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Corporate governance Framework in India: Analysis

What is Corporate Governance: Corporate governance is the system by which companies are directed and controlled. Boards of directors are responsible for the governance of their companies.  Corporate governance is therefore about what the board of a company does and how it sets the values of the company, and it is to be distinguished from the day to day operational management of the company by full-time executives.

Background:

  • In the past ten years, India has faced public governance scandals at some of its largest blue chips. Examples include the Satyam accounting errors of 2009 (which in 2018 resulted in PWC being barred from conducting audits in India for 2 years), the disregard for minority shareholders’ interests at Tata Group in 2016, and the shareholder revolt over related-party transactions at Raymond in 2017.

Why we need corporate governance:

  • Good corporate governance helps to build an environment of trust, transparency and accountability necessary for fostering long-term investment, financial stability and business integrity, thereby supporting stronger growth and more inclusive societies.
  • From this perspective, corporate governance would focus on internal structure and rules of the Board of Directors, the creation of independent audit committees, rules for disclosure of information to shareholders and creditors, and control the management.

Corporate Governance Framework in India

  • The Indian framework on Corporate Governance has been vastly in sync with the international standards. Broadly, it can be described in the following:
    • The basic framework for regulation of all companies in India is contained in the Companies Act, 1956, which provides for checks and balances over the powers of the Board of Directors.
    • The Companies Acts 2013 has provisions concerning Independent Directors, Board Constitution, General meetings, Board meetings, Board processes, Related Party Transactions, Audit Committees, etc.
    • SEBI (Securities and Exchange Board of India) Guidelines ensure the protection of investors and have mandated the companies to adhere to the best practices mentioned in the guidelines.
    • Accounting Standards issued by the ICAI (Institute of Chartered Accountants of India) wherein the ICAI is an autonomous body and issues accounting standards. The disclosure of financial statements is also made mandatory by the ICAI backed by the Companies Act 2013, Sec. 129.
    • Standard Listing Agreement of Stock Exchanges applies to the companies whose shares are listed on various stock exchanges.
    • Secretarial Standards Issued by the ICSI (Institute of Company Secretaries of India) on ‘Meetings of the board of Directors’, General Meetings’, etc. The companies Act 2013 empowers this autonomous body to provide standards which each and every company is required to adhere to so that they are not punished under the Companies Act itself.

Weakness of Corporate Governance:

Several efforts by the government, Securities and Exchange Board of India and the stock exchanges, the corporate governance norms in India have been tightened significantly focus on corporate boards However, some critical issues remain such as

  • Ownership issues – Ownership of corporates in India, including the listed ones, is still held in a few hands (a single shareholder or family controls a large group of companies), promoter-run companies account for 45% of the market.
    • This leads to several governance-related challenges which creates opportunities for controlling shareholders to enrich themselves at the cost of minority shareholders.
    • Promoters can and do abuse related party transactions (RPTs) as a means for expropriating corporate value.
      • A related-party transaction is a business deal or arrangement between two parties who are joined by a preexisting special relationship. An example is how a dominant shareholder may benefit from making one of their company trade to the other at advantageous prices.
    • Independent directors’ – was supposed to be the biggest corporate governance reform. However, they have hardly been able to make the desired impact as they are being removed frequently by promoters due to passive role played by them on board.
      • This aspect does not seem to have been addressed effectively yet, despite the strengthening of the regulations regarding independent directors.
    • No Proper Structure – Corporate Governance’ has no unique structure or design and is largely considered ambiguous. There is still lack of awareness about its various issues, like, quality and frequency of financial and managerial disclosure, compliance with the code of best practice, roles and responsibilities of Board of Directories, shareholder’s rights, etc.
    • Board performance – The requirement of at least one-woman director is necessary, and also the balance of executive and non-executive directors is not maintained. Evaluation is not performed from time to time and transparency is lost somewhere. The performance is not result oriented. These requirements are not always met with
    • Accountability to Stakeholders – The accountability is not restricted to that of the shareholders or the company, it is for the society at large and also the environment. The directors are not to keep in mind their own interests but also the interests of the community.
    • Insider Trading – Corporate insiders like officers, directors and employees by the virtue of their position have access to confidential information may misappropriate that information to reap profits.
      • SEBI lacks the thorough investigative mechanism and a vigilant approach due to which the culprits are able to escape from the clutches of law
    • Basis of Indian Model – The central problem in Indian corporate governance is not a conflict between management and owners as in the US and the UK, but a conflict between the dominant shareholders and the minority shareholders
      • Problem of corporate governance abuses by the dominant shareholder for instance, in public sector units (PSUs) where the government is the dominant (in fact, majority) shareholder and the general public holds a minority stake.
    • Noncompliance with disclosure norms and even the failure of auditor’s reports to conform to the law attract nominal fines with hardly any punitive action.
    • Misleading financial statements– There are many ways to present factually accurate information on a financial statement in a manner that is misleading to investors. By, for example, selling property from a parent company to a subsidiary to maximize parent company revenues.
    • Corporate Social Responsibility (CSR) –In India it is mandatory for companies to invest minimum 2% of the profits in the last 3 years for CSR activities. The companies seem to be reluctant towards making such investments.

Steps taken to improve Corporate Governance:

  • The first initiative in India was taken by Confederation of Indian Industry (CII), India’s largest industry and business association to examine corporate governance issues, and recommend a voluntary code of best practices.
  • The second major initiative was taken by Security Exchange Board of India (SEBI) as clause 49 of the listing agreement.
Clause 49 of the country’s listing rules sets out a series of corporate governance regulations. For example, a listed company must have a non-executive and one-third of its board should be non-executive directors. The nonexecutives should be on the board to challenge management etc.
  • The third initiative was taken by Naresh Chandra Committee.
    • Established in 2002 by the Department of Company Affairs (DCA) under the Ministry of Finance and Company Affairs
    • It made recommendations in two key aspects of corporate governance: financial and non-financial disclosures, and independent auditing and board oversight of management.
  • Fourth initiative taken by Narayana Murthy Committee
    • The committee was set up by SEBI, under the chairmanship of Mr. N. R. Narayana Murthy, to review Clause 49, and suggest measures to improve corporate governance standards
    • Major recommendations of the committee were primarily related to audit committees, audit reports, independent directors, related party transactions, risk management, directorships and director compensation, codes of conduct and financial disclosures
  • Companies Act 2013 created a new paradigm and provided for:
    • Independent Director – Mandated board and director evaluation and also requires the evaluation to be formal, regular and transparent. An important provision is that the continuance of the independent directors has been made contingent upon their respective evaluations.
    • Also, provided the strengths and qualification of independent directors in listed and non-listed companies.
    • Audit Committees: Increased ambit of companies to constitute audit committees. The Chairperson should be able to read and understand the financial statement of all the listed companies or non-listed public companies having paid up share capital of Rs.10 crores or more.
    • Serious Fraud Investigation Office (SFIO) – To investigate fraud relating to Company.
    • Corporate Social Responsibility – Every company shall constitute Corporate Social Responsibility Committee constituting of three or more directors with at least one independent director.
  • The SEBI Committee on Corporate Governance was formed in 2017 under the Chairmanship of Mr. UdayKotak (hereinafter referred to as the “Committee”) with the aim of improving standards of corporate governance of listed companies in India.
  • Highlights of recommendations
    • Composition of the board – It has recommended that a listed company should have a minimum of six directors, at least one independent woman director, and a minimum 50% of the directors should be non-executive.
    • Role of Independent Directors
      • The committee has recommended that at least half of the board members should be independent directors.
      • No board meeting can be conducted without the presence of an independent director.
      • Given importance to independent directors in governance, it has been recommended that listed companies should have to give detailed reasons if an independent director resigns.
      • The committee has also recommended the separation of roles of chairperson and managing director, and the chairperson should be a non-executive director.
    • Board meetings – The committee has suggested that the number of board meetings in a year should be increased from four to five and aspects such as succession planning, strategy and broad evaluation should be discussed at least once a year.
    • Helping Small Investors – The committee has advocated several changes that will help small investors. For instance, it has recommended that disclosures by companies to stock exchanges and on their own websites should be in a format that allows investors to find information with ease.
    • Financial Statements – The committee has recommended that all listed companies should publish cash flow statements on a half-yearly basis. All this will help the common investors—who normally don’t have access to financial databases—understand and track companies with relative ease.
    • Power to SEBI – It has also recommended that Sebi should have the power to act against auditors if the need arises.
    • Overall, the recommendations of the Kotak committee will enhance transparency and effectiveness in the way boards of listed companies function

Significance of Good Corporate Governance:

  • Robust governance practices are imperative for companies to create positive sentiment in the minds of investors and the public at large.
  • To ensure that a company produces relevant, adequate and credible information, which investors and independent observers can use to assess the company’s performance.
  • Research shows that the quality of board-level dynamics is highly correlated with firm’s profitability.
  • It improves strategic thinking at the top by inducting independent directors who bring a wealth of experience, and a host of new ideas.
  • It rationalizes the management and monitoring of risk that a firm face globally.
  • It limits the liability of top management and directors, by carefully articulating the decision making process.

Suggestions For An Effective Corporate Governance:

  • The Structure of the Board and Its Committees – It should include an appropriate combination of executive directors, independent directors and non-independent non-executive directors to prevent one individual or a small group of individuals from dominating the board’s decision taking.
  • New method for the appointment of Independent Director – The board should ensure that a formal, rigorous and transparent procedure be in place for planning the succession of all key officeholders.
  • Regulations for Credit Rating Agencies – Need for having regulations of SEBI for the credit rating agencies need to develop criteria that focus on substance rather than the form of governance.
  • Objective performance evaluation – Compensation of executive directors should flow from an objective performance evaluation process conducted by the board.
  • Enhancing Objectivity – Codes of conduct and Effective implementation of code of corporate governance.
  • Making Governance Transparent- The board should present a fair, balanced and understandable assessment of the organisation’s financial, environmental, social and governance position, performance and outlook in its annual report and on its website.
  • Risk Governance and Internal Control – The board should be responsible for risk governance and should ensure that the organisation develops and executes a comprehensive and robust system of risk management in order to maintain a sound internal control system.
  • Relations with Shareholders and other key Stakeholders –The board should be responsible for ensuring that an appropriate dialogue takes place among the organisation, its shareholders and other key stakeholders.
  • Effective and independent internal audit function–To enhance respect, confidence and cooperation of both the board and the management, board should establish formal and transparent arrangements to appoint and maintain an appropriate relationship with the organisation’s auditors.
  • Foster Ethical Culture – Directors should observe and foster high ethical standards and a strong ethical culture in their organisation. Each director must be able to allocate sufficient time to discharge his or her duties effectively. Conflicts of interest should be disclosed and managed.
  • Insider Trading – SEBI should show further seriousness about checking insider trading and there should be a separate code by itself.
  • Organisation for Economic Co-operation and Development (OECD) lays down certain principles for reforming corporate governance.
    • The rights of shareholders– These include a set of rights including secure ownership of their shares, the right to full disclosure of information, voting rights, participation in decisions.
    • The Equitable Treatment of Shareholders– The corporate governance framework should ensure the equitable treatment of all shareholders, including minority and foreign shareholders. All shareholders should have the opportunity to obtain effective redress for violation of their rights.
    • Timely and accurate disclosure – The corporate governance framework should ensure that timely and accurate disclosure is made on all material matters regarding the corporation, including the financial situation, performance, ownership, and governance of the company.
    • Responsibilities of the Board – The corporate governance framework should ensure the strategic guidance of the company, the effective monitoring of management by the board, and the board’s accountability to the company and the shareholders. 

Best Practice:

  • German corporate governance structures are in some ways among the most robust. In particular, it is a legal requirement that a separate supervisory board comprising both shareholder and employee representatives oversees the activities of a company’s management board.
  • In Germany, one initiative aimed to improving German corporate governance through better corporate transparency was the publication of a report by the Deutsche Bundestag (1998)
  • German accounting and auditing practices allow companies to make provisions for various short-term and long-term risks.
  • In UK, companies required to disclose in their annual reports to the extent of their compliance with the Code and their reasons for non-compliance Corporate Governance from a Global Perspective.
  • The US approach to corporate governance is to minimize conflicts of interest between owner and managers. This is attempted by giving managers profit-related incentives such as shares and stock options.

Conclusion:

  • The new norms after the Companies Act 2013 came into the picture, are very balanced and innovative. They have helped reformed the growth of Indian companies as per international standards.
  • Shareholders are involved in the decision making of the companies and various safeguards have been put in order so that the interests of the shareholders and the society as a whole is not sidelined.
  • It is expected that regular and formal board evaluationswould lead boards to adopt improved practices, raise board effectiveness and ultimately lead to a better alignment of interests and investor protection.
  • Considering that few recommendations make us believe that India does not need more regulation; better enforcement is required which will lead to greater participation, transparency and serious business on the company’s board.
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