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Workshop on Corporate Governance

Workshop on Corporate Governance . Presented at the ALB In-House Legal Summit October 14, 2004 Mohit Saraf B.D. Ushir (Partner) (Partner) Luthra & Luthra Law Offices. Framework. Section I The Need for Corporate Governance

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Workshop on Corporate Governance

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  1. Workshop on Corporate Governance Presented at the ALB In-House Legal Summit October 14, 2004 Mohit Saraf B.D. Ushir (Partner) (Partner) Luthra & LuthraLaw Offices

  2. Framework Section I The Need for Corporate Governance Section II Conceptualizing Corporate Governance Section III Evolution of Systems of Accountability Section IV Director: The Fiduciary Section V Auditors: The Watchful Eye Section VI Reinventing Corporate Governance

  3. Section IThe Need for Corporate Governance • Responsibility to Stakeholders • Predictability • Transparency • Accountability • Easier access to capital (FII, VCF) • Efficiency (at the firm level) and Global Competitiveness (IPRs) Luthra & Luthra Law Offices

  4. Section IIConceptualizing Corporate Governance • Narrow Definition - A set of relationships between the company and shareholders, directors and management. • Broad Definition - Going beyond and looking to the implicit and explicit relationships of the company with employees, creditors, consumers, distributors, local communities. Luthra & Luthra Law Offices

  5. Conceptualizing Corporate Governance (Contd.) • OECD Definition • System by which corporations are directed and controlled. • Spells out the rules / procedures for making decisions on corporate affairs. • Provide the structure through which the company objectives are set, and the means of attaining those objectives and monitoring performance • Specifies the distribution of rights and responsibilities among different participants in the corporation, such as, the board, managers, shareholders and other stakeholders • World Bank Definition • Corporate governance is about promoting corporate fairness, transparency and accountability Luthra & Luthra Law Offices

  6. Conceptualizing Corporate Governance (Contd.) • What constitutes shareholders’ interest? sustainable profitability versus profitability • Need for external regulation • FOR: • Conflict of interest b/w Management/Promoters and other constituencies • To protect small investors • To account for Externalities • AGAINST: • Risk of excessive policing (time & cost of compliance) • Increase costs • Check the box approach Luthra & Luthra Law Offices

  7. Section IIIEvolution of Systems of Accountability: Indian Initiatives • In December 1995, CII set up a task force to design a voluntary code of corporate governance • In April 1998, the Desirable Corporate Governance: A Code, was released • SEBI set up the Kumar Mangalam Birla Committee in 1999 to design a mandatory-cum-recommendatory code for listed companies (Clause 49) • DCA set up the Naresh Chandra Committee Report in 2002. The key recommendation related to financial and non-financial disclosures and independent auditing and board oversight of management (Draft Companies Bill) • The Narayana Murthy Committee was set up by SEBI in 2002 to review clause 49 and suggest measures to improve corporate governance standards (Proposed Clause 49) Luthra & Luthra Law Offices

  8. Developments in the U.S • ENRON • Bankruptcy filing in 2001 (largest in US history) • Accounting techniques involving unconsolidated partnerships and “special purpose entities” to hide losses from financial statements & conceal indebtedness. • Issues regarding independence of auditors, provision of non audit services & conflict of interest • Independence of directors • SARBANES OXLEY ACT, 2002 (SOX) • Signed into law July 30, 2002 • Enhances reporting obligations of public companies to prevent securities fraud & other abuses Luthra & Luthra Law Offices

  9. SOX • Applicable to: • Companies listed or traded in the U.S (including non U.S Companies) • Subsidiaries of U.S Companies in India (provided they have a business connection in the U.S) • Foreign accounting firms that prepare or furnish audit report for an issuer • Sometimes compliance expected by U.S Companies from business partners in India (implications for BPO sector) Luthra & Luthra Law Offices

  10. SOX-Brief Overview • CEO & CFO certification in SEC Reports (Ss 302 & 906) • Compliance with Securities Exchange Act, 1934 • Financial statements represent the true financial condition of the Company operations • Financial results contain no untrue statement /omission of material fact • Company has complied with Disclosure norms • Management have disclosed significant deficiencies, changes, fraud to auditors & audit committee • Ban on loans to executive officers and directors • Accelerated filings of periodic reports • Filing of change of beneficial ownership within 2 days Luthra & Luthra Law Offices

  11. SOX-Brief Overview (Contd.) • Reimbursement by CEO/CFO upon restatement of financial statements due to misconduct • Bonus/other incentive based compensation • Profits from sale of securities • Independence of Board of Directors/ Committees • Enhanced Criminal Penalties (upto $5 million fine for individuals, $25 million for entities, prison terms upto 20 years) • Strict Reporting of illegal or unethical behavior Luthra & Luthra Law Offices

  12. SOX-Brief Overview (Contd.) • Audit Committee • Independent • Financial Literacy of members • At least one financial expert • Responsible for appointment, compensation & oversight of auditor & approval of audit/non audit services • Create compliant mechanism regarding accounting and auditing • Approve all related party transactions • Implementation of a ‘Whistleblower’ policy Luthra & Luthra Law Offices

  13. SOX-Brief Overview (Contd.) • Additional Disclosures • Off Balance Sheet Items & transactions that may have material current/future effect on financial condition/results of operations • Pro forma Information must conform to financials prepared under GAAP - No untruth/omission • All fees billed by auditors in annual report • Audit Partner Rotation • Registration with Public Company Accounting Oversight Board (including foreign audit firms that audit Issuers) Luthra & Luthra Law Offices

  14. Major Areas of Debate • Directors • Independent Directors • Audit Committees • Auditors Luthra & Luthra Law Offices

  15. Section IVDirector: The Fiduciary “If directorsact within their powers, if they act with such care as is reasonably to be expected from them, having regard to their knowledge and experience, and if they act honestly for the benefit of the company they represent, they discharge both their equitable as well as their legal duty to the company” Luthra & Luthra Law Offices

  16. WHO DO DIRECTORS OWE A DUTY TO? SHAREHOLDERS COMPANY EMPLOYEES PUBLIC CREDITORS Luthra & Luthra Law Offices

  17. General Duties of Directors • Duty of care and skill • Duty of loyalty & disclosure • Duty of disgorging profit in relation to corporate opportunity Luthra & Luthra Law Offices

  18. Duty of Care and Skill A director or officer has a duty to the corporation to perform his functions in good faith, and in a manner that he reasonably believes to be in the best interest of the corporation, and with a care that an ordinary prudent person would reasonably be expected to exercise in a like position and under similar circumstances Luthra & Luthra Law Offices

  19. Duty of Care and Skill (Contd.) Courts in UK and USA have held that directors in banks and financial institutions owe a higher degree of care • The banking industry is involved in regular receipt of public cash and property and is thus more vulnerable than other businesses and therefore a greater care is required; • A director of a company (a bank) that has a large amount of liquid assets carries with him higher risks and temptation to which such assets give rise; • There are more legislative and regulatory monitoring and liability provisions pertaining to banking companies than any other company and such provisions may also extend to the director of the bank or financial institution. Luthra & Luthra Law Offices

  20. Duty of Care and Skill (Contd.) • Exercise reasonable care, skill and diligence • Continuing knowledge of company’s business • Reliance on Co-directors and Power to delegate with supervision • Bona fide and good faith intention Luthra & Luthra Law Offices

  21. Duty of Loyalty & Disclosure • Section 299, Companies Act, 1956 • principal is based on the rudiments of law that the same person cannot act for himself/herself and at the same time, with respect to the same matter, act with another whose interests are conflicting • Effect of disclosure • Disclosure to whom • How extensive should the disclosure be Luthra & Luthra Law Offices

  22. Duty in Relation to Corporate Opportunity • By occupying a position of trust, a director must not make a profit which he can acquire only by use of his position and, if he does, he must account for the profit so made. Luthra & Luthra Law Offices

  23. Corporate Opportunity • Any profit made by a Director through holding the office of such director must be accounted for. Therefore, a Director would be held accountable for personal profits made from: • The sale of goods, materials or services earlier dealt with by Company for its business • Forestalling the company’s business opportunity unless the company has rejected such opportunity • Requesting the customer to place orders for goods, materials and services with another company in which he has some interest • Receiving Commission from another company, which has sold goods to the company Luthra & Luthra Law Offices

  24. Liabilities of Directors • Derivative Action • Statutory Liability • Contractual Liability • Tortuous Liability Luthra & Luthra Law Offices

  25. Derivative Action • Resolutions by directors for transferring the controlling interest of the company wherein there is a complete changeover of the structure to the detriment of the company • Sale of land to oneself at a discounted value • Directors passing an ordinary resolution where the act in question would require a special resolution Luthra & Luthra Law Offices

  26. Statutory Liability • Companies Act, 1956: Officers in default • Banking Regulation Act, 1949 • Insurance Act, 1948 • Pollution Laws • Income Tax Act, 1961 Luthra & Luthra Law Offices

  27. Director:Legal Provisions • Restrictions on loans to directors or other specified entities (s. 295) • Interest rate shall not be less than 4% above prevailing bank rate • Quantum of loan to not exceed 25 times the gross salary • No default on public deposit by the company • Boards sanction for contracts in which directors are interested (s. 297) • Consent by way of board resolution • Prior to the contract or within three months • Except contract between two public companies • Prior approval of the central government for a contract where the company has paid up share capital of not less than Rs 1 crore Luthra & Luthra Law Offices

  28. Director: Legal Provisions (Contd.) • Disclosure of interest by directors (s. 299) • Default ground for vacation under s. 283. • Interested directors not to participate or vote in board proceedings (s. 300) • Applicable only to public companies • Maintenance of records of contracts, companies, firms in which directors are interested (s. 301) • to be signed by all the directors present in the next board meeting • kept at registered office and available for inspection • Restriction on directors from holding office of profit (s. 314) • Company can give consent by special resolution • Does not apply to managing directors Luthra & Luthra Law Offices

  29. Issues for Consideration • Should the directors be educated on the risk profile of the company and their duties as a director? • Narayana Murthy Committee Report • Should there be codified duties and responsibilities? • Should the liability of the non-executive directors mirror the liability of the executive directors? Luthra & Luthra Law Offices

  30. Independent Directors • No mention in the Companies Act • Clause 49 - Optimum combination of executive and non-executive directors - Not less that fifty per cent being non-executive - If non executive chairman, at least one third of the board should comprise of independent directors - If executive chairman, at least half of the board should comprise of independent directors • Clause 63, Draft Companies Bill • Every public company of prescribed paid up capital or turnover to have at least seven directors of which at least three or fifty percent, whichever is higher, to be independent directors • Would include unlisted public companies also Luthra & Luthra Law Offices

  31. Who is an Independent Director? • Independence of judgement • No material relationship • No pecuniary relationship Luthra & Luthra Law Offices

  32. What is Independence? • The Cadbury Report defines independence as: Apart from their directors’ fees and shareholdings, they should be independent of management and free from any business or other relationship which could materially interfere with the exercise of their independent judgement. • Clause 49 ‘Independent’ defined as those directors who, apart from receiving director’s remuneration do not have any other material pecuniary relationship or transactions with the company, its promoters, management or subsidiaries, which in the view of the board may affect independence of judgment Luthra & Luthra Law Offices

  33. What is Independence? (Contd.) • Clause 2(45), Draft Companies Bill “Independent Director” means a non-executive director of a company who apart from receiving director’s remuneration, does not have any material pecuniary relationship or transactions of such amount as may be prescribed, with the company , its promoters, managing director, whole time director, other directors, manager or its holding company and its subsidiaries apart from possessing such attributes for being treated as Independent director as may be prescribed by the Central Government from time to time. • Excessively restrictive? Luthra & Luthra Law Offices

  34. Independent Directors • External expert • Independent director: watchdog? Luthra & Luthra Law Offices

  35. Audit Committee • Clause 49, Listing Agreement • Minimum three members, all non-executive directors • Majority independent, chairman independent • At least one director having financial and accounting knowledge • Must have at least three meetings per year Luthra & Luthra Law Offices

  36. Audit Committee (Contd.) • Section 292A, Companies Act • public companies • minimum three directors • two thirds other than managing or whole time directors • no other qualifications prescribed • recommendations relating to financial management binding • reasons for not accepting any recommendation • Auditors required to attend the meetings • Clause 62, Draft Companies Bill • not less than two independent directors • no other qualifications prescribed Luthra & Luthra Law Offices

  37. Audit Committee (Contd.) • Proposed Clause 49 (pursuant to N.M. Report) • At least one member having financial and accounting expertise • All members to be financially literate • Expanded role- independent judgment • Focusing on • Quality of accounting policies • Alternate accounting policies • Internal control deficiencies • Implementation of ‘whistleblower’ policy Luthra & Luthra Law Offices

  38. Audit Committee (Contd.) • Audit committees- Efficacy? • Chairman of Enron’s audit committee was a Stanford professor with 30 years experience in auditing and accounts • Should the members of audit committee be financially literate? • Should the scope of audit committee be decided by the Board of Directors? • Is remuneration of members an issue? Luthra & Luthra Law Offices

  39. Section VAuditors: The Watchful Eye • Appointment regulated by the Companies Act (s.224) • Maximum number of companies prescribed (20) • Qualifications & Disqualifications (s. 226) • Person holding any security of that company (2000 Amendment) • Requirement to report on specific matters (s. 227) • ICAI Code of Conduct Luthra & Luthra Law Offices

  40. Section VAuditors: The Watchful Eye • Duties of Auditor • Duty of Care (Re Kingston Cotton Mills Co.) • Reasonable care and skill • Auditor is the servant of the shareholder and whose duty is to examine the affairs of the company on their behalf at the end of a year and to report to them what he has found. • The auditor is like a trustee for shareholders. • Watchdog and not a bloodhound Luthra & Luthra Law Offices

  41. Auditor’s Liability • Basis of Liability • Contractual and Fiduciary • Company • Shareholders as a body • Tortuous • “Holding out” Luthra & Luthra Law Offices

  42. Auditor’s Liability (Contd.) • Stage I (Upto 1963) • Candler v. Crane • Privity doctrine: a third party not in privity with the auditor cannot recover damages for negligence • Justice Denning gave a dissenting judgment • it must be known to the advise42r that the advice would be communicated to the plaintiff in order to induce him to adopt a particular course of action • the advice must be relied upon for the purpose of the particular transaction for which it was known to the advisers that the advice was required. • Stage II (1964-1990) • Hedley Byrne & Co. v. Heller & Partners • Liability for a negligent misstatement made by one person to another, even in the absence of any contractual or fiduciary relationship causing financial loss Luthra & Luthra Law Offices

  43. Caparo Industries Plc v. Dickman • Stage III (Post 1990) • Watered down in Caparo Industries case • The three criteria for the imposition of a duty of care are • foreseeability of damage • proximity of relationship • the reasonableness or otherwise of imposing a duty • The auditor of a public company's accounts owed no duty of care to a member of the public at large, who relied on the accounts to buy shares in the company. • An auditor owed no duty of care to an individual shareholder in the company who wished to buy more shares in the company • The purpose for which accounts are prepared and audited is to enable the shareholders as a body to exercise informed control of the company Luthra & Luthra Law Offices

  44. Caparo Industries Plc v. Dickman • Cadbury Committee on Caparo Industries • the case exposed two widely held misconceptions: • audit report is a guarantee to the accuracy of the accounts, and perhaps even as to the soundness of the company • that anyone (including investors and creditors) can rely on the audit, not only in a general sense but also very specifically by being able to sue the auditors if they are negligent • In light of Enron is there a need to re-examine the issue of auditor’s liability as set out in the Caparo Industries case? Luthra & Luthra Law Offices

  45. Issues for Consideration • Should statute set out the liability? • Should ‘breach of care’ be extended to any other group? • Whether rules for auditors liability need to be codified and made stricter? • Recommendations of Naresh Chandra Committee Report • Should Audit committees evaluate independence of auditors? Luthra & Luthra Law Offices

  46. SOX CEO/CFO Certification Reimbursement for misstatement Ban on loans to directors Code of Conduct/Ethics Independent Board/ Committee Disclosure of Off Balance Sheet/transactions that may have future impact Narayana Murthy Committee CEO/CFO Certification Reimbursement for misstatement Restriction on loan to directors Written/Public Code of Conduct Independent Board of Directors More limited disclosures-but left open for consideration Similarities between US position & Indian Proposals Luthra & Luthra Law Offices

  47. SOX Audit Partner Rotation Audit Committee Financial Literacy One financial expert Oversee auditor Approve related party transactions Whistleblowers policy Narayana Murthy Committee Audit Partner Rotation Audit Committee Financial Literacy One financial expert Oversee auditor Approve related party transactions Whistleblowers policy Comparison between US & Indian Position Luthra & Luthra Law Offices

  48. Proposed Amendments • Proposed amendments to clause 49 and Draft Companies Bill address major issues • Appointment of a Chief Accounting Officer by a Company • Definition of related party transactions expanded and specific approval requirements introduced • Disclosure of all contingent liabilities • Timely communication of Risk Management activities • CEO/ CFO certification requirements Luthra & Luthra Law Offices

  49. Section VIReinventing Corporate Governance in India • Super regulator v. Multiple regulators? - Efficiency - Cost of Compliance • Transparency by the regulators? - Late trading and market timing investigations • Enforcement by stock exchanges? Luthra & Luthra Law Offices

  50. Reinventing Corporate Governance in India (Contd.) • Disclosure of voting agreements which impact governance of companies? • Pro-active role by institutional investors? • Mandatory Corporate Governance Ratings? - Will it lead to better corporate governance? Luthra & Luthra Law Offices

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