2005. However, bowing to general demand from corporates, SEBI decided in its board meet held on 23 March 2005, to defer the implementation of Clause 49 till 31 December to provide listed entities, including public sector companies, time to appoint adequate number of independent directors and comply with norms. No special concession is to be extended to state-owned enterprises which demanded exemption on this issue. SEBI felt that PSUs are not to be looked upon as special class of companies.

Under the new provisions, chief executive officers (CEOs) and chief financial officers (CFOs) in the country are preparing for a litmus test. Beginning 31 December 2005 all CEOs and CFOs embarked on massive documentation to meet the requirements of Clause 49 of SEBI’s listing agreement.

Rules of the Game

• CEOs and CFOs to be directly responsible for risk management (Provision 4C), internal control systems (Section 5)
• Clause 49 is largely derived from the Sarbanes-Oxley Act
• Companies seek legal advice, tap consultants to adopt new standards
• Want clarity on “material” association of independent directors
• Fear new norms will lead to shortage of independent directors
• Companies will have to spend more time and money on compliance.

Reserve Bank’s and Other Regulations

The Reserve Bank of India (RBI) also constituted its own advisory group on corporate governance under the aegis of the standing committee on International Financial Standards and Codes to review and recommend norms of corporate governance from the perspective of the banking sector. Based on the suggestions received from these committees, the Department of Company Affairs amended the Companies Act in December 2000 to include corporate governance provisions, which would be applicable to all companies. These new provisions came into effect from 1 April 2001.

The regulatory move is extended to non-listed companies also. The Companies Act is applicable to all Indian companies—both listed and unlisted. It incorporates recommendations of the Birla Committee report, including those related to non-executive directors, independent directors, composition of related party disclosures, audit committees etc. The concept of “a deemed public company” has been eliminated from the Act and therefore, all companies now are either public or private. While most of the large companies are public, the committee’s requirements are applicable only to companies with a share capital of over Rs. 5 crores. Also, only a 100 per cent subsidiary of a foreign company can seek exemptions as a private company. The Companies Act has reduced the number of companies a person can be a director from 20 to 15. The SEBI code also forbids them to sit on more than ten committees and to chair more than 5. The intent is to ensure that all directors fulfil their obligations and contribute in a greater measure towards the company affairs.

The Companies Act now allows shareholders to participate in critical company resolutions through postal ballot. Until now, special resolutions required at least 75 per cent of the shareholders present at the meeting to vote. Hence, if 200 of a company’s 1,000 shareholders were present at a meeting, 150 votes were sufficient to pass a resolution. Under the new provision, however, all shareholders will be able to participate in the voting process. Of late, postal ballot has become a common practice and stock exchanges are informed almost on a daily basis about an impending postal ballot by companies. Recently, Hindustan Lever got the approval of BSE to transfer its Sewri plant and one Sp. Polimer unit through postal ballot. Likewise, ITC got approval to amend its objects clause to start a new business. The ICICI Bank has sought approval for its ADS issue, while Blue Dart which wants to sell its subsidiary, ACC its Mancherial cement unit, Godrej Industries, Pantaloon, Reliance Energy and Glennmark have all sought this postal ballot route to seek their shareholders’ approval.⁴

Self-regulation

Self-regulation has been somewhat lagging behind in the area of corporate governance in the country. While admittedly some of the Indian companies compare most favourably with the best elsewhere in the world in the field of professional management and corporate governance, the vast majority has been languishing with outdated practices nurtured during the years of insulated economic environment that obtained in the country for the better part of its post-independence history. The liberalisation initiatives of the nineties have exposed the inefficiencies of many of these organisations which are now trying to come to terms with the paradigm shift in doing business.

 

Pioneers in Good Governance Practices

Industry Initiatives

Changing with the times, industry associations have taken the initiative to come up with guidelines for their member companies in the area of governance. A formal effort was initiated by the Confederation of Indian Industry when it produced in 1998, a document titled “Corporate Governance—A Desirable Code” through a Task Force headed by Rahul Bajaj, which for the first time formally recognised the obligation of listed corporations to create corporate wealth and distribute it among all their stakeholders. The need for transparency in reporting and the imperatives of having independent non-executive directors who could protect the interests of shareholders were clearly articulated. A similar initiative was mounted by SEBI with the constitution of a committee under the chairmanship of Kumar Mangalam Birla. Its report recommending guidelines on corporate governance published in February 2000 is a well balanced compendium of good practices that will stand corporates in good stead in their governance-improvement endeavours. These recommendations that have been categorised as mandatory, have since been incorporated in the listing agreements of the stock exchanges. To this extent, this initiative may be termed part-regulatory, part-voluntary.

As a service to the corporate sector, the CII is putting together a roster of independent directors from which companies can choose their non-executive directors while constituting their boards. The CII will provide the necessary guidelines to choose good directors, screen them, and continue to monitor and rate them. This will help companies overcome the difficulties they face in identifying professionally competent and ethically sound non-executive directors.

The existing diversity and complexity of forms and patterns of corporate governance will continue and, very probably, increase with time. Alternative governance will be needed to improve the effectiveness of governance, to influence the healthy development of corporate regulation, and to understand the reality of the political processes by which companies are governed, rather than the structures and mechanisms through which governance is exercised. In any development, it will be important to avoid the polarities of governance based on an expensive bureaucracy of regulation and the adversarial clash of vested interests.

Corporate Initiatives

Several studies have pointed out that the movement to introduce corporate governance practices in the country has achieved commendable progress. In fact, the country has evolved a system and structure of corporate governance considered to be one of the best among all developing countries. Unlike several other emerging markets, Indian companies maintain their shareholding patterns, making it possible to identify the ownership affiliation of each firm easily. “It is by and large a hybrid of the ‘outsiders’ systems’ and “insiders systems’ of corporate governance.”

 

“The legal framework for all corporate activities including governance and administration of companies, disclosures, shareholders’ rights, dividend announcements has been in place since the enactment of the Companies Act in 1956 and has been fairly stable. The listing agreements of stock exchanges have also been prescribing on-going conditions and continuous obligations to companies.”

“India has a well-established regulatory framework for more than four decades, which forms the foundation of the corporate governance system in India. Numerous initiatives have been taken by the Securities and Exchange Board of India (SEBI) to enhance corporate governance practice, in fulfillment of the objectives: Investor protection and market development, for example, streamlining of the disclosure, investor protection guidelines, book building, entry norms, listing agreement, preferential allotment disclosures and lot more …. Accounting system in India is well-established and accounting standards are similar to those followed in most of the advanced economies (Khanna and Palepu, 2000).

According to a survey on corporate excellence carried out by Credit Lyonnais, three Indian companies—Infosys, Hindustan Lever Limited and Wipro are amongst Asia’s top ten corporations in terms of good governance practices. Likewise, ICICI, Cummins India, HDFC, Ranbaxy, Dr. Reddy’s Lab, Orchid Chemicals and several Tata group companies also share this honour.

The Birla Group has already adopted corporate governance provisions. Non-executive directors now dominate the group’s company boards, and they have also constituted nomination, remuneration and audit committees.

Individual Initiatives

There were some outstanding initiatives in India from individual personalities even before the concept of corporate governance gained currency. J.R.D. Tata, from the time he took over the reins of the group till his death, ran the Tata industrial empire professionally, unlike other family-run businesses. Under his guidance, the Tata Group produced some outstanding CEOs. His belief in keeping business and politics separate did give the group a great deal of credibility and brought him laurels, and won the trust of everybody. The man who believed in empowerment never craved for power, money or glory. He ensured that the House of Tatas followed corporate governance practices in all its forms, both in the letter and spirit. Tata was, and continues to be, a household name and his shareholders had always been happy with him.

Keshub Mahindra is another industrialist who like J.R.D. Tata runs his empire professionally. He kept his daughters and relatives out of the boardroom. He has ensured that it is Mahindra & Mahindra that is projected and not personalities. He has, like the Tatas, ensured that the business is divorced from politics. He has created a code of corproate governance for the company.

N.R. Narayanamurthy is the new icon and undisputed king of the new economy. He shook the corporate world by giving his employees a stock option scheme (ESOPS) that saw many corporates taking a leaf out of Infosys’ book. Even before corporate governance became the buzzword, Infosys showed the way by giving detailed information and guidance reports in its 200 page plus annual report. So much so, that the SEC has been asking US companies to use the Infosys annual report as a model. The man who has created hundreds of millionaires within and at the bourses has set such high standards that Infosys keeps getting awards for being the best-run company, best at maintaining investor relations, best employer and so on. The ultimate tribute to Murthy was the government of India bestowing on Infosys the National Award for Excellence in Corporate Governance. By leveraging brainpower and sweat equity, Murthy has built a world-class software firm from the scratch.

Kumar Mangalam Birla who inherited a huge industrial empire challenged the conventional practices within the group companies when he took over in 1995. He has changed the culture of the group from being mainly a family-run enterprise of old-timers to one with professional ethos. His group companies have been making extensive disclosures. Impressed by this young Birla’s initiative, the regulatory body, SEBI appointed him on a committee which is now known as the Kumar Mangalam Birla Committee on corproate governance.

Banks and Corporate Governance

Banks in India as corporates are as much required to be governed under corporate governance norms as other firms. Additionally, they are also covered under the internationally followed Basel Committee norms about which details are provided in the chapter on banking and corporate governance.

 

The Basel Committee norms relate only to commercial banks and financial institutions. Banking and financial institutions stand to benefit only if corporate governance is accepted universally by industry and business, whom banks and financial institutions have to interact and deal with. SEBI only partially attends to this need.

Realising the importance of corporate governance to banks which are highly leveraged entities whose failures would pose large risks to the entire economic system, the Reserve Bank of India formed an advisory group on corporate governance that submitted its report in 2001 and another called the consultative group of directors of banks/financial institutions (known as the Ganguly Committee) which submitted its report in 2002. The Reserve Bank of India, after due deliberations of both these reports, acted on their recommendations that have considerably strengthened corporate governance mechanism in banks.

Transparency in the Private Sector

The need for transparency, so far, appears to have been felt in the context of public authorities alone. Consequently, we have the Right to Information Act and a modification of the Official Secrets Act. While, there is no doubt that the government has to be completely transparent in its dealings since it deals with public money, privately managed companies also have a wide shareholder base. They also deal with large volumes of public money. The need for transparency in the private sector is, therefore, in no way less important than in the public sector.

 

However, private companies use “competitive advantage/company interests” as a pretext to hide essential information. Awarding of contracts, recruitments, transfer pricing (for instance, through under/over invoicing of goods in intra-company transfers) are the areas which require greater transparency. Environmental conservation, redressal of customer complaints and use of company resources for personal purposes are some of the other crucial areas, which call for greater disclosure. Relevant details about these must be available for public scrutiny. Fear of public scrutiny will ensure corporate governance on sound principles both in the public as well as the private sectors.

Initiatives of the Department of Company Affairs

In May 2000, the Department of Company Affairs invited a group of leading industrialists, professionals and academics to study and recommend measures to enhance corporate excellence in India. This Study group in turn set up a Task Force under the chairmanship of Dr. P.L. Sanjeev Reddy, which examined the subject of “Corporate Excellence Through Sound Corporate Governance” and submitted its report in November 2000. The Task Force in its recommendations identified two classifications, namely, essential and desirable, with the former to be introduced immediately by legislation and the latter to be left to the discretion of companies and their shareholders. Some of the recommendations of the Task Force include the following:

• Greater role and influence for non-executive, independent directors
• Stringent punishment for executive directors for failing to comply with listing and other requirements
• Limitation on the nature and number of directorship of managing and full-time directors
• Proper disclosure to the shareholders and investing community
• Interested shareholders to abstain from voting on specified matters
• More meaningful and transparent accounting and reporting
• Tougher listing and compliance regimen through a centralised national listing authority
• Highest and toughest standards of corporate governance for listed companies
• A code of public behaviour for public sector units

Setting up of Centre for Corporate Excellence

The Government of India has set up the Centre for Corporate Excellence under the aegis of the Department of Company Affairs as an independent and autonomous body as recommended by the study group. The centre would undertake research on corporate governance; provide a scheme by which companies could rate themselves in terms of their corporate governance performance; promote corporate governance through certifying companies who practise acceptable standards of corporate governance and by instituting annual awards for outstanding performance in this area. Government’s initiative in promoting corporate excellence in the country by setting up such a centre is indeed a very important step in the right direction. It is likely to spread greater awareness among the corporate sector regarding matters relating to good corporate governance, motivating them to seek accreditation from this body. Cumulative effect of the companies achieving levels of corporate excellence would undoubtedly be visible in the form of much enhanced competitive strength of our country in the global market for goods and services.

National Award for Excellence in Corporate Governance

The national award for excellence in corporate governance, instituted in 1999 by the Ministry of Finance under the aegis of the Department of Company Affairs is sponsored by Unit Trust of India. For the very first year, the award was presented to Infosys. A panel chaired by Justice P. N. Bhagwati and comprising eminent persons unanimously selected Infosys Technologies (Limited) for the award for the year 1999. The panel commended the company thus: “Infosys is an ethical organisation whose value system ensures fairness, honesty, transparency, and courtesy to all its constituents and society at large.” For the year 2000, a panel chaired by Justice M.N. Venkatachaliah and comprising eminent persons unanimously selected The Tata Iron and Steel Limited (TISCO) for the award. This prestigious award was given to the company’s management for showing fairness, honesty, transparency and courtesy to all stakeholders and for its deep concern for the environment, pioneering social audit, taking good care of its employees and for driving change within the company in terms of knowledge management systems.

 

Corporate Restructuring

Besides, there are several substantive improvements in the law. It provides for initiation of restructuring of a corporate at a much earlier stage of financial sickness, thereby enhancing the possibility of its revival. It also provides for a safety net for the workers and the investors through better terms by setting up a rehabilitation fund and other allied measures. The jurisdiction and powers relating to winding up, presently vested with the High Courts, are also being shifted to the National Company Law Tribunal.

With globalisation and opening up of the economy, the need was felt that the Indian market should be geared to face competition not only from within the country, but from outside as well. Based on several recommendations, the Competition Bill was introduced in the Lok Sabha.

The Competition Bill, 2002, is a landmark development in economic legislation. The government had set up a high-level committee to examine the existing Monopolies and Restrictive Trade Practices (MRTP) Act, 1969, for shifting the focus of the law from curbing monopolies to promoting competition and to suggest a modern competition law in line with international developments to suit Indian conditions.

Best Practices

The law governing corporates has been fine-tuned by amending the Companies Act to create the right ambience for the corporate enterprises to function effectively in the era of liberalisation. With these amendments, corporates are now in a position to adopt the best practices in corporate governance in vogue elsewhere in the world. The DCA has undertaken an ambitious programme to completely overhaul its services to the corporate sector by undertaking modernisation and placing the services on the Internet. This is being undertaken with a view to reducing the time and resources spent by corporates. The offices of the Registrar of Companies (ROC) curb malpractices that arise out of the situation and also tap the immense amount of economic data received through filing in ROC offices and through the cost audit branches in the DCA. Computerisation and modernisation is planned to be undertaken through private or public partnership.

As mentioned earlier, Naresh Chandra Committee was set up to look into issues relating to auditor-company relationship such as rotation of auditors/auditing partners, restrictions on non-audit work/fees, procedures for appointment of auditors, determination of audit fees, the role of independent directors and disciplinary procedures for accountants. The recommendations of the committee are expected to help improve the credibility of company accounts and the integrity of audit work. They would also help in strengthening the disciplinary mechanism against erring accountants.

Establishment of the Serious Fraud Office

The Department of Company Affairs has set up a Serious Fraud Office (SFO) as part of a new push to crack down on company fraud and improve corporate governance. The SFO will investigate economic crimes such as bribery by companies trying to win lucrative deals. The SFO which is to be part of the Department of Company Affairs will investigate company finances and prosecute them in cases where there has been violation of corporate laws.

The establishment of the SFO has come as part of a general climate of change in corporate governance in India. The government is contemplating to set up a National Centre for Corporate Governance as a joint initiative with the private sector. A committee is also recently commissioned to examine how to make the country’s businesses more transparent. The SFO will pass the case on to other authorities if there is evidence that other laws, such as banking laws or tax laws, have been broken.⁵

Establishment of the National Foundation of Corporate Governance

To provide a platform to deliberate on issues relating to good corporate governance as key to sustainable wealth creation, the Indian government has taken a step forward in settingup the National Foundation for Corporate Governance (NFCG). In September 2003, the Union Cabinet had given its consent for setting up NFCG as a Trust. The Foundation has since been registered as a trust with the objective of promoting good corporate governance in India.⁶ Managing the trust will be a three-tier body comprising a governing council, a board of trustees and an Executive directorate.

 

The foundation will work in synergy with the Investor Protection and Education Fund (IE&PF), a corpus used for investor awareness programmes on issues such as capacity building. Promoting investor associations will be a common activity between the two bodies.

Among the broad objectives of NFCG will be to provide research and training in the field of corporate governance. It would also be a source of financial or any other assistance for activities aimed at promoting corporate governance, including research and training. Besides, the US-based Global Corporate Governance Forum will also be supporting the India-centric activities taken up by various agencies.

Meanwhile, IE&PF on its part is setting up a prime database called ‘Investor Watch out’ on the lines of a similar concept in Europe that will help educate the investors and list the names of the erring companies.

In exercise of the powers conferred by Section 205C of the Companies Act, Department of Company Affairs has, in October 2001, established an Investor Education and Protection Fund(IE&PF), the one mentioned earlier in connection with NFCG. The Fund will get contributions from companies having unpaid dividend, matured deposits and debentures and share application money lying with them for more than seven years. The funds are to be utilised for promoting investors’ awareness and protection of their interests. A committee to administer this fund has already been constituted by the DCA. Recognising the increasing concerns about the levels of corporate governance and ethical practices in the corporate sector, the DCA has undertaken active measures by promoting good corporate governance and enhancing the image of the corporate sector.

Need For Accounting Standards

Apart from these issues, there is another area, which needs to be attended to for bringing about further improvements in corporate governance in India. One such area is the introduction of internationally acceptable accounting standards. There are some gaps in accounting standards, which need to be closed or narrowed down for greater transparency.

 

One of the first and foremost demands of good corporate governance is to let investors know how their money has been used to further the interests of the company they have invested in.

The question that assumes importance in this context is, how effectively the resources of the company are utilised to strengthen the organisation. The only available source of information regarding the affairs of a company appears to be its balance sheet. Yet, for obvious reasons, the balance sheet remains the most abused statement of several companies. What is revealed by them may be significant, but what is hidden is vital.

The common methods by which companies hide their wrongful practices, which are all too well known, are to use legal jargon and accounting parlance, non-disclosure and selective adoption of only those policies that are mandatory in nature. It is only a handful of qualified persons, primarily the chartered accountants and the other knowledgeable people, who can get to the real picture behind the scenes and unmask the actual from the portrayed picture. It is in this context that the adoption of the US Generally Accepted Accounting Principles (GAAP), which provides for rigorous accounting standards and disclosures, assumes relevance.

The Institute of Chartered Accountants of India has come out with a set of new accounting standards, which became mandatory from 1 April 2001. These include standards regarding segmental reporting and related party transactions. Companies with subsidiaries will now have to present a consolidated financial statement for the entire group. Also, deferred tax payments will now have to be reflected in the current financial statements. Standards for triple bottom-line accounting, wherein companies will have to formally provide information regarding their social and environment related initiatives are likely to be introduced shortly.

As a result of the overall changes made by SEBI, the Department of Company Affairs and industry-based voluntary codes, Indian accounting and financial reporting standards are now at par with European standards, although they still significantly lag behind the generally accepted US accounting principles. Indian companies with overseas interests find it easy to adopt international standards.

There are many areas such as consolidation of accounts, treatment of fixed assets, depreciation, R&D costs, etc. where Indian Accounting Standards (IAS) are at variance with the US GAAP. However, it is heartening to note that things appear to be changing for the better on the Indian turf thanks to the impetus towards a more transparent accounting system shown by market leaders. The Institute of Chartered Accountants of India (ICAI) has already issued the Accounting Standard 21 (AS-21) for consolidation of accounts whereby accounts of companies would be presented along with those of their subsidiaries. This would meet the long pending demand of investors on greater transparency and disclosure.

The move towards corporate governance, however, brings along some unusual risks. With most organisations moving at an extremely fast pace to be recognised as responsible corporate citizens, those who do not will witness an erosion of their reputations with corporate governance standards continuously evolving, auditors all over the world are still unclear on what exactly they have to report. This is a great challenge since operating processes and internal audit functions will have to be redefined to ensure compliance.

Corporate Governance Rating

The Department of Company Affairs has set up an institute to rate corporate excellence similar to credit rating agencies such as CRISIL. This institute will undertake research in the area of corporate governance to be able to improve the overall legal framework and to advise companies and directors on how they can take corporate excellence forward. Individual corporate excellence ratings will be made available to investors, lenders and the public. The institute will be funded from the penalties paid by companies for violating the provisions of the Companies Act.

 

The Securities and Exchange Board of India has sought the services of two of the leading credit rating agencies in the country—Credit Rating Information Services of India Ltd. (CRISIL) and Investment Information and Credit Rating Agency (ICRA) to prepare a comprehensive instrument for rating the good corporate governance practices of listed companies. Besides these two, there are two other credit rating agencies (CRAs). These are CARE and FITCH India. According to the former SEBI Chairman, Mr. G.N. Bajpai, CRAs would enable the securities market regulator judge the compliance status of corporates on parameters such as effective creation, management and distribution of investors’ wealth. CRAs are normally expected to carry out periodic reviews of the ratings given.

ICRA’s Rating Methodology

Corporate governance rating is being done by ICRA, where assigning it is still very much a learning process.

In order to evaluate corporate governance, ICRA has decided to look at the following:

1. Shareholding structure: A transparent shareholding structure where the key shareholders are clearly identifiable and where an absence of opaque cross holdings is considered a positive feature.
2. Governance structure and management process: This focusses on the internal decision making process and the quality and nature of information presented to a company’s board. In looking at the decision making process, how responsibility is delegated and how accountability is ensured, a view is taken of not just what is laid down in procedures but what is actually practised. As to the quality of information submitted to the board, what is examined is whether it is told enough to know what is going on and whether its quality is satisfactory, are important. Emphasis is laid on matters such as inter-corporate loans, “related-party” transactions, large capital expenditure, diversification, and of course, mergers and acquisitions.
3. Board structure and process: The board structure and process of decision making is all very important. The bottomline is whether a company is board-managed or its board is a rubber stamping body whose members hold their positions at the pleasure of the effective owner. For this, the size of the board, selection criteria for directors, proportion of independent directors and the expertise they can command, compensation policy for directors, number and nature of board committees, attendance record of directors and frequency of board meetings are all taken into consideration.
4. Examine stakeholder relations: ICRA’s methodology on this matter relates almost wholly to the rights of shareholders and the duty of the company to service them well. There is a passing reference to other financial stakeholders such as banks, financial institutions and fixed-deposit holders. But the whole idea of stakeholder is that it goes far beyond the shareholder and includes the workers, a company’s customers and the society at large.
5. Transparency and disclosures: It is found that better-run companies disclose more than they are required by the law. But in assessing a company’s performance in this regard, emphasis is laid on how materialistic the disclosures are and whether they really shed any light or hide more than they reveal.
6. Financial discipline: Considerations under this criterion would broadly overlap with the determinants governing financial rating. But it is emphasised that a financial rating says nothing about the nature of corporate governance prevailing in a company and similarly, a governance rating says nothing about the financial position of a company. The risk of governance failure will not be apparent from the financial rating of a company, but from its corporate governance rating. Here again, the conceptual scope of corporate governance and the way ICRA sees the idea may be a little divergent. While discussing financial discipline, it says that the ultimate objective of corporate governance is to maximise shareholder value to the extent that if the company goes down in its governance record, no matter how excellent otherwise, will mean nothing. But what if a company’s shareholders are happy with it but its workers or society at large are not, then the conflict of interest needs to be dealt with and a mutually beneficial situation needs to be arrived at, but one should remember that shareholders are also members of the society.

Credit ratings for debt paper, which did not start off very well, later picked up, thanks to the pressures of the market which forced issuers of debt to get themselves rated in order to raise money. Similarly, market pressures will force more and more corporates in India to go in for corporate governance ratings. Eventually, SEBI, which can legitimately take credit for spearheading the movement for corporate governance ratings in India, must make such ratings mandatory for issuers of equity, so that investors have a comprehensive understanding of the companies where they are putting their money.

Corporate Governance in India—A Performance Appraisal

It is over a decade that the concept of corporate governance has become a passion with industry analysts in India. It has long passed the stage of being a fashion statement which was the case in early 1990s, as its ideals having been propagated as the be-all and end-all of all corporate endeavour in the aftermath of economic liberalisation in the country on one hand, and the then newly published Cadbury Report, on the other. All these got irretrievably intermixed to give the concept an aura and a halo. Now, after more than a decade down the line and with a lot of studies and in-depth research having been done by several committees, a reality check and analysis throw up a lot of somewhat unpalatable home truths.

Indian industry has come a long way since 1991. There has been a phenomenal growth both in the quality and number of corporates in the country. Some of them are implanting their footprints abroad and some worldwide objective research has shown that our corporates, albeit small in number, are second to none in terms of corporate governance standards. Companies like Infosys are on top of the heap. If the American capital market regulator, SEC, commend Infosys’ balance sheet as a model to be emulated by US companies, it speaks volumes about our better-governed corporates.

In the table below a list of 63 companies that were shortlisted for the conferment of the Government of India’s Award for Excellence in Corporate Governance for the period 1999–2001 is given. The list was prepared on the bases of certain corporate governance criteria such as (i) governance structure, which includes composition of the board and committees of the board; (ii) disclosures in the annual report, which covers statutory disclosures and non-statutory disclosures; (iii) timeliness and content of information to the investors and the public, which take into account compliance with the listing agreement with the concerned stock exchange, contents on website and grievance resolution ratio and (iv) enhancement of shareholder value determined on the bases of share prices and return on net worth. These 63 corporates that have been chosen for consideration of the topmost award for corporate governance standards they follow (Table 19.1), represent only a sample and not exhaustive enough to cover all companies that are worthy enough for being shortlisted. This implies that there are a sizeable number of corproates in the country that make serious efforts to adopt better corporate governance standards.

 

TABLE 19.1 Companies nominated for the consideration of the Award for Excellence in Corporate Governance (1999, 2000, 2001)

1. Agervo (India) Ltd.	24. GACL
2. Archies Greetings and Gifts Ltd.	25. Glaxo India Ltd.
3. Asea Brown Boveri Ltd.	26. Global Telesystem Ltd.
4. Asian Paints Ltd.	27. HCL Infosystems Ltd.
5. Bajaj Auto Ltd.	28. HCL Technologies Ltd.
6. BFL Software Ltd.	29. HDFC Bank Ltd.
7. Bharat Forge Ltd.	30. HDFC Ltd.
8. BPCL	31. Hero Honda Motors Ltd.
9. Britannia Industries Ltd.	32. Hindalco
10. BSES Ltd.	33. Hindustan Lever Ltd.
11. Cadbury India Ltd.	34. HPCL
12. Castrol India Ltd.	35. ICICI Ltd.
13. Cipla Pharma	36. Indian Hotels Company Ltd.
14. Colgate India Ltd.	37. Indian Oil Corporation
15. Container Corporation of India Ltd.	38. ITC Ltd.
16. Corporation Bank	39. Larsen & Toubro Ltd.
17. CRISIL	40.Lupin Laboratories Ltd.
18.Dabur India Ltd.	42. Mahindra & Mahindra
19.Digital Equipment India Ltd.	43.Mphasis BFL Ltd.
20.Dr. Reddy’s Laboratories Ltd.	43.Motor Industries Company Ltd.
21.E I H Ltd.	44.MRF Ltd.
22. Finolex Cables Ltd	45. Nicholas Piramal India Ltd.
23. Finolex Industries Ltd.	46. NIIT Ltd.
47.Novartis India Ltd.	56.SmithKline Beecham India Ltd.
48.ONGC	57. State Bank of India
49. Pidilite Industries Ltd.	58. Sun Pharmaceuticals Ltd.
50.Procter & Gamble India Ltd.	59.Sundaram Fastners Ltd.
51.Punjab Tractors Ltd.	60.TVS Suzuki Ltd.
52. Ranbaxy Laboratories Ltd.	61.VSNL
53.Reckitt & Coleman India Ltd.	62.Wipro Ltd.
54.Reliance Industries Ltd.	63.Wockhardt Ltd.
55.Satyam Computers Ltd.

 

There is another perspective to the issue of the Indian corporate sector’s earnest attempt to put in place corporate governance practices. According to Tata & Sons Executive Director, R. Gopalakrishnan, Indian firms have spent Rs. 800 crore so far on corporate governance. “In the last three years, the money paid to auditors has jumped to Rs. 800 crore from Rs. 400 crore. This, I would say, is arguably the cost of corporate governance.” He pointed out that industry groups like the Tatas and Birlas believed in the trusteeship concept of wealth⁷ which is one way of looking at corporate governance.

Viewed from another angle, if many Indian industries are recognised across the world, it is also due to the image they have been projecting as successful corporations with good governance systems. In that sense Indian industry seems to have arrived. Two Indian companies—Infosys and Reliance Industries—are among the 44 global strategic partners, which are contributing their expertise and resources to the organisation of the Annual Meeting of the World Economic Forum 2005. Infosys Chairman and Chief Mentor, N.R. Narayana Murthy is also one of the co-chairs in this prestigious annual event of the WEF held in Devos, Switzerland.⁸

A Report Card That Does Not Impress

However, the success of the Indian corporates in achieving good corporate governance seems to be only skin deep. Corporate governance seems to have favourably impacted only a handful of corporates whose leaders imbued with its lofty ideals, have taken them to such dizzy heights, while others have done nothing but cosmetic changes in the governance of their companies and seem to have satisfied themselves with their meagre attempts.

In early 2004, a corporate governance country assessment for India was carried out as part of the joint World Bank—IMF programme of report on the Observance of Standards and Codes. The objective was to benchmark the observance by Indian corporations against the OECD principles of corporate governance, which were originally framed in 1999, revised in early 2004 and are considered as benchmark on corporate governance by the World Bank.⁹

 

The report assesses India’s compliance with each of the OECD principles of corporate governance. The compliance level has been classified into five categories, namely, (i) “observed”, (ii) “largely observed”, (iii) “partially observed”, (iv) “materially not observed” and (v) “not observed”. Out of 23 OECD principles, Indian corporations have been found to be observing 10, 6 were “largely observed”, another 6 “partially observed” and 1 was “materially not observed”.

The one category where the assessment team had found Indian corporates “materially not observing” concerns facilitating all shareholders, including institutional shareholders to exercise their voting rights. These principles call for institutional shareholders to disclose their voting policy and also to disclose when they act in a fiduciary capacity, how they manage material conflicts of interest that may affect exercise of their key ownership rights.

Table 19.2 presents the areas where the assessment team had found Indian corporations to be only “partially observant” of the OECD principles. The report has made several policy recommendations in the case of a principle which is less than fully observed. Some of the important policy recommendations are:

1.  Sanction and enforcement: The existing provisions on sanctions in the Companies Act are considered inadequate, particularly the magnitude of fines. Stock Exchanges, at present, do not have power to impose fines. Sanction and enforcements should be credible deterrents for the corporates to carry out their business practices within the applicable laws and regulations. It should be such as to ensure that business practices are aligned with the legal and regulatory framework, in particular with regard to related party transactions and insider trading.

 

TABLE 19.2 Areas where Indian companies are “partially observant” of the OECD principles

Principles	Comments
All shareholders should be treated equally	While shareholders can approach SEBI, the company law board or the investors grievance committee of the concerned stock exchange for redress of grievances, doubts persist about the effectiveness of legal remedies.
Prohibition of insider trading	While insider trading is a criminal offence, the enforcement is weak and often ineffective.
Board/managers to disclose interests	It is reported that misuse of corporate assets and abuse in related party transactions remain a problem.
Redress for violation of stakeholders’ rights	Redress can be sought through civil and high courts, but there are long delays and backlogs.
Annual independent audit	Auditors can provide consulting service to the auditee company to the extent of the level of audit fee, but disciplinary proceedings are lengthy.
The Board should be able to exercise objective judgement	As multiple board membership can interfere with performance of direction, the desirability of such a situation should be considered. Special training and certification programme for audit committee members should be considered.

 

2. Necessity for clear demarcation of controls: The current regulatory framework places the responsibility of oversight of listed companies partly with the Department of Company Affairs (DCA), SEBI and the stock exchanges. This multiplicity of regulators without clear demarcations leads to overlapping controls and enables violators go off the hook. The fragmented structure also gives rise to regulatory arbitrage and weaken enforcement. Keeping in view the enormous size of the country’s equity market, there is a need to thoroughly review this three-tiered supervision system and clearly demarcate the responsibility of each regulator. This is the reason why the N. K. Mitra Committee recommended that SEBI alone should be the capital market regulator clothed with powers of investigation in the corporate governance mechanism obtained in India.

3.  Lack of professionalism of directors: A key missing ingredient is a strong focus on professionalism of directors. Director training institutes can play a key capacity-building role and expand the pool of competent candidates on a priority basis. Directors should upgrade their knowledge and skill. If boards are not expected to simply “rubber stamping” the decisions of management or promoters, they must have a clear understanding of what is expected from them.

4.  Role of institutional investors: Institutional investors acting in a fiduciary capacity should be encouraged to form a comprehensive corporate governance policy, including voting and Board representation. In addition to the above policy recommendations of the World Bank - IMF Team, there are other deficiencies in the country’s capital market that need to be addressed effectively.

5.  Indian boards show poor professionalism: The corporate governance reforms have been mostly on paper. The hollowness of the system is indicated by the fact that the “independent directors” are all nominated by the controlling group whom they are supposed to supervise!

An analysis by L.C. Gupta and his team of researchers shows that a vast majority of the Indian listed companies have destroyed shareholder value. Whether or not a company has given proper attention to the interest of shareholders, would ordinarily get reflected in two indicators of shareholders’ return, viz., dividends and capital appreciation.¹⁰

• The study shows that the great majority of Indian listed companies have, in fact, destroyed shareholder value.
• Instead of severely punishing the guilty corporate managements, the Indian authorities let them go scot free.

Indian directors give only lip service to corporate governance practices, as pointed out by Dilip Kumar Sen in his article quoted above. In India, like in most developing, and to some extent, even in some developed countries, corporates are run like CEO’s personal fiefdom. CEOs do not generally care for welfare of all stakeholders, but for the interest of the principal shareholders only. The majority of directors are unaware that they are agents of shareholders and that they hold a position of trust and faith. Participation of a non-executive director in meetings, whether of the board or its committees, is inversely proportional to the health of bottom line—better the bottom line, lesser the participation.

Most directors of companies do not consider it necessary to update their knowledge and understanding on changes in laws and regulations or the business model of the company of which they are directors and which affect their duties and responsibilities as directors. So long as the performance of the company is satisfactory, which is judged by the health of bottom line, refusal to approve or object to any proposal of management is considered bad manners.

6. Independent directors are not so independent: Independence of independent directors seems to be only on paper. Most of the independent directors are hand-in-glove with the promoters. They rubber-stamp questionable decisions of promoters and ignore fund diversion and mismanagement in their companies. In several top companies, there are people who have remained as independent directors for as many as 20-30 years. In Reliance industries, for example, these directors remained silent when the company made massive investment in other unlisted companies. A SEBI panel tried to stop this practice and proposed a limit (9 years) on their tenure with a retrospective effect. But Indian corporate bigwigs “intervened” and lobbied for changes—finally, the limit is now with prospective effect.

Sen continues to assert that non-executive directors do not consider themselves as watch-dogs of shareholders. Board rooms are invariably filled up with “yes” men who do not raise relevant questions and assent to all proposals put up by the management. A person is invited to become a non-executive director only if he/she enjoys the patronage of the chairman/ CEO through old school connection or social circuit or golf club. Except during a crisis even nominee directors play a passive role at meetings. This has been demonstrated time and again, when an objective analysis of corporate failures is made. A general rule for the domestic corporate sector is that what you preach on corporate governance need not necessarily be practised in the company you manage. Same non-participating directors can become extremely vocal and inquisitive and raise uncomfortable questions the moment performance of the company becomes unsatisfactory. In India non-executive directorships are considered more as a symbol of social status and connections than as a position of responsibility.

A couple of years after Indian corporates tom-tommed the virtues of good corporate governance practices, the revelations at Reliance, the country’s largest private sector company, show that a lot still needs to be done. To be sure, corporate governance levels have improved in the last 5 years, but Indian industry still finds itself on the opposing side.¹¹

7.  Whistle blower policy: SEBI had proposed sometime ago that a whistle blower policy should be made mandatory. However, after stiff resistance from the industry, it asked the N.R. Narayana Murthy panel to rework the policy. Later, the whistleblower policy was made optional for companies.

8.  Unlisted investment companies: This is the most confusing part of Indian industry and one that companies will protect tooth and nail. Companies and promoters have promoted thousands of unlisted subsidiaries. Many of them divert funds through these companies. The modus operandi: The listed company will give a loan (even interest-free) to these unlisted companies, which, in turn, will default repayment. A major chunk of these investment companies hold shares in their listed companies. In fact, promoters have floated several layers of such subsidiaries to hold their stakes in leading group companies. Most of corporate India including the Tatas, Birlas, and Reliance follow this practice.

9.  Accounting gimmicks: While there are some gaps in financial statements, corporate sources claim, “We are now pretty close to the global best practices”. But this has to be taken with a pinch of salt. For instance, a study by CRISIL in 2004 reclassified and sanitized the annual accounts of 616 manufacturing companies. It re-stated the accounts of 243 companies and showed that their actual profits are different from what they had reported. Simply put, their books were cooked.

10.  Poor shareholder participation: Corporate misgovernance in India would not have gone thus far and promoter families would not have ruled the roost this much, had there been a well-directed shareholder activism. The Indian investors, more than their counterparts elsewhere, are scattered, unorganised, ill-informed, mute and un-interested in the affairs of the company they have invested in, except for the dividends and other annual gifts doled out to them. They give their consent most obligingly enabling unscrupulous managements to perpetrate their dynastic rule with glee and making corporate democracy a sham. Voices of dissent are few and rarely recorded. The worst part of it is that even large institutional shareholders rarely record their dissent, and if they find board decisions and practices unacceptable they simply sell their securities and quit, rather than fight and help establish better governance practices. No wonder there has been a sizeable erosion of investor confidence in the Indian industry with scams coming to light almost every year in quick succession.

11.  Obliging auditors: Another weak link in the wobbling chain of corporate governance in the country is that of the auditing profession. Obliging auditors help companies in window-dressing, manipulation of profit and loss accounts, hedging and fudging of unexplainable expenditures and resorting to continuous upward evaluation of assets to conceal poor performance. It is common knowledge that there is a dire need for independent auditors who are reputed and above board. Due to distrust in Indian auditors, most of the multinational companies in India have insisted on their parent companies’ auditors to audit their subsidiaries in the country. Things have started improving with the Institute of Chartered Accountants of India insisting on the profession adopting improved accounting practices, but there is a lot to be achieved.¹²

12.  Other Problems: There are of course, several other problems in the country’s capital market that are responsible for the poor record of corporate governance in the country. It has been mentioned earlier and it requires repetition in this context. A soft state, a lethargic and slow-moving judicial system, a value system that is indifferent to moral turpitudes, an inefficient market regulator and poor enforcement of rules and regulations have all combined together to ensure that though the ideal of corporate governance is kept on a high pedestal, it is only occasionally put into practice.

The Future of Corporate Governance in India

Although India has a long way to go to be ranked among the best in the world in corporate governance, the driver is exactly right. A large number of CEOs now realise that their companies need financial and human capital in order to grow to scales necessary to survive international competition. They also understand that such capital will not be available in a non-transparent corporate regime that is bereft of international quality of disclosures and accountability. It is precisely this realisation which is driving the corporate governance movement in India and which, has greater chances of delivering substance rather than ticking mandated governance checklists.

 

It is important to note that there are still some lacunae in different aspects of corporate governance.

• India still has poor bankruptcy laws and procedures (legal and procedural barriers to good corporate governance).
• Indian accounting standards still do not mandate consolidation—although this is slated to change.
• Indian stock markets are still inefficiently run, and do have adequate depth or width to give shareholders greater comfort.
• The Indian bond market is in its infancy. Pension funds need to invest much more in equity, and play an activist role. Mutual funds “need to walk the talk” in corporate governance.

Even so, it is necessary to recognise that corporate India has gone a long way in the business of governance, especially in the last 4 years—and more so given its legacy of the past.

Impetus for the Growth of Corporate Governance in India

Although corporate governance has been slow in making its mark in India, the next few years will see a flurry of activity. This will be driven by several factors:

 

1.  Competition-driven: Most important is the force of competition. With the dismantling of licences and controls, reduction of import tariffs and quotas, virtual elimination of public sector reservations, and a much more liberalised regime for foreign direct and portfolio investments, Indian companies have faced more competition in the second half of the 1990s than they did since Independence. Competition has forced companies to drastically restructure their ways of doing business.

2.  New players’ professionalism: Many companies and business groups that were on the top of the pecking order in 1991 have been relegated to the bottom. Simultaneously, new aggressive companies have clawed their way to the top. Therefore, they are more than willing to have professional boards and voluntarily follow disclosure standards that measure up to the best in the world.

3.  Growth in market capitalisation: There has been a phenomenal growth in market capitalisation. This growth has triggered a fundamental change in mindset from the earlier one of appropriating larger slices of a small pie, to doing all that is needed to let the pie grow, even if it involves dilution in share ownership.

4.  Foreign portfolio investors: One cannot exaggerate the impact of well-focussed, well-researched foreign portfolio investors. These investors have steadily raised their demands for better corporate governance, more transparency and greater disclosure. Over the last few years, they have systematically increased their exposure in well-governed firms at the expense of poorly run ones.

5.  Media Influences: India has a strong financial press, which will get stronger with the years. In the last 5 years, the press and financial analysts have induced a level of disclosure that was inconceivable a decade ago. This will increase and force companies to become more transparent—not just in their financial statements but also in matters relating to internal governance.

6.  Influence of banks and financial institutions: Despite serious lacunae in Indian bankruptcy provisions, neither banks nor financial institutions will continue to support managements irrespective of performance. Already, the more aggressive and market oriented FIs have started converting some of their outstanding debt to equity, and setting up merger and acquisition subsidiaries to sell their shares in under performing companies to more dynamic entrepreneurs and managerial groups. This will intensify over time, especially with the advent of universal banking.

7.  Realisation among Indian corporates of the benefits of corporate governance: Ultimately, Indian corporations have appreciated the fact that good corporate governance and internationally accepted standards of accounting and disclosure can help them access the US capital markets. Until 1998, this premise existed only in theory. It changed with Infosys making its highly successful NASDAQ issue in March 1998. This was followed by five more US depository issues—ICICI (which is listed on NYSE), Satyam, Infosys, Rediff and WIPRO. There are more and more companies gearing up to issue US depository receipts, and all of them will get listed either at NYSE or at NASDAQ. This trend has had two major beneficial effects. First, it has shown that good governance pays off, and allows companies to access the world’s largest capital market. By the latest count, external commercial borrowings of Indian corporations (ECBs) during the financial year 2004-05 would top $10 billion, apart from an equivalent amount of FDI inflows.¹³ Second, it has demonstrated that good corporate governance and disclosures are not difficult to implement—and Indian companies can do all that is needed to satisfy US investors and the SEC. The message is now clear: it makes good business sense to be a transparent, well governed company, incorporating internally acceptable accounting standards.

8.  Impending full capital account convertability will exert its own pressure: Moreover, sooner than later India will move to full capital account convertibility. When that happens, an Indian investor will seriously consider whether to put his funds in an Indian company or to place it with a foreign mutual or pension fund. That kind of freedom will be the ultimate weapon in favour of good corporate governance. Thankfully for India, the companies that matter have already seen the writing on the wall. Thus, it may not be wrong to predict that in another couple of years India might have the largest concentration of well-governed companies in South and Southeast Asia.

• A report card
• Accounting Standards
• Best practices
• Corporate governance rating
• Corporate initiatives
• Ethics and values
• Impetus for growth
• Individual initiatives
• Industry initiatives
• Legislative changes
• N ational Foundation for Corporate Governance
• Performance appraisal
• Rating methodology
• Reserve Bank of India
• Restructuring
• Self-regulation
• Serious Fraud Office
• The harbinger of corporate governance
• Transparency

1. What do you understand by the term ‘corporate governance’? Why is it important?
2. Elucidate the need for corporate governance in India.
3. What roles, values and ethics play in ensuring corporate governance?
4. What were the efforts initiated by India to ensure corporate governance in the country?
5. What do you understand by the term ‘Listing Agreement’? In this context, explain Clause 49.
6. Discuss the extent to which efforts to ensure corporate governance has been effective in India.

• Banerjee, A.M. and K.A. Chandrasekaran (1996), Renewing Governance: Issues and Options, Tata McGraw Hill Publications.
• Corporate Boards and Governance (1998), edited by N. Balasubramanian, Indian Institute of Management, Bangalore.
• Panchali, J.N. (1999), Corporate Governance: Indian Experiences, A Background Paper for National Roundtable on Corporate Governance (1999).
• Panchali, J.N. (2001), Corporate Governance: Indian Experiences, in “Corporate Excellence through Corporate Governance—Contemporary Practices and Prognosis, edited by ICSI Centre for Corporation Research and Training (2001).
• Balasubramanian, N. (1999), Changing Perceptions of Corporate Governance in India, ASCI Journal of Management, 27 (1&2).
• Sengupta, N.K. (1983), Changing Patterns of Corporate Management, Delhi: Vikas Publishing House Pvt. Ltd.
• Panchali, Jinesh N., Excellence in Corporate Governance (An Exercise in Assessment of Corporate Governance Ppractices in the Indian Corporate Sector), Indian Institute of Capital Markets.
• Kathuria, V. and S. Dash, Board Size and Corporate Financial Performance: An Investigation, Vikalpa, Vol. 24, No. (3 July-September 1999).

1. Cadbury Committee Report, A Report by the Committee on the Financial Aspects of Corporate Governance. The committee was chaired by Sir Adrian Cadbury and issued for public comment on 27 May 1992.
2. Greenbury Committee Report, 1994, Investigating Board Members Remuneration and Responsibilities.
3. The Committee on Corporate Governance, The Hampel Committee Report, 1998.
4. The Combined Code of Best Practices in Corporate Governance, The Turnbull Committee Report, 1998.
5. Principles of Corporate Governance: A Report by OECD Task Force on Corporate Governance, 1999.
6. Patterson Report: The Link Between Corporate Governance and Performance, 2001.
7. Confederation of Indian Industry, Desirable Corporate Governance: A Code, March 1998.

 

 

Case Study

Insider Trading: HLL-BBLIL Merger

(This case is based on print and electronic media and is meant for classroom discussion only. The author has no intention to tarnish the reputataion of either the corporates or the individuals involved).

Statement of the Case

The Indian capital market has witnessed several price-rigging and insider-trading activities both of which are considered unlawful by the Securities and Exchange Board of India (SEBI). Price rigging occurs when persons acting in concert with each other collude to increase or decrease artificially the price of a security. Insider trading refers to a situation when a person having unpublished price-sensitive information such as financial results, expansion plans, take-over bids etc. by virtue of his association with a company, trades its shares to make undue profits. This is a case that studies one such instance of alleged insider trading by officials of Hindustan Lever Limited (HLL) when the company wanted a merger with its sister concern Brooke Bond Lipton India Limited (BBLIL). This is the first ever case of insider trading in India which was taken up by SEBI to scrutinise the manner of the involvement of a big company, HLL. It also exposes the major flaws in SEBI’s insider-trading regulations and the need to plug the loopholes in them. Although SEBI was investigating the case from May 1996, the final verdict was passed 2 years thereafter by the market regulator which took the whole of corporate India by storm.

Establishing the Case

SEBI in its order that tried to establish an insider trading case against HLL management observed that it could be conclusively stated that while entering into the transaction for the purchase of 8 lakh shares of BBLIL from the Unit Trust of India (UTI), HLL was acting on the basis of the privileged information in its possession, regarding the impending merger of BBLIL with HLL. “It also may be stated that, by its very nature, when it comes to motives and intentions, there may not always be any direct evidence. However, the chain of circumstances, the timing of the transaction, and other related factors demonstrates beyond doubt that the transaction was founded upon and effected on the basis of unpublished price sensitive information about the impending merger.”

On 4 August 1997, SEBI issued a show cause notice to HLL claiming that there was prima facie evidence of the company indulging in insider trading, through the use of “unpublished price sensitive information” prior to its merger with Brooke Bond Lipton India Ltd. (BBLIL). In March 1998, SEBI passed an exhaustive order, which sent shock waves through the country’s corporate sector. SEBI found HLL guilty of insider trading because it bought shares of BBLIL from Unit Trust of India with the full knowledge that the two sister concerns were going to merge. Since it bought the shares before the merger was formally announced, SEBI held that HLL was using unpublished, price-sensitive information to trade, and was therefore, guilty of insider trading. SEBI directed HLL to pay UTI Rs 3.4 crore in compensation, and also initiated criminal proceedings against the five common directors of HLL and BBLIL: S.M. Datta, K.V. Dadiseth, R. Gopalakrishnan, A. Lahiri and M.K. Sharma, who were on the core team which discussed the merger.

The History of the Case

The case dates back to 1996 when the FMCG giant, Hindustan Lever, had decided to merge with its sister concern, Brooke Bond Lipton India Limited, so as to enable their parent company, Uniliver have a major stake in the merged entity. Both the companies informed the concerned stock exchanges of their desire to become a single entity by entering into a merger on 19 April 1996. However, much before the merger move became public, the share price and the volumes of BBLIL traded on the stock exchanges witnessed a steep hike. On 12 May 1996 SEBI, the market regulator, in an uncharacteristically swift move launched an investigation on HLL and on 4 August 1997 charged the company of indulging in insider trading. SEBI did not accuse any individual for the wrongdoing, but the company itself was accused of it. The culmination of the proceedings of the case took place on 11 March 1998 in the form of SEBI holding HLL guilty and prosecuting the five above cited HLL directors for the offence of insider trading.

Questions of Law and Its Interpretations in the Case

Naturally enough, Hindustan Lever decided to appeal against SEBI’s verdict to the Union Ministry of Finance, the appellate authority in such cases. The questions which were in everyone’s mind were two-fold: (i) is HLL guilty of insider trading and (ii) would SEBI’s charges stand legal scrutiny when contested, as there were several questions of law and its interpretations which would have to be settled.

SEBI took the stand that only HLL knew about the forthcoming merger and it acted on the basis of such unpublished information it was privileged to know. According to SEBI, HLL and its directors misused such information. HLL was an “Insider” and by buying 800,000 shares of BBLIL from UTI (pre-merger), it violated the insider trading regulation. Shares were purchased from the UTI to ensure 51% stake to Unilever in the post-merger company with the prior knowledge of share-swap ratio. On 17 January 1996 the merger decision made by the parent company, Unilever, was communicated to the core team of directors by C.M. Jemmett, the parent company’s representative. In March 1996, HLL bought the shares from UTI. HLL announced the merger with BBLIL in April 1996.

SEBI also charged HLL of acting in a manner inimical to the interests of thousands of ordinary shareholders. Besides, Hindustan Lever depleted its own resources by helping its holding company, Unilever obtain major stake in the merged entity. “The funds that were shelled out by HLL to purchase BBLIL’s shares were to be extinguished and that too for the holding company”, As per SEBI’s contention, this was against the interest of the ordinary shareholders. Further, SEBI charged that HLL deprived the country of precious foreign exchange, as Unilever would have invested nearly Rs. 45–50 crores to raise its holding to 51% in the post-merger consolidated company.

Arguments For and Against SEBI’s Ruling

SEBI’s notice to Hindustan Lever, the penalty the market regulator imposed on the company and its indictment of the directors of the company not only created a storm in the Indian corporate sector, but also raised a number of legal issues relating to SEBI’s penal action and its sustainability by appellate authorities when contested by the company. These issues were: (i) whether HLL was an “insider” or not, (ii) whether or not the premerger information HLL had access to was “unpublished”, (iii) whether or not HLL had any price-sensitive information with regard to the merger (iv) whether or not HLL had gained any unfair advantage out of the deal.

The first and most debated issue was concerning whether HLL was an insider at all. According to Clause 2(e) of SEBI’s regulations: “Insider means any person who is or was connected with the company or is deemed to have been connected with the company, and who is reasonably expected to have access, by virtue of such connection, to unpublished price-sensitive information in respect of securities of the company, or who has received or has had access to such unpublished price-sensitive information.”

To rebut this allegation of SEBI, Hindustan Lever countered that though it was deemed to be connected to BBLIL, and though it knew about the merger before it bought BBLIL’s shares, it received the information only because it was one of the parties to the merger itself and not merely because of its connection to BBLIL. HLL stressed this distinction because, to be an “insider”, HLL should have received the information “by virtue of such connection” with the other company. HLL’s defense centred around the fact that as an initiator and also as the transferee, it was the “primary party” to the merger. the legal Director of Hindustan Lever argued: “Nowhere in the world is the primary party to a merger considered to be an insider from the point of view of insider-trading.”

SEBI refused to accept the company’s interpretation of the clause. It argued: “The phrase ‘by virtue of such connection” applied only to one kind of insider, ‘the connected’ or ‘deemed connected person’ who was expected to have access to information because of his connection.” SEBI underscored the point that HLL also fell under the definition of someone “who was reasonably expected to have access by virtue of such connection”, as the core team of five common directors discussed the merger, and Unilever, the common parent, granted the “in principle” approval, and besides, HLL was free to use the information to further the merger, but not to buy shares. There is a second part of the clause, argued SEBI, that defined another kind of insider, who might not be connected to the company at all, but “who had received or has had access to such unpublished price sensitive information”. Therefore, SEBI argued that even if BBLIL was construed to be unconnected, HLL could still be an insider of the second type. Its order said, “If we were to accept HLL’s argument…it would permit a ‘connected’ or ‘deemed connected’ person to misuse the price-sensitive information because he has received the information independently”.

The second issue raised in the case was whether or not the information, which HLL had access to, was “unpublished”. According to clause 2(k) of SEBI’s regulation on Insider Trading: “Unpublished price-sensitive information means any information which is of concern, directly or indirectly, to a company, and is not generally known or published by such company for general information, but which if published or known, is likely to materially affect the price of securities of that company in the market.”

While SEBI argued that Hindustan Lever has gone against this regulation, HLL contended that before the transaction, the merger was the subject of wide market and media speculation. After the formal announcement, press reports highlighted the fact that the merger caused no surprise at all to anyone as it was part of the market grapevine for long. HLL pointed out that before the transaction, the share price of BBLIL moved up from Rs. 242 to Rs. 320 between January and March 1996, showing that the merger was “a generally known information”.

HLL also pointed out that the public sector mutual fund, UTI was a large enough institutional player and, given the speculation, how could UTI had remained unaware that the merger was forthcoming? Inspite of its being the second largest shareholder in both BBLIL and HLL, UTI did not complain against the transaction either formally to SEBI, or informally to HLL after the formal merger announcement. Moreover, Hindustan Lever had, between the transaction and the formal announcement, privately told UTI of the merger. UTI also hosted an inter-institutional meeting to discuss it. UTI even sold HLL some more shares 9 months later, though at a higher price.

SEBI tried to show as proof that the information was not generally known to people at large by relying on an UTI official’s testimony that he was unaware of the merger, though he was, in his official capacity, concerned with the company. Though it had not defined either “unpublished” or “generally known information”, SEBI officials were of the view that these could include press reports, even if unconfirmed by the company. “Since these reports were speculative, technically HLL’s knowledge was qualitatively better.” SEBI also claimed that one of the press reports carried a denial by the company.

The third legal issue concerned the price-sensitive nature of the information regarding the merger. Section 2(k) of SEBI’s regulation laid down eight examples of price-sensitive information which included inter alia “amalgamations, mergers, or takeovers”.

Hindustan Lever asserted that it was unaware of the swap ratio when the company bought BBLIL shares in March 1996. Further, it was not privy to any special price-sensitive information on the merger, as it had been highlighted by the media even before the official announcement. Hindustan Lever also argued that both the companies, namely, itself and BBLIL involved in the deal were sister concerns and subsidiaries of Uniliver; operated in the same industry, and were large profit making enterprises with common recruitment of personnel. They had some common directors on their boards and were listed in several of the country’s stock exchanges, and their securities were actively traded. HLL argued that such being the case, information of the merger by itself was not enough to induce a reasonably knowledgeable investor to buy its shares until the share-swap ratio was known. The company thus argued that the merger information per se had little relevance to the issue. The only thing that was price sensitive was the swap ratio, and HLL was not aware of it when it purchased BBLIL shares from UTI.

However SEBI, emphasised that the regulation cited explicitly defined “mergers” as price-sensitive information. It said, “(the) swap ratio may be price-sensitive information, but that does not mean that information of the overall fact of merger is not price-sensitive”.

The fourth issue, that was debated between the contending parties was whether HLL had profited from the deal or gained any unfair advantage. In regard to this, neither the Act nor the regulations stated that SEBI must prove that a profit was made or a loss was avoided. However, Section 15 of the Act prescribed that the regulator should consider “the amount of disproportionate gain or unfair advantage wherever quantifiable”, when levying penalties.

With regard to this issue, Hindustan Lever contended that the onus of proof of insider trading and the resultant gain by the concerned party rested with SEBI. The company also argued that it made no gain out of the deal: (i) after the merger, the company cancelled its BBLIL shareholding, and so financially there was no gain; (ii) HLL bought 80,0000 shares from UTI at Rs. 350 per share at a premium of almost 10 per cent over the market price of Rs. 318 and (iii) HLL also contended that its intentions were only to consolidate Uniliver’s shareholdings, and to achieve this, it had cheaper options which it did not resort to, such as the issue of preferential shares either to Uniliver or to HLL.

SEBI maintained that the provisions HLL quoted helped the regulator to determine the penalty, not the violation itself. SEBl’s order said: “Making profi t or avoiding loss is not a legal requirement under the regulation to establish the charge of insider trading. Section 15…(is) only applicable in cases of levy of monetary penalties (and) has no bearing on determination of the contravention.” SEBI’s contention was that HLL did benefit from the deal inasmuch as the company could not predict how prices would move after the merger announcement, it might well have had to pay more for the BBLIL shares then. In support of its argument, it cited the instance that immediately after the merger announcement, BBLIL’s share price closed at Rs. 405, though it fell subsequently. Alternatively, if UTI had not sold, it would have got shares worth Rs. 48.83 crore in the merged HLL, Rs. 20.83 crore more than its sale price.

Was SEBI’s Stand Justified?

Experts maintain that SEBI as a market regulator has erred in its decision by favouring UTI and imposing a fine on HLL to pay 3.04 crores as compensation to the public sector mutual fund. But being a regulator also calls for protection of the interests of all market players which essentially includes investors, both small ordinary and large institutional shareholders. Therefore, SEBI argued that it was justified in awarding compensation to UTI. But this line of argument also was countered by Hindustan Lever when it explained that it had paid UTI Rs. 350 per share as against the then market price of Rs. 318. The interest for Rs. 28 crore for 9 months at the rate of 18 per cent works out to 3.78 crores which is far more than the compensation set by SEBI.