Consentia on Law - VOl - II

JJ IRANI COMMITTEE: A COMMENT

INTRODUCTION

Corporate Governance, has assumed remarkable importance for all the corporate players in India as well as abroad. The Organization for Economic Co-operation and Development (OECD) has issued a revised set of Corporate Governance Principles which are adaptable to varying social, legal and economic frameworks in different countries and are considered as widely acceptable global benchmarks of Corporate Governance. Companies all over the world have realized that a vigorous quest of good governance is crucial for enduring success.[1]

The present Committee was constituted on 2nd December, 2004 under the chairmanship of Dr. J J Irani, Director, Tata Sons, with the task of advising the Government on the proposed revisions to the Companies Act, 1956. The objective of this exercise is perceived as the desire on the part of the Government to have a simplified compact law that will be able to address the changes taking place in the national and international scenario, enable adoption of internationally accepted best practices as well as provide adequate flexibility for timely evolution of new arrangements in response to the requirements of ever-changing business models. It is a welcome attempt to provide India with a modern Company Law to meet the requirements of a competitive economy. [2]

Companies have now become conscious of the importance of pursuing good Corporate Governance for reaping rich benefits for the Company and its stakeholders. Corporate Governance is no longer a rigid set of guidelines; it has now become an integral part of the companies’ functioning and progress.

SHRI NARAYANA MURTHY COMMITTEE’S REPORT

The SEBI, while analysing the financial statements of companies and the reports on corporate governance, observed that their quality was not uniform.  It therefore felt a need to review the existing code on corporate governance as to the adequacy of the present practices and to improve such practices.

SEBI believed it necessary to form a committee on corporate governance, comprising representatives from the stock exchanges, chambers of commerce, investor associations and professional bodies.[3] The SEBI Committee on Corporate Governance (the “Committee”) was constituted  under the Chairmanship of Shri N. R. Narayana Murthy, Chairman and Chief  Mentor of Infosys Technologies Limited. The Committee met thrice on December 7, 2002, January 7, 2003 and February 8, 2003, to deliberate the issues related to corporate governance and finalize its recommendations to SEBI.

The terms of reference were:

1.to review the performance of corporate governance and

2.to determine the role of companies in responding to rumour and other price sensitive information circulating in the market, in order to enhance the transparency and integrity of the market. [4]

Key Issues Discussed and Recommendations

The important mandatory and non-mandatory recommendations of the committee are discussed below:

MANDATORY RECOMMENDATIONS

  1. Audit committee

Suggestions were received from members that audit committees of publicly listed companies should be required to review the following information mandatorily:

  • Financial statements;
  • Management discussion and analysis of financial condition and results of operations;
  • Reports relating to compliance with laws and to risk management;
  • Management letters / letters of internal control weaknesses issued by statutory / internal auditors; and
  • Records of related party transactions.

The Committee noted that most of this information was already reviewed by audit committees during the audit committee meeting. Further, it was already contained as a recommendation in the Kumarmangalam Birla Committee on Corporate Governance.[5]

The Committee also noted that the recommendation in the Birla Committee Report cast a responsibility on the audit committee vis-à-vis their duties and role. Further, the compliance report of the Mumbai Stock Exchange showed that approximately only 53% of the companies complied with this requirement contained in the Birla Committee Report.[6]

In view of the above deliberations, the Committee made all the suggestions provided as mandatory recommendations in the report. It also made mandatory for all audit committee that, its members should be “financially literate” and at least one member should have accounting or related financial management expertise.[7]

Explanation 1 – The term “financially literate” means the ability to read and understand basic financial statements i.e. balance sheet, profit and loss account, and statement of cash flows.

Explanation 2 – A member will be considered to have accounting or related financial management expertise if he or she possesses experience in finance or accounting, or requisite professional certification in accounting, or any other comparable experience or background which results in the individual’s financial sophistication, including being or having been a chief executive officer, chief financial officer, or other senior officer with financial oversight responsibilities.

  1. Audit Reports and Audit Qualifications

It was suggested that in case a company has followed a treatment different from that prescribed in an accounting standard, independent / statutory auditors should justify why they believe such alternative treatment is more representative of the underlying business transaction. This should also be explained clearly in the footnotes to the financial statements. Since, it was upon the Company’s management to decide upon the accounting standard, the auditor’s responsibility is just to express a qualification in case he disagrees with the explanation given by the company’s management. Hence, this suggestion was made a mandatory requirement.

  1. Audit qualifications

Suggestions were received that where financial statements contain qualifications, companies should be given a reasonable period of time within which to cure the qualifications, by SEBI / Stock Exchanges. Mere explanations from companies may not be sufficient.

However, the non-mandatory recommendation that was brought in here was that Companies should be encouraged to move towards a regime of unqualified financial statements. This recommendation should be reviewed at an appropriate juncture to determine whether the financial reporting climate is conducive towards a system of filing only unqualified financial statements.[8]

  1. Related party transactions

A statement of all transactions with related parties including their bases should be placed before the audit committee for formal approval/ratification and that if any transaction is not on an arm’s length basis, management should provide explanation to the audit committee justifying the same.

Suggestions were received that for each related party, a statement shall be recorded disclosing the basis / methodology for various types of transactions and it be placed before the independent audit committee at each Board meeting for formal approval/ratification. This should include any exceptional transactions that are not on an arm’s length principle together with reasons for such deviation.[9] The Committee also noted that the definition of “arm’s length” should be clarified in the recommendation. It noted that a reference may be made to the report of the Department of Company Affairs’ Expert Group on Transfer Pricing Guidelines for a suitable definition.

However, the mandatory recommendation that the Committee came up with was that a statement of all transactions with related parties including their bases should be placed before the independent audit committee for formal approval / ratification. If any transaction is not on an arm’s length basis, management should provide an explanation to the audit committee justifying the same.[10]

It was also reiterated that the term “related party” shall have the same meaning as contained in Accounting Standard 18, Related Party Transactions, issued by the Institute of Chartered Accountants of India.

  1. Proceeds from initial public offerings

 The companies raising money through initial public offering, should disclose to the audit committee the uses/application of funds under major heads on a quarterly basis.  Each year the company shall prepare a statement of funds utilised for the purposes other than those stated in offer document/prospectus.[11]This statement shall be certified by the independent auditors of the company.  The audit committee should make appropriate recommendations to the Board to take steps in the matter.  The suggestion enlarges the existing requirement in this regard and is a response to manipulations perpetrated by some corporate in this area.

  1. Risk Management

The committee has deemed it necessary for the boards of the companies to be fully aware of the risks involved in the business and that it is also important for the shareholders to know about the process by which companies manage their business risks.  The mandatory recommendations in this regard are:

“procedures should be in place to inform board members about the risk assessment and minimization procedures.  These procedures should be periodically reviewed to ensure that executive management controls risks through means of a properly defined frame work”

Management should place a report before the entire board of directors, every quarter, documenting the business risks faced by the company, measures to address and minimise such risks, and any limitations to the risk taking capacity of the Corporation.  This document should be formally approved; by the board.

The Committee believed that this recommendation is important. This is because the Management Discussion, and Analysis of Financial Condition and Results of Operations, are the responsibility of a company’s management. It is, therefore important, that the audit committee be made aware of the risks faced by a company. It is management’s responsibility to demonstrate to the audit committee the measures taken to address business risks. Further, it was added that the Compliance Officer of the company should certify the Risk Management report placed before the audit committee.[12]

The Committee also noted that it was not practicable to put the responsibility of review of risk management only on the audit committee. It agreed that there must be a process by which key risks are reviewed by the entire Board of Directors and not just the audit committee. Further, there must be evidence demonstrating that this review process has actually taken place. Investors in a company would therefore know how the company has identified and addressed its business risks. Hence, it made the laying down of transactions important.[13]

A non-mandatory recommendation was also made in which Companies were supposed to train their Board members in the business model of the company as well as the risk profile of the business parameters of the company, their responsibilities as directors, and the best ways to discharge them.

At present, in clause-49 of the Listing Agreement, there is a stipulation that the management discussion and analysis report forming part of the board’s annual report should include discussion on “risks and concerns”.  The suggestion contained in the Narayana Murthy Committee’s report is more elaborate and this would encourage a meaningful discussion at the board level periodically and the company will have the benefit of advice from board members who are not in day-to-day management.[14]

  1. Code of conduct

The Committee noted that the Birla Committee Report had defined the broad roles and responsibilities of management. It was obligatory on the part of the Board of Directors of a company to define a code of conduct for itself and the senior management of the company, not just senior financial personnel. Concerns were expressed on two main areas, (a) enforceability, and (b) definition of senior management.

The committee then recommended making it obligatory for the board of a company to lay down a code of conduct for all board members and senior management of the company and that this code should be posted on the company’s website and all board members and senior management personnel shall affirm compliance with the code on an annual basis.[15]  The annual report of the company shall contain a declaration to this effect, signed off by the CEO and COO.  This suggestion is in line with the best practices adopted by corporate in developed countries. For the purposes of the Committee report, the term “senior management” shall mean personnel of the company who are members of its management / operating council (i.e. core management team excluding Board of Directors). Normally, this would comprise all members of management one level below the executive directors .

A suggestion regarding a written code of conduct of Board members (by category of directors – executive directors, independent directors, nominee directors and promoter directors) and also for senior financial personnel including the Chief Financial officer, Treasurer and Financial Controller (or the officer who discharges these functions) was put forth by the report. But the same was rejected.[16]

  1. Nominee directors

 The committee recommended doing away with nominee directors. The Committee felt that the institution of nominee directors creates a conflict of interest that should be avoided.[17] Such directors often claim that they are answerable only to the institutions they represent and take no responsibility for the company’s management or fiduciary responsibility to other shareholders. It is necessary that all directors, whether representing institutions or otherwise, should have the same responsibilities and liabilities. If an institution wishes to appoint a director on the board, such appointment should be made by the shareholders.  Nominee of the Government on public sector companies shall be similarly elected and shall be subject to the same responsibilities and liabilities as other directors.[18]

OTHER MANDATORY RECOMMENDATIONS

  • Compensation to non executive directors to be approved by the shareholders in general meeting; restrictions placed on grant of stock option, requirement of proper disclosures of details of compensation.
  • Whistle blower policy to be in place in a company (freedom to company’s personnel to approach the audit committee without necessarily informing the superiors if they observe an unethical or improper practice, protection for the complainant from retaliation etc.
  • The directors of the holding company are to be in the picture; audit committee of the holding company to review financial statements of subsidiaries etc.

NON-MANDATORY RECOMMENDATIONS

The non-mandatory recommendations pertain to moving to a regime providing for unqualified corporate financial statements, training of board members and evaluation of non-executive director’s performance by a peer group comprising the entire board of directors, excluding the director being evaluated.

The SEBI has approved modifications in clause-49 of Listing Agreement to give effect to the recommendations of Shri N.R. Narayana Murthy Committee‘s report on corporate governance.  SEBI issued a circular dated August 26, 2003 to all the stock exchanges in this regard.  The revised clause-49 contains the sub-clause as per the existing clause-49m as well as new sub-clauses.  All listed entities having a paid up capital of Rs. 3 Crore and above or net worth of Rs. 25 crore or more at any time in the history of the entity, are required to comply with the provisions of revised clause-49, effective from April 1, 2004.

INDEPENDENT DIRECTOR

Under the report, the term “independent director” was defined as a non-executive director of the company who[19]:

  • apart from receiving director remuneration, does not have any material pecuniary relationships or transactions with the company, its promoters, its senior management or its holding company, its subsidiaries and associated companies;
  • is not related to promoters or management at the board level or at one level below the board;
  • has not been an executive of the company in the immediately preceding three financial years;
  • is not a partner or an executive of the statutory audit firm or the internal audit firm that is associated with the company, and has not been a partner or an executive of any such firm for the last three years. This will also apply to legal firm(s) and consulting firm(s) that have a material association with the entity.
  • is not a supplier, service provider or customer of the company. This should include lessor-lessee type relationships also; and
  • is not a substantial shareholder of the company, i.e. owning two percent or more of the block of voting shares.

The considerations as regards remuneration paid to an independent director was deemed to be the same as those applied to a non-executive director.

WHISTLE BLOWER POLICY

This was one of the most important recommendations put forth by the Narayan Murthy committee. It was suggested that personnel who observe an unethical or improper practice should be able to approach the independent audit committee without necessarily informing the Board. There should also be a mechanism for employees to be aware of this privilege.[20]

However, a mandatory recommendation was made wherein Companies should annually affirm that they had not been denied any personnel access to the audit committee of the company (in respect of matters involving alleged misconduct) and that they had been provided protection to “whistle blowers” from unfair termination and other unfair or prejudicial employment practices.

The appointment, removal and terms of remuneration of the chief internal auditor must be subject to review by the Audit Committee. Such affirmation shall form a part of the Board report on Corporate Governance that is required to be prepared and submitted together with the annual report.

IMPLEMENTATION OF THE RECOMMENDATIONS IN THE COMPANIES ACT,2013

The 2013 Act also intends to improve corporate governance by requiring disclosure of nature of concern or interest of every director, manager, any other key managerial personnel and relatives of such a director, manager or any other key managerial personnel and reduction in threshold of disclosure from 20% to 2%. The term ‘key managerial personnel’ has now been defined in the 2013 Act and means the chief executive officer, managing director, manager, company secretary, whole-time director, chief financial officer and any such other officer as may be prescribed.

Independent directors

Overview of significant changes

  1. Currently, clause 49 of the listing agreement requires that a board of a listed company will have an optimum combination of executive and non-executive directors with not less than 50% of the board comprising non-executive directors. It also provides that where the Chairman of the board is a non-executive director, at least one-third of the board should comprise independent directors. In case the Chairman is an executive director, at least half of the board should comprise independent directors. The Companies Act, 2013 states that every listed company will have at least one-third of total number of directors as independent directors, with any fraction to be rounded off as one. Unlike the listing agreement, the Companies Act, 2013 does not contain any specific requirement for 50% independent directors if the Chairman of the board is an executive director.[21]
  2. The listing agreement requires that the board of all the material non-listed subsidiaries of a listed parent company will have at least one independent director from the board of directors of the parent company. The Companies Act, 2013 does not have similar requirement.
  3. Under the Companies Act, 2013, the Central Government will have the power to prescribe minimum number of independent directors in other class of public companies. The Companies Act, 1956 does not contain any such requirement.
  4. The meaning of the term “independent director” given in the Companies Act, 2013 contains most of the attributes prescribed in the listing agreement. The Companies Act, 2013, however, contains certain additional criteria, e.g.,:

(a) An independent director should be a person of integrity and possess relevant expertise and experience.

(b) The language used in clause 49 suggests that a person to be appointed as “independent director” should not have any material pecuniary relationship/ transactions with the company, its promoters, its directors or its holding company, its subsidiaries and associates, which will affect independence of the director. The listing agreement does not specify any particular timeframe to be considered in this regard.

However, the Companies Act, 2013 states that such relationship should not have existed either in the current financial year or immediately preceding two years. Also, the Companies Act, 2013 covers all pecuniary relationships, instead of material pecuniary relationships covered under the listing agreement.

(c) A person will not be eligible to be appointed as “independent director,” if parties listed in (b) above have/had pecuniary relationship/transactions exceeding prescribed amount with a relative of the said person. The listing agreement does not prohibit appointment based on pecuniary relationship/ transactions with relatives.

(d) Clause 49 prohibits a person from being appointed as “independent director,” if that person is/was a partner/executive in statutory audit firm, internal audit firm, legal firm and/or consulting firm(s), which have association with the company. The Companies Act, 2013 also prohibits a person from being appointed as “independent director” if that person’s relative is/was a partner/executive in the said firm.

(e) Under the Companies Act, 2013, the Central Government may prescribe additional qualifications for an “independent director.”

(f) Clause 49 states that the nominee directors appointed by an institution, which has invested in or lent to the company, is deemed to be an independent director.

Serious Fraud Investigation Office

Currently, the SFIO has been set-up by the Central Government under resolution No. 45011/16/2003-Adm-I dated 2 July 2003. Under the Companies Act, 2013, statutory status will be conferred upon the SFIO. Till the time SFIO is established under the Companies Act, 2013, the SFIO previously set-up by the Central Government will be deemed to be SFIO under the Companies Act, 2013.[22] The Central Government may assign investigation into the affairs of a company to SFIO

(i) on receipt of a report of the registrar or inspector,

 (ii) on intimation of a special resolution passed by a company that its affairs are required to be investigated,

(iii) in public interest, or

(iv) on request from any department of the Central Government/state government.

Where any case has been assigned by the Central Government to SFIO for investigation, no other investigating agency of the Central Government/state government will proceed with investigation in such cases. If authorized by the Central Government, SFIO will have the power to arrest in respect of certain offences, which attract the punishment for fraud. Those offences will be cognizable and the person accused of any such offence will be released on bail only upon fulfilling stipulated conditions. Investigation report of SFIO filed with the special court for framing of charges will be deemed as a report filed by a police officer. Stringent penalties are prescribed for fraud-related offences.[23]

Corporate social responsibility

The Companies Act, 2013 requires that every company with net worth of `500 crore or more, or turnover of `1,000 crore or more or a net profit of `5 crore or more during any financial year will constitute a CSR committee. The CSR committee will consist of three or more directors, out of which at least one director will be an independent director. The board’s report will disclose the composition of this CSR committee. The CSR committee would constitute a board. The board will ensure that company spends, in every financial year, at least 2% of its average net profits made during the three immediately preceding financial years in pursuance of CSR policy. The company will give preference to local area and areas around where it operates, for spending the amount earmarked for CSR activities.

Class action and constitution of NCLT

Members or depositors or any class of them may claim damages or compensation or demand any other suitable action from or against the auditor including audit firm of the company for any improper or misleading statement made in his audit report or for any fraudulent, unlawful

or wrongful act or conduct. Where the members or depositors seek any damages or compensation or demand any other suitable action from or against an audit firm, the liability will be of the firm as well as of each partner who was involved in making any improper or misleading statement of particulars in the audit report or who acted in a fraudulent, unlawful or wrongful manner.

CONCLUSION

The governance of companies in India does not mean just replicating the systems prevalent elsewhere. The Indian environment is changing, the pace of which will further increase. Therefore, it makes good business sense to evolve our own unique solution to manage this change, using the bedrock principles of international Corporate Governance. Companies must inculcate a culture of transparency and accountability which must permeate the entire organisation; a sacrosanct code of business ethics must be woven into the very fabric of the company. Audit should shift attention from fault-finding to assuring employees of a balance between risks and responsibilities. Disclosures should focus on the quality of data, rather than the quantity. Boards must be energized, professionalized and renewed to have the right balance of expertise, experience, knowledge, wisdom and dynamism.

The laws cannot predict the future of businesses and bourses. With increasing awareness, the investors will no longer depend on the regulators to protect them. Guided by unforgiving stock markets, they will on their own shift allegiances and do so overnight to the companies which maximize the shareholder value. The key differentiator, with everything else being common, will be the ability to create self-driven, self-assessed, self-regulated organisations with a conscience. That ultimately is what Corporate Governance in India has to be all about.

[1] J.P. Singh ,Improving The Quality Of Corporate Governance In India, IJIR, Vol. 43, No. 1, 116,113-123(July 2007)

[2] http://www.primedirectors.com/pdf/JJ%20Irani%20Report-MCA.pdf

[3] N. R.Narayan Murthy, Report of the SEBI Committee on Corporate Governance, 9( February 8, 2003) http://www.sebi.gov.in/commreport/corpgov.pdf, last accessed 25th March,2014.

[4] Id. at 10.

[5] Discussion Paper Corporate Governance In India: Theory And Practice, Natonal Foundation For Corporate Governance, 4 (September,2004) http://www.nfcgindia.org/library/cgitp.pdf, last accessed on 28th March,2014

[6] Supra note 3 at 10.

[7] Corporate Governance,http://www.nseindia.com/getting_listed/content/clause_49.pdf, last accessed on 24th March,2014.

[8] Ethics, Governance And Sustainability , ICSI,95, http://www.icsi.in/Study%20Material%20Professional/NewSyllabus/EGAS.pdf, last accessed on 22nd March,2014

[9] Supra note 2 at 14.

[10] Ibid.

[11] Supra note 2 at 16.

[12] Supra note 7 at 7.

[13] Supra note 2.

[14] A Ramaiya, Guide To The Companies Act, 16th edition, Wadhwa, Nagpur.

[15] Committees On Corporate Governance, 96, http://shodhganga.inflibnet.ac.in:8080/jspui/bitstream/10603/8683/11/11_chapter%203.pdf, last accessed on 27th March,2014

[16] A Ramaiya, Guide To The Companies Act, 16th edition, Wadhwa, Nagpur.

[17] Supra note 7.

[18] Ibid.

[19] Supra note 2 at 110.

[20] Supra note 7.

[21] Preety Gupta, Listing-Agreement not in Consonance with the Companies Act , (Oct 1,2013)http://www.caclubindia.com/experts/listing-agreement-not-in-consonance-with-the-companies-act–1462284.asp#.UzXNN6iSzRg, last accessed on 27th March,2014

[22] India Inc – Companies Act 2013:An overview, Ernest Young,81 (September 2,2013)http://www.ey.com/Publication/vwLUAssets/India_Inc_Companies_Act_2013/$FILE/India_Inc_Companies_Act_2013.pdf, last accessed on 28th March,2014

[23] Ibid.

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