a comparative analysis of corporate governance in...

A Comparative Analysis of Corporate Governance in South Asia:

Charting a Roadmap for Bangladesh

Edited by Farooq Sobhan and Wendy Werner Published by Bangladesh Enterprise Institute House 20, Road 5, Gulshan 1, Dhaka 1212, Bangladesh Tel: (8802) 9892662-3 www.bei-bd.org; [email protected]

Acknowledgements The authors would like to thank the UK Department for International Development (DFID), Global Corporate Governance Forum (GCGF), and the Commonwealth Secretariat for their support of this research and project. In particular, Bangladesh Enterprise Institute would like to thank Frank Matsaert and Michael Gillibrand for their valuable comments and advice.

Table of Contents

Preface 1

Introduction 3

How to Contact the Authors 11

Bangladesh

Diagnostic Study of the Existing Corporate Governance Scenario in Bangladesh

12

India

Getting There — Pretty Rapidly: The State of Corporate Governance in India

130

Pakistan

Corporate Governance in Pakistan: Ownership, Control and the Law

166

Sri Lanka

Corporate Governance in Sri Lanka. Fast off the Tracks: But Is The Progress Real Progress?

266

Comparative Analysis of Corporate Governance in South Asia 1

Preface

In 2002, Bangladesh Enterprise Institute embarked on a project to examine the current state of corporate governance norms and practices in Bangladesh, India, Sri Lanka, and Pakistan. From the outset, we knew that Bangladesh lagged behind its South Asian neighbours with regard to corporate governance standards and practice and hoped that a comparative analysis would provide regional examples of initiatives that could be applied in Bangladesh to improve the situation. This publication is the product of the first stage of the project, which comprised of four reports on the state of corporate governance in Bangladesh, India, Sri Lanka, and Pakistan. We were fortunate to be able to work with experts in corporate governance in each of the countries involved. Through the research process, the project has identified areas where reform is needed in Bangladesh and explored successful Corporate Governance initiatives and practices in the region. The country reports use the Organisation for Economic Cooperation and Development (OECD) Principles of Corporate Governance as an international benchmark. Each of the reports covers:

• A review or survey of literature relating to CG in the country; • Identification of the strengths and weaknesses and key institutions of the CG

landscape; • Identification and analysis of the disparities between legal and regulatory corporate

governance requirements and actual corporate governance practices; • Examination of arrangements and incentive structures in place to enable good CG; • Analysis of unsuccessful corporate governance initiatives and the causes of

continuing poor corporate governance behaviour; • Evidence of indicative improvements in company performance and investment

resulting from better corporate governance. As is documented in this volume, in Bangladesh, failings in institutions, government agencies, legal enforcement, and market behaviour have resulted in weak corporate governance. In many cases, the current system in Bangladesh does not provide sufficient legal, institutional, or economic motivations for stakeholders to encourage and enforce good corporate governance practices. As a result, there are few rewards for companies that institute good corporate governance practices and no penalties for failing to do so. Targeted reforms in institutions or sectors can begin to provide the internal and external motivation for transparency and accountability that will lead to better corporate governance. Although Pakistan, Sri Lanka, and India have some similarities with Bangladesh in the way that the financial sector and private sector have developed historically, Bangladesh’s neighbours have recognized the importance of corporate governance and increased transparency in the corporate sector. Pakistan has a Code for Corporate Governance to which all listed companies are now required to comply. India has had several high-level committees looking at corporate governance. The Confederation of Indian Industry (CII) issued a voluntary code of desirable corporate governance in 1998 and the Securities and Exchange Board of India (SEBI) approved mandatory corporate governance listing requirements in the year 2000. Sri Lanka also has a Code of Best Practice on Corporate Governance drawn up by the Institute of Chartered Accountants of Sri Lanka. In each country, the codes have begun the process of encouraging or requiring companies to recognize the importance of good corporate governance practices.


In concert with the efforts to design benchmarks for good corporate governance that are relevant to South Asian countries, efforts are under way to harmonise and improve accounting and auditing standards. The Accounting and Auditing Standards Monitoring Board in Sri Lanka and the Audit Quality Control Review Committee in Pakistan are two particularly good examples that could be emulated in Bangladesh. The process of strengthening corporate governance in South Asia is ongoing. As the reports in this volume point out, there are many aspects of the corporate governance regime in South Asian countries that continues to lack strength. As Ajith Nivard Cabraal points out in his report on Sri Lanka, there are questions regarding actual corporate governance performance compared to stated corporate governance practices. Procedures for bankruptcy and insolvency in India are identified as a sticking point by Omkar Goswami. Finally, Faisal Bari and Ali Cheema question whether the requirements enshrined in the Pakistani Code of Corporate Governance will be too onerous for small companies. However, Bangladesh has much to learn from its South Asian neighbours and learn it must. For Bangladesh to improve its economic performance, it must attract more investment capital both from domestic and foreign investors. Better corporate governance is a prerequisite for investors to entrust their funds to corporations. For Bangladesh, the first step in strengthening the role of stakeholders in corporate governance is raising awareness regarding these issues and increase consensus about the need for better corporate governance. In addition, there should be more recognition that corporate governance is integral and necessary to the development of the private sector in Bangladesh. To achieve these goals of better awareness and recognition of good corporate governance practices, starting in August 2003, Bangladesh Enterprise Institute is convening a Taskforce on Corporate Governance that will develop and endorse a Code of Corporate Governance for Bangladesh. This Taskforce will begin the first step in bringing Bangladesh up to a level equivalent with international and regional standards of corporate governance. This project would not have been possible without the support we received from Department for International Development (DFID), Global Corporate Governance Forum (GCGF) and the Commonwealth Secretariat. We were also extremely fortunate in having as our country partners Omkar Goswami, one of India’s leading experts on Corporate Governance, Ajith Cabraal, who chaired the very first taskforce established in Sri Lanka on Corporate Governance and Faisal Bari and Ali Cheema two of the leading experts in Pakistan, who took a keen interest in the whole project from the start. The seven-member BEI team on Corporate Governance consisting of Ms. Nihad Kabir, Ms. Wendy Werner, Ms. Sheela R. Rahman, Mr. Yawar Sayeed, Mr. Monzurul Haque, Ms. Shahnila T. Azhar and myself was a model of dedication, enthusiasm and hard work. Though the collective effort of the team we were able to cover a lot of ground on all aspects of Corporate Governance in Bangladesh. Throughout this period we received valuable advice and suggestions from Michael Gillibrand (the Commonwealth Secretariat), Anne Simpson (GCGF) and Frank Matsaert (DFID). I would like to thank all the persons mentioned above for their support and contribution. I would also like to say how much we appreciated the encouragement we received from the Minister of Commerce, the Minister of Law and Parliamentary Affairs, the Governor of Bangladesh Bank, the Securities and Exchange Commission, the Institute of Chartered Accountants and a host of other people in the government and in the private sector. Farooq Sobhan President, Bangladesh Enterprise Institute August 2003


Introduction Michael Gillibrand Special Adviser and Head of Advisory Services Commonwealth Secretariat 1. Purpose and Framework for the South Asian Comparative Analysis. This comparative analysis of the state of corporate governance in South Asia was launched by the Bangladesh Enterprise Institute (BEI) in 2002, with the objective of laying a firm foundation of clear strategic thinking, combined with practical experience from other countries, for the commencement of a national programme to promote good corporate governance in Bangladesh. This initiative of the BEI is to be highly commended, not only in terms of its academic value but also of its practical purpose in preparing for major development policy innovations. There are few precedents in the world where national programmes have been based on systematic research on neighbouring countries. The research has been funded by the Department for International Development of the British Government, with support from the Global Corporate Governance Forum of the World Bank and the OECD, and the Commonwealth Secretariat. The project aims to assess the development to date of corporate governance in Bangladesh, India, Pakistan and Sri Lanka, using the OECD Principles for Corporate Governance as the common reference. The terms of reference for the research team in each country were to: - carry out a review of the literature relating to corporate governance in each country; - identify the major features of corporate governance in each country, including the current

strengths and weaknesses; - identify the disparities between the theory and the practice of corporate governance and

assess the causes of such disparities; - examine the conditions for enabling good corporate governance, in particular through

case studies focussing on successful arrangements such as the institutions and their underlying incentive structures, and also on unsuccessful initiatives.

This comparative analysis is part of three continuing and interlinked processes. First, by compiling the history to date of corporate governance in Bangladesh, India, Pakistan and Sri Lanka, it makes a significant academic contribution to the knowledge of corporate governance in the emerging markets and developing economies of the world. This is still a relatively unknown area, as by far the greatest amount of research on corporate governance has been done in the advanced capital markets of North America and Europe, and a certain amount in South East Asia. The analysis of the structures, processes and constraints of the capital markets of the sub-continent which are provided by the writers of this BEI study significantly advance our understanding of the realities of the markets, and can therefore lead to much better informed policies for South Asia and for other developing economies across the world. The special feature of this comparative analysis is its diversity within its commonality: it pays equal attention to all four countries and so encompasses the experiences of India, whose sophisticated capital markets have over a century of experience and with a large and diversified manufacturing base which was established prior to independence half a century ago, with the experiences of Bangladesh, one of the poorest countries in the world with a very small capital market, a limited industrial base and a private sector which has effectively developed only over the past quarter century. Despite these


differences, the shared heritages of these four countries of the sub-continent, together with the similarities of their legal systems, public and private institutions and government structures, enable valuable lessons of experience to be gained for the future development of corporate governance in developing countries. Otherwise, the main comparative analysis has been the review of selected emerging markets undertaken by the OECD Development Centre, and published in July 2003 as Corporate Governance in Development - The Experiences of Brazil, Chile, India and South Africa1. The second process is the promotion of corporate governance in Bangladesh. On the basis of the well proven principle that ‘time spent on reconnaissance is seldom wasted’, the publication of this comparative analysis in August 2003, will be followed by the BEI helping to initiate a comprehensive corporate governance programme covering all the main sectors of the economy. It is envisaged that this will include the formation of a national taskforce on corporate governance, with the immediate objectives of exploring the need for national codes and other key elements for the implementation of good corporate governance practice. This study well illustrates a critical issue which had been perceived by the BEI at the commencement of the whole exercise – that Bangladesh lags behind the other large countries of the region in the field of corporate governance. India, Pakistan and Sri Lanka already have, for example, national codes and one or several institutions actively implementing corporate governance programmes, while in Bangladesh the subject has been a matter for discussion but not yet for policy or implementation, with a few exceptions. In fact, after the completion of the research for this comparative analysis, the Bangladesh Bank has, in mid-2003, commenced a series of banking sector reforms which involve corporate governance systems. As part of the national programme, the results of this comparative analysis, and the recommendations given in the report on Bangladesh, will be presented and debated in a series of policy workshops involving all the key stakeholders. The first such workshop was held in January 2003 to consider the preliminary findings of the report on Bangladesh, while the next workshops will cover the comparative analysis and culminate in a national conference which will help to set out the road map and the milestones for good corporate governance. This study is thus the first large stride in a long road. The third process is the building of a network of corporate governance specialists in the whole sub-continent. This comparative analysis has been prepared by a team of multi-disciplinary specialists, comprising professional accountants, bankers, economists, lawyers and policy analysts, from Bangladesh, India, Pakistan and Sri Lanka who have, as part of this joint effort, formed a regional network. This network in turn can evolve to become a platform to promote further regional-scale corporate governance programmes to try and benefit the whole sub-continent. Whether entirely reasonable or not, it is a reality that in the world of international investment, the reputation of one national market can influence the reputation of others in the same region, either positively or negatively. Hence there is a need for regional cooperation to reduce the risk of deficiencies in one country of a regional market being perceived as contagious and also attributed to neighbouring countries – a fact recognized by the South Asia Federation of Exchanges (SAFE), consisting of the stock exchanges of Bangladesh, India, Pakistan, Sri Lanka, Nepal and Mauritius. In this regional context, it should be noted that Mauritius had initiated corporate governance policies in 1996, formed a national task force in 2001, and have released their national code in 2003, which further emphasizes the need for action in Bangladesh. 2. The Significance of Corporate Governance

1 Corporate Governance in Development - The Experiences of Brazil, Chile, India and South Africa. by C. Oman, CIPE and OECD Development Centre, 2003. The chapters on India are authored by Omkar Goswami, who is also the writer of the report on India for this BEI study.


Why is there all this attention to corporate governance, not only in South Asia but throughout the world? This comparative analysis provides clear answers to the question. The South Asian country studies show that the attention to corporate governance was motivated not by the East Asian financial crisis in 1997/98 (which did not involve South Asian countries, though the whole of Asia was effected by the fear of ‘contagion’), nor by the scandals in America, Australia, Britain and Canada, in the late 1980’s and early 1990’s, which led to the high profile reports such as from the Bosch, Cadbury and Dey committees and gave such prominence to the previously scarcely known subject of ‘corporate governance’, but by home-grown problems in their own financial markets. In India there was the securities scam (involving a large number of banks) leading to the stock market crash in 1992, followed by the consolidation of equity ownership by multinational companies listed on the stock markets, and then by the stock market bubble in 1993 and crash of the ‘disappearing companies’ in 1994, which devastated the primary market until the end of the century. These led to the formation by the Confederation of Indian Industry of the Bajaj Committee on corporate governance in late 1995, well before the East Asian financial crisis. In addition, the country report shows how the Indian capital markets had reached a crisis-point where the accumulated distortions of decades of restrictive state policies and of corporate control (traced back to the ‘managing agencies’ in the earliest days of the stock markets in the 19th Century) had highlighted the need for urgent capital market reform. In Sri Lanka, the concern for corporate governance originated in the numerous company failures, especially finance companies, in the late 1980’s and early 1990’s, which caused investors to lose faith in the regulatory and semi-regulatory frameworks, as well as the standards of financial reporting. Accordingly, the Institute of Chartered Accountants of Sri Lanka set up a task force in 1992 (about the same time as the Cadbury committee in UK) to enforce Sri Lankan accounting standards, and then extended this initiative in 1996 (again before the East Asian financial crisis) to set up a committee to make recommendations on the financial aspects of corporate governance. Pakistan commenced its corporate governance programmes later, following the Securities and Exchange Commission of Pakistan Act in 1997, the commencement of operations by the Commission in 1999, and the introduction of the national Code for Corporate Governance in early 2002. But despite the later start, it is evident from the country report that the initiatives in Pakistan were driven by home-grown realities, in particular the recognition that the traditional structures and operations of the capital market, especially lending from state-owned banks, could no longer sustain the financing needed for growth, hence there is a critical need for reform of the capital markets in order to mobilize domestic savings and foreign portfolio investment, as there had been in India a decade earlier. In fact, despite the later start with formal national policies, it could be said that Pakistan focused on corporate governance earlier than many countries in the world, not just the region – the Pakistan country report emphasizes the importance of the 1984 Companies Ordinance Act, which introduced a number of key features of good corporate governance, at a time when the very term ‘corporate governance’ had only just been coined and was still effectively unknown outside very specialized academic circles2. Furthermore, during the mid-1980s there were some significant policy and training programmes to strengthen corporate control, board direction and chairmanship in both the state enterprises and the private sector, through the Expert Advisory Cell of the Ministry of Industry and the Lahore University of Management Sciences and Institute of Personnel, supported by USAID. Although these

2 The origin of the term ‘corporate governance’ is generally credited to Professor Tricker in 1984.


programmes were not described as ‘corporate governance’, they could be said to form part of the corporate governance heritage of Pakistan. In Bangladesh, however, there have been no serious corporate scandals which have been enough to send shock waves to undermine confidence in the financial system, nor has the country found that it has reached the limits of conventional corporate financing mainly through bank lending. The country report identifies that “the relatively low level of international investment in Bangladesh does not provide a sufficient motivation for improving corporate governance, nor are there many traditional domestic motivations for improvement in corporate governance practices in Bangladesh”. Nevertheless, the report concludes that this does not mean that Bangladesh should give low priority to corporate governance, as there are reasons other than capital market reforms to focus on corporate governance. The Bangladesh country report notes the significance of corporate governance for a competitive private sector in a global market as well as for efficiently utilizing domestic investment to achieve greater economic development. Good corporate governance practices will help develop and stimulate better business management, strategic management, and risk management, which, in the long-term, will make Bangladeshi businesses more competitive. In addition, the lessons from the experience of the neighbouring countries in South Asia are such that Bangladesh can deploy good corporate governance to prevent the problems which have afflicted other countries rather than to solve them after the event. The country reports go beyond describing the significance of corporate governance in theoretical and policy terms – they also provide indications of the effectiveness of corporate governance. Perhaps the most important question for corporate governance is whether well-governed companies perform better (in terms of growth, profitability and share price) and behave better (in terms of corporate social and environmental responsibility and of corporate citizenship, especially in tackling the supply side of corruption) than do badly-governed companies. Good corporate governance is virtuous, but does it deliver results? It could be said that this question implicitly runs like a theme through the Bangladesh country report, and explicitly emerges in conclusions such as “nor are there many traditional domestic motivations for improvement in corporate governance practices in Bangladesh”. There is a possible challenge that, unless there are satisfactory answers to this question of the efficacy of corporate governance, Bangladesh – and other countries – will, quite reasonably, not be convinced of the need to assign high priority to corporate governance programmes. As the author of the India country report remarked on his second page: “by the middle of 2001, however, most of Asia was getting back to a concerted growth phase, and the psyche of investors had swung from fear to greed.” Not unsurprisingly, there were incipient signs that while every country was faithfully mouthing the mantras, the spirit of corporate governance was being prepared for a quiet burial in most. Thankfully, then came Enron, followed by World Com, Q West, Global Crossing and the rest of their ilk.” The feelings attributed to Asia in 2001 were not new: after the sequence of the Cadbury, Greenbury and Hampel reports in Britain in 1998, there was a general complaint of ‘governance fatigue’ in the corporate sector, and a request that ‘a line be drawn under corporate governance’. Corporate governance was seen as a ‘box-ticking’ exercise in compliance with standards designed to prevent fraud and gross negligence, not as a tool to improve the real performance of companies which consider themselves to be fundamentally honest and competent – and the great majority of companies consider themselves to be so, even if some might be deluded. Enron, and Marconi in UK for different reasons, showed that corporate governance is still essential, and also demonstrated that it must be applied in the spirit as well as the letter. But the question still remains whether corporate governance can enhance the performance of fundamentally sound companies, and must be answered, not by another scandal, but by consistently improved performance by well-governed companies.


It has to be acknowledged that, globally as well as in the South Asia region, these are still early days for the full assessment of the results which can be achieved by corporate governance, and the task is complicated by methodological difficulties of isolating the influence of corporate governance from other factors. Hence there is still a lack of conclusive evidence on this subject. Nevertheless, the India country report states some firm conclusions : “Indian corporations have appreciated the fact that good corporate governance and internationally accepted standards of accounting and disclosure can help them to access the US capital markets . . .with Infosys making its highly successful NASDAQ issue 1 March 1998, followed by ICICI, Satyam Infoways, Satyam, ICICI Bank, Wipro, HDFC Bank, Dr. Reddy’s Laboratories and others …this has shown that good governance pays off and allows companies to access the world’s largest capital market; second, it has demonstrated that good corporate governance and disclosures are not difficult to implement … the message is now clear: it makes good business sense to be a transparent, well governed company.” It should also be noted that these benefits may be gained only with some ‘costs’: in order to access the US capital markets ICICI Bank voluntarily recast its accounts for 1999 in terms of US accounting standards, which eroded its bottom-line by a third – but gained enormous investor confidence so that its domestic initial public offer was oversubscribed by 80%. This case has a resonance of the experience of Siemens, which found that its impressive profitability was turned into a loss the first time it had to present its accounts under US rather than German accounting standards. The India country report also concludes with the benefits of capital market reforms, of which corporate governance is an essential part. These benefits include the “phenomenal growth in market capitalization, (which) has triggered a fundamental change in mindset from appropriating larger slices of a small pie, to doing all that is needed to let the pie grow, even if it involves dilution of share ownership”, and the increase in foreign portfolio investors, who have “voted with their feet. . .. Over the last two years they have systematically increased their exposure in well governed firms at the expense of poorly run ones.” Finally, there has been the restructuring of the Indian corporate sector, which is a consequence not only of corporate governance but of the whole package of reforms. The India country report highlights that by 2002, 22 out of the top 50 Indian companies in terms of market capitalization either did not exist or were not listed on any stock exchange in 1991, and 35 out of the top 50 companies in 2002 are now professionally managed, while the rank of the top 50 companies in 1991 fell by an average of 88 points on the stock market. Thus, the questions which may be posed in Bangladesh are: in 2015, which will be the top companies on the Dhaka and Chittagong stock exchanges, and how large will they be, without corporate governance reforms, and with corporate governance reforms? The Sri Lanka country report also indicates the tangible benefits of good corporate governance – but, it should be noted, with some serious caveats concerning the actual practice of good corporate governance as opposed to the pro-forma presence of the main criteria of good corporate governance. The Sri Lanka country report included a sample survey of 21% of all the companies listed on the Colombo Stock Exchange, and found that the average score was 45% of the total achievable 19 criteria for good corporate governance. However, some companies scored significantly higher with over 60%, and it was found that these companies had outperformed the stock market index. The report therefore concludes that “while there may be a number of factors influencing the performance of a company, we believe that corporate governance disclosure and good corporate governance practices are a significant contributory factor.” In addition to the country reports, there are external indicators that good corporate governance generates improved performance and benefits to companies. McKinsey’s Global Investor Survey has long been quoted as evidence of the advantages of corporate governance, and the 2002 survey showed that over 80% of Asian investors ranked good corporate governance as equally or more


important as financial issues, and 78% said that they would be willing to pay a premium for shares in a well governed company. In May 2003, the Asian Corporate Governance Association released its annual survey of corporate governance in Asia, covering 10 countries and 380 companies across the region. Among the major findings were that companies with strong governance outperformed their markets by an average of 35 percentage points over 5 years (1998-2002), while those with poor governance underperformed by 25 percentage points over the same period. The average company score in corporate governance standards has risen by 4 percentage points - from 58% in 2002 to 62% in 2003 - but the range in company scores remains extremely wide and a cause for concern, so that the survey concludes – like the Sri Lanka country report – that “much of the improvement in CG is in form rather than substance.” Nevertheless, the indicators are that where form is indeed backed by substance there are significant gains to the company 3. Features and Lessons of the Comparative Analysis The four country studies provide an immensely rich resource which can be mined for numerous lessons of experience and critical factors for corporate governance. One special feature of the reports are the case studies and anecdotes of the successes and failures of corporate governance, which both bring to life the realities of what is otherwise a dry and complicated subject, and can provide valuable training cases. Each country report contains a convenient summary or conclusion which encapsulates the main results of the study, and demonstrates the particular approach and focus of the research team, with similarities and differences among the countries, and most certainly each report merits thorough attention. The reports provide an extensive checklist of critical factors for good corporate governance, which are too extensive to summarise in a brief introduction, but some are of particular significance as they reflect issues and factors which have not been well highlighted in other studies, or are likely to be of particular importance in developing practical policies for South Asia. The first lesson which emerges from the country reports is that corporate governance cannot be introduced in isolation from a range of other reforms (macro-economic, micro-economic, accounting, legal, banking and institutional) – nor can these other reforms achieve all their objectives without corporate governance initiatives. The India and the Pakistan country reports both provide outstanding analyses of the problems and market distortions which have built up from decades of varying government policies and from strong entrenched structures and interests of the private sector, and the complexity of picking apart the range of policies and targeting the reforms. Reform is a cumulative process, and one set of reforms uncovers the need for other reforms, so the challenges lie in policy management – in conceptualizing and implementing a road map of parallel and sequential reforms which constitute a comprehensive programme, without becoming an unmanageable ‘grand plan’ needing some form of philosopher-king to enforce all the provisions in perfect synchronisation. Bitter experience shows that this cannot be achieved, especially in vibrant democracies, but there is also the bitter experience that liberalization reforms without effective regulatory systems and agencies may have very high transitional costs (as India learned after 1994). A second lesson, closely associated with the first, is the need to monitor the trends in different sectors of the markets so as to try and avoid (or at least prepare for) a ‘perfect storm’, when there is a confluence of several negative trends which, individually might be manageable, but together form a crisis. Again, the India, Pakistan and Sri Lanka country reports show the dangers of multiple ‘fault lines’ in the financial and corporate sectors, such as the burden of non-performing loans, dependency on formal and informal protection and on state development finance


institutions, structural imbalances between ownership and control and high agency costs, outmoded laws, and lack of inflow of investment capital. A third lesson is the need for a range of players to improve corporate governance, and the indication that a degree of ‘stick’ may be needed together with the ‘carrots’ of increased investment and performance. It is noticeable that in India the initiative for improved corporate governance came from the Confederation of Indian Industry, who produced a voluntary code and which they encouraged their members to follow and to demonstrate in highly advanced model annual reports, again designed by the C.I.I. These model reports included sections of corporate social and environmental responsibility as well as corporate governance, and set out rigorous points of detail such as the board attendance record as well as the remuneration of individual board members. However, only about 20 companies followed these guidelines, and it required the intervention of the regulator (in the form of SEBI, the Securities Exchange Board of India, and the Ministry of Company Affairs) to significantly widen the application of corporate governance. Even then progress has been slow, and both the Indian and Sri Lankan country reports note the significance of ratings agencies in demanding good corporate governance as well as financial management systems for better credit ratings. Sri Lanka in particular shows the roles of the regulators and credit agencies, combined with professional institutions such as the chartered accountants, chartered company secretaries, institutes of directors, chambers of commerce. A fourth lesson is the critical importance of the company and contract laws and the efficacy of the legal system. It is notable that all the countries have developed special commercial courts of one sort or another to handle the commercial disputed, but the reports all generate a sense of gloom, almost of despair, when it comes to the efficacy of the law, and of the need to modernize bankruptcy and liquidation proceedings. This is linked with the fifth lesson, which is the critical importance of the traditional family ownership and control structures, and the concern that corporate governance is observed more in form than substance. This is shown by the sub title of the Sri Lanka country report (“Corporate Governance in Sri Lanka – Fast off the Tracks: But is the Progress Real Progress?”) and of the Asian Corporate Governance Association survey for 2003 (“Fakin’ It: Board Games in Asia”). The Pakistan country paper provides an incisive view of the family control system and the prevalence of the pyramid structures of control (higher than countries in South East Asia), while the India country paper gives a brief but penetrating analysis of the contrasts between the agency costs of the conventional ‘Jensenian’ (Anglo-Saxon) model of the critical relationship of separation of ownership and control in corporate governance in the US and Britain, and the interlinked ownership and control (including pyramid corporate cross-holdings) which characterise Asian companies. But the India report also leads towards the solution which is a change in the mindset, with a new focus on ‘ growing the pie’ even if it involves dilution in share ownership, so that families can increase and diversify their wealth by becoming investors in other companies instead of concentrating on control of their own company. These realities would compel a sense of caution of expectations of rapid improvement, but while caution is an essential discipline the sixth lesson is that it should not be a reason or an excuse for inaction and despondency. In contrast to Sri Lanka and the Asian Corporate Governance Association, the India country report has a confident title : “Getting there – Pretty Rapidly : the State of Corporate Governance in India”, and its concluding sentence is “by the time Beijing hosts the 2008 Olympics, India might have the largest concentration of well governed companies in South and South East Asia”. One of the reasons for this optimism is the old “80/20” rule, meaning in this context that if the top 20% of companies are targeted for good corporate


governance they will cover a level of 80% of the stock market capitalisation, and thus have a powerful demonstration effect on the rest of the country. This is probably a valid strategy for all the countries, where there is a heavy concentration of capitalisation in the top 100 companies, though not as much as 80% due to the increased capitalisation. This matter of the materiality of the largest companies brings to the seventh main lesson of the comparative analysis (which is the last for this Introduction but not for the whole programme): the significance of corporate governance for other types of enterprises which are not extensively covered in these reports (necessarily as the terms of reference have to be confined for this initial stages). Perhaps the most important of these other types of enterprises are the state enterprises, which still loom very large in all these four countries. The India country report has a section dealing with state enterprises, and notes that these account for 34% of India’s corporate paid-up capital. The Bangladesh report alludes to the significance of the state enterprises, and the research has also shown the need for good corporate governance practices for medium enterprises and for Non-Governmental Organisations, which in Bangladesh and other countries often form important trading enterprises as well as crucial social development agencies. But these matters can at this stage be left for the next phases of the regional and national corporate governance programmes, and for further research which will be undoubtedly required to fine-tune many of the critical aspects of corporate governance policies.


How to Contact the Authors

Bangladesh

Farooq Sobhan ([email protected]) Wendy Werner ([email protected]) Nihad Kabir ([email protected]) Sheela Rahman ([email protected]) Yawer Sayeed ([email protected]) Monzurul Haque ([email protected]) Shahnila Azher ([email protected])

India

Omkar Goswami ([email protected]) Pakistan

Faisal Bari ([email protected]) Ali Cheema ([email protected])

Sri Lanka

Ajith Nivard Cabraal ([email protected]) Commonwealth Secretariat

Michael Gillibrand ([email protected])


Diagnostic Study of the Existing Corporate Governance Scenario

in Bangladesh

Authors and Consultants: Farooq Sobhan Shahnila Azher Monzurul Haque Nihad Kabir Sheela Rahman Yawer Sayeed Wendy Werner Table of Contents List of Abbreviations 14

Acknowledgements 15

Project Introduction 15

Executive Summary 21

Companies, Corporate Laws and Practice 28

Financial Sector Scenario and Governance 29

Accounting Standards and Disclosures 52

Independent Regulators 55

The Judiciary 65

State Owned Enterprises 65

Existence and Role of Pressure Points 67

Conclusion 68

List of Appendices

Appendix A. Terms of Reference for Country Partners 72

Appendix B. List of Organisations Interviewed 76


Appendix C. List of Corporate Governance Stakeholders Interviewed 77

Appendix D. Questionnaire – Corporate Sector 78

Appendix E. Questionnaire – Financial Sector 84

Appendix F. Corporate Survey Findings 89

Appendix G. List of Relevant Laws and Regulations in Bangladesh 95

Appendix H. Forms to be Submitted to the RJSC and Other Bodies 98

Appendix I. Current ICAB Adoption Status of IAS 100

Appendix J. Summaries of Literature Reviewed 101

Appendix K. Financial Institutions in Bangladesh 113

Appendix L. Resources 116

Appendix M. Report on January 7, 2003 Seminar 118


List of Abbreviations ADB Asian Development Bank AGM Annual General Meeting BAS Bangladesh Accounting Standards BB Bangladesh Bank BRPD Banking Regulation and Policy Division (of the Bangladesh Bank) CA Chartered Accountant CAG Office of the Comptroller and Auditor General CCI Controller of Capital Issues CEO Chief Executive Officer CG Corporate Governance CIB Credit Information Bureau CLO Collaterized Loan Obligations CSE Chittagong Stock Exchange DSE Dhaka Stock Exchange EGM Extraordinary General Meeting GOB Government of Bangladesh IAPC International Auditing Practices Committee IAS International Accounting Standards IASC International Accounting Standards Committee ICAB Institute of Chartered Accountants of Bangladesh ICB Investment Corporation of Bangladesh ICMAB Institute of Cost and Management Accountants of Bangladesh IFAC International Federation of Accountants IPO Initial Public Offering ISA International Standards of Auditing ISA International Standards on Auditing JBC Jiban Bima Company LRA Lending Risk Assessment MD Managing Director MFI Microfinance Institution NCB Nationalised Commercial Banks NGO Non-Governmental Organization NPL Non-Performing Loans OECD Organisation for Economic Cooperation and Development PAC Public Accounts Committee (of Parliament) PB Private Banks PKSF Palli Karma-Sahayak RJSC Registrar of Joint Stock Companies and Firms SBC Sadharan Bima Company SCB State-owned Commercial Banks SEC Securities and Exchange Commission SECA 1993 Securities and Exchange Commission Act 1993 SECA 1993 Securities and Exchange Commission Act, 1993 SEO 1969 Securities and Exchange Ordinance, 1969 SER 1987 Securities and Exchange Rules 1987 SOE State owned enterprise Tk. Bangladeshi Taka (US$1 = 59 Taka)


Acknowledgements Bangladesh Enterprise Institute and the authors would like to acknowledge the support of the following organisations in funding and promoting the project “A Comparative Analysis of Corporate Governance in South Asia: Charting a Roadmap for Bangladesh”:

• Department for International Development, UK (DFID) • Global Corporate Governance Forum (GCGF) • Commonwealth Secretariat

We would also like to thank all the business organisations and stakeholders that generously gave their time to complete our survey and give us interviews. Project Introduction This project focuses on the structures and institutions in place to support good corporate governance practices. A valid preliminary question is, therefore, why one should focus on corporate governance in Bangladesh. Meeting International standards is typically the first reason cited. The need to meet international standards of corporate governance is increasingly a requirement, not an option, to attract foreign direct and/or portfolio investment. The preamble to the OECD Principles of Corporate Governance makes this point clear:

The degree to which corporations observe basic principles of good corporate governance is an increasingly important factor for investment decisions. Of particular relevance is the relation between corporate governance practices and the increasingly international character of investment. International flows of capital enable companies to access financing from a much larger pool of investors. If countries are to reap the full benefits of the global capital market, and if they are to attract long-term “patient” capital, corporate governance arrangements must be credible and well understood across borders.3

This report identifies that the relatively low level of international investment in Bangladesh does not provide a sufficient motivation for improving corporate governance (CG), nor are there many traditional domestic motivations for improvement in corporate governance practices in Bangladesh. However, this does not mean that one should not strive to improve corporate governance in Bangladesh; there are other reasons to focus on corporate governance. As Bangladesh begins to focus on the development of the private sector, strong corporate governance is a key part of increasing economic efficiency and efficiently utilizing domestic investment to achieve greater economic development. Good corporate governance practices will help develop and stimulate better business management, strategic management, and risk management. In the long-term, this will make Bangladeshi businesses more competitive.

One key element in improving economic efficiency is corporate governance, which involves a set of relationships between a company’s management, its board, its shareholders and other stakeholders. Corporate governance also provides the structure through which the objectives of the company are set, and the means of attaining those objectives and monitoring performance are determined. Good corporate governance . . . should facilitate effective monitoring, thereby encouraging firms to use resources more efficiently.4

3 OECD Principles of Corporate Governance, p. 12 4 ibid, p. 11


Finally, good corporate governance practices ensure that high quality information is provided to investors as well as the general public to ensure that companies sustain the support and trust of their investors and the public. In a country where the state has been the primary economic actor, it is important that the burgeoning private sector prove that it has the ability to maintain high standards and operate in the best interests of the people. “Good corporate governance helps, too, to ensure that corporations take into account the interests of a wide range of constituencies, as well as of the communities within which they operate. . . This, in turn, helps to assure that corporations operate for the benefit of society as a whole.”5 Although the impetus for improvement in corporate governance in most countries comes from investors and the capital markets, these stakeholders are weak in Bangladesh and are unlikely to wield the influence necessary to change corporate practices. However, there are still compelling reasons for the corporate sector and governmental and non-governmental stakeholders to encourage better corporate governance practices. First, Bangladesh should strive to reach international standards with regard to corporate practices not only as a prerequisite to attracting international capital, but also to enhance the commercial reputation of the country generally. Second, good corporate governance practices can be an important tool in improving domestic economic efficiency, business management, and risk management, which will assist in the development of the private sector. Finally, the corporate sector should strive to improve corporate governance as a mechanism to demonstrate corporate responsibility and attain the trust and support of the public. The Objectives of the Project and Report As the global markets have re-evaluated corporate governance practices in developed countries, the awareness of and need for better corporate governance in developing countries has gained momentum. This project originated from the fact that no systematic effort has been undertaken to develop and improve the quality of corporate governance in Bangladesh. This report essentially forms the first step in an overarching sequence of three stages and aims to deliver a diagnostic view of the existing corporate governance (CG) landscape in Bangladesh (see Appendix A for Terms of Reference). As part of the first stage of the project, the findings of this study and a draft of the report were presented at a national seminar in Dhaka in January 2003. Stage 1 also includes studies of corporate governance in Pakistan, India, and Sri Lanka. Stages 2 and 3 of the project will take the conclusions of this diagnostic work forward into creating a concrete agenda for reform and, subsequently, intervention strategies.

Figure 1: Overarching Scheme of Project

Stage 1 Country Studies

Stage 2 Synthesis for Bangladesh

Stage 3 Design of Intervention

This project and report seeks to focus on key areas that have been identified internationally as important to good corporate governance practices. The report does not attempt to study every aspect of the economy or financial sector that may have some bearing on corporate governance, but instead focuses on the most important areas in which there is greater likelihood of seeing changes come about in the near future. In keeping with the OECD Principles of Corporate Governance, five topics were the focus of the diagnostic study:

The Rights of Shareholders The Equitable Treatment of Shareholders The Role of Stakeholders in Corporate Governance Disclosure and Transparency Responsibilities of the Board

5 ibid, p. 7.


In the Terms of Reference, specific questions or subtopics were identified under each of the above-listed topics. First, with regard to the rights of shareholders, the report discusses to what extent the corporate governance framework protects shareholders’ rights. This discussion includes the relationship between corporate ownership structure (e.g. concentrated and family-based structure) and corporate governance practices. In addition, requirements to protect the rights of shareholders by regulatory agencies and stock exchanges are discussed. This topic is discussed in the Companies, Corporate Laws, and Practice section of the report. The second major topic is the equitable treatment of shareholders, which is defined as to what extent shareholders of different categories are treated equitably and what mechanisms are in place for obtaining effective redress in case of violation of shareholder rights. This topic is particularly relevant for minority shareholders. The study evaluates the extent to which existing company laws help to define and enforce the rights of minority shareholders in the section on Companies, Corporate Laws, and Practice. Third, the OECD guidelines recognize the role of stakeholders in corporate governance. This is interpreted to mean to what extent the corporate governance framework recognizes the rights of stakeholders as established by law and encourages active cooperation between companies and stakeholders in creating wealth, jobs, and the sustainability of sound enterprises. In the context of Bangladesh, the major problems in this area are the role of independent regulators and creditors’ rights. These issues are discussed mainly in the sections on Independent Regulators and The Banking Sector. Fourth, requirements for disclosure and transparency are at the heart of corporate governance. The sections on Companies, Corporate Law and Practice; Accounting Standards and Disclosures; and the Institute of Chartered Accountants of Bangladesh (ICAB) examine the current situation in Bangladesh with respect to audit firms, the fees they are allowed to charge, the accounting standards they actually follow, the role of national accounting associations in prescribing audit and reporting standards, and the adequacy of the current self-regulatory system. Fifth, in the Companies, Corporate Laws, and Practice section the report explores the responsibilities of the board. It identifies the legal, statutory, and practical framework that ensures the board’s accountability to shareholders and the company, the strategic guidance of the company, and the effective monitoring of management by the board. The authors recognize that other factors may contribute to corporate governance practices in Bangladesh, but, in some cases, they are beyond the scope of this project. The project was guided by the OECD Principles of Corporate Governance, which has identified the above topics and subtopics as those of primary importance in evaluating and implementing corporate governance practices. In addition to the focus on the OECD Principles, the report in Stage 1 has focused mainly on public and public-listed companies. Although corporate governance principles are relevant to all corporations, the project team found that more information was available regarding public companies and corporate governance statutory requirements applied most to these types of companies. It would have been useful to chalk out a split between the private and public corporate sectors in Bangladesh. However, any kind of materiality mapping exercise turned out to be a formidable task just because of the complete lack of relevant statistics. The RJSC cites 50,000 as the total number of entities that are incorporated in the country and 216 are publicly listed, but the relevant share of capital of public and private companies was not available.


The state-owned enterprise (SOE) sector also comprises a large sector of the country to which corporate governance practices should be applied. The lack of reliable statistics makes it difficult to quantify the size of the SOE sector, however the World Bank cites an asset value figure of around 35% of GDP for the SOEs - a figure that admittedly should be used with significant caution. The application of good corporate governance practices to the SOE sector could, therefore, have a significant effect on the economy, but at present the concept or practice of corporate governance is almost non-existent in SOEs. Therefore, the Diagnostic Report for Stage 1 has focused on public corporations as the sector with the most scope for improving corporate governance practices. Outline of the Report To address the topics and subtopics identified above, the report is organized by the various stakeholders and requirements that define corporate governance practices in Bangladesh. The report begins by examining the legal framework in which corporate entities operate; the section entitled Companies, Corporate Laws and Practice explains the requirements on a corporate organisation from various laws and regulations and compares the requirements with practice. Evidence of observed practice comes from the survey of corporate organizations, interviews with stakeholders, and project research. The Financial Sector Scenario and Governance explains the market in which corporations and financial institutions operate in Bangladesh, including their sources of financing, which plays a large part in corporate governance practices. The report next examines Accounting Standards and Disclosures. This section includes both the disclosures required by statutory requirements and level of disclosures observed in everyday practice. The following section explores the function and role of the independent regulators, which have the responsibility to ensure that practices follow regulations. The sections Judiciary and Existence and Role of Pressure Points explore the other external actors that can enforce or encourage good corporate governance practices. The current state of corporate governance in State-Owned Enterprises is briefly explored. Finally, the conclusion summarises the findings and identifies sectors in which further study is warranted. Report Methodology The methodology followed to prepare this report was essentially three-pronged:

1. Review of the available literature/ secondary material 2. Survey of corporate entities 3. Interviews with relevant stakeholders

As a primary step in the country study, a review of relevant literature on corporate governance in Bangladesh was conducted. This review examined recent articles, periodicals, books, and reports, both public and non-public. Sources included multilateral development agencies, non-governmental organizations, government publications, and periodicals. The literature reviewed was relevant to at least one aspect of corporate governance. At times, the focus of the literature was not corporate governance, but contained some analysis or information relevant to the topic. The literature review summaries contained in Appendix J provide a short summary of the more important materials reviewed. The literature summaries cover the facts and assertions of the article and include the author(s) recommendations or opinions that relate to corporate governance; sections of an article, for instance, that did not relate to corporate governance were not summarized. Other resources were also used in the report and are cited in the text and in Appendix L. As is evident from the summaries of literature reviewed, to date limited work has been done on corporate governance in Bangladesh. As part of the research for this report, a survey of corporate entities was completed. The survey looked at a sample group of 30 entities (detailed list in Appendix B) – comprised of eighteen public listed


companies, ten private companies, and two SOEs. In order to obtain a representative picture, the sample included a mix of organisations of different performance levels across different sectors – ranging from successful multinationals to non-performing locals, from banks to leasing and insurance companies. The basic tool used for these interviews was a questionnaire. Two qualitative questionnaires (see Appendix D and E) were designed, following the OECD CG guidelines, to probe separately into critical issues for the corporate and financial sectors. The interview for each organisation was conducted with the chief executive, either the Chief Executive Officer (CEO) or Managing Director (MD). Findings have been integrated into main text of the report, where relevant, as well as summarised in Appendix F. Corporate governance, in the true essence of the term, is more relevant for the public listed companies in Bangladesh than their private counterparts. Even though one-third of the corporate organisations interviewed for this study are private companies, the results are neither extraordinary nor unexpected. Private companies in Bangladesh are mostly closely held family businesses where the original source of corporate governance – separation of ownership and management – is absent and the major issues of insider trading, minority shareholders, or inadequate disclosure are not critical problems. For the purposes of this report, the more important area of public listed companies has been the focus. The stakeholders of the CG process who were interviewed for this report comprise a varied group of high-level public and private sector officials (see Appendix C for list). These are the individuals whose ownership of the CG concept is a necessary prerequisite for the later stages of this project to succeed. Discussions with this select group included essentially two components: first, asking questions about the actual practices/policies followed in their respective areas and, second, current and potential reform initiatives. Seminar on Strengthening Corporate Governance in Bangladesh As part of Stage 1 of the project “A Comparative Analysis of Corporate Governance in South Asia: Charting a Roadmap for Bangladesh”, Bangladesh Enterprise Institute (BEI) held a seminar on Strengthening Corporate Governance in Bangladesh on January 7, 2003. Seminar participants, discussants, and speakers came from a variety of stakeholder groups, including company directors, corporate managers, chambers and business organisations, regulatory officials, and government officials. A full report, programme, and list of attendees for the seminar are included in Appendix M. Participants were provided with the Executive Summary of the December 30, 2002 Draft of this Report. Discussants were provided with the full December 30, 2002 Draft. The Honourable Minister of Law, Justice and Parliamentary Affairs, Mr. Moudud Ahmed, MP, served as Chief Guest in the opening session of the seminar. Dr. Fakhruddin Ahmed, the Governor of the Bangladesh Bank also addressed the seminar as Special Guest. Other distinguished discussants addressed the seminar throughout the day. Generally, the report was well-received by all, other than the representative from the Securities and Exchange Commission (SEC), and the audience felt that there was important work to be done to improve corporate governance in Bangladesh. The seminar and discussions were divided into thematic sessions as follows:

The Role of the Directors and Shareholders The Role of Banks and Financial Institutions Auditing and Accounting Standards The Regulatory and Legal Environment

For each session, knowledgeable persons were asked to serve as discussants on the report and its findings. The audience was also given opportunities to comment and ask questions of the discussants.


The Role of the Directors and Shareholders The discussion of directors and shareholders focused on the (1) disclosures regarding the board that could help shareholders evaluate their performance, (2) the existing difficulties regard family-dominated boards and large boards, and (3) independent directors. First, a basic problem with regard to boards is holding and attending board meetings. To provide shareholders with information about the board’s activities, it was recommended that required disclosures should include the dates of board meetings, the attendance records of directors, the director’s individual shareholdings, and changes in director shareholdings. This last suggestion relates directly to a second problem identified by the discussants: boards are usually dominated by a family group or sponsors and shareholders do not want these sponsors to reduce their holdings. This makes it difficult to implement some good CG principles. Another problem identified by discussants was the large size of boards in Bangladesh. It was recommended that boards be limited to ten members. Third, although independent directors were thought to be important there were concerns that an independent director can easily become marginalized on a board dominated by executive directors. Corporate participants generally thought that the number and role of independent directors should be left up to the sponsors and shareholders. Representatives of regulatory agencies and shareholders feel that the inclusion of independent directors should be required through some sort of proportional representation. One example is the proposal being considered by Bangladesh Bank that they appoint a director to represent depositors. Throughout the discussion, the idea of director training was consistently discussed and favourably received by most participants. There was also discussion of the blackmailing activities of certain shareholders or shareholder groups and disruption of Annual General Meetings (AGMs). In a number of sessions throughout the seminar, the lack of board committees was brought up. Few boards have audit committees and almost none have nomination or remuneration committees. The Role of Banks and Financial Institutions Beyond the measures proposed by Bangladesh Bank that would impose and/or encourage stronger Corporate Governance practices in financial institutions, the group discussed a number of other issues related to the financial sector. First, there is legal uncertainty with regard to the proper jurisdiction for financial cases. Banks often face questions of which court to take a case to, the Money Loan Court or Bankruptcy Court. Second, internal Corporate Governance of Bangladesh Bank was discussed. Attendees raised some issues regarding the composition of the Bangladesh Bank Board of Governors, including the inclusion of a medical doctor on the board. Furthermore, it was emphasized that there was a need to have some public transparency and accountability from Bangladesh Bank, particularly with regard to the management of risk by Bangladesh Bank. Earlier in the seminar, Dr. Fakhruddin Ahmed (Governor of Bangladesh Bank) had mentioned that Bangladesh Bank would be complying fully with International Accounting Standards (IAS) and would be audited in compliance with International Standards of Auditing (ISA). Discussants and participants pointed out that certain areas of the financial sector were not discussed in the report, particularly micro-credit and non-banking financial institutions. The report focused on the most important areas of the financial sector with regard to Corporate Governance and rightly did not cover all parts of the financial sector. This point will be clarified in the report. Auditing and Accounting Standards Three main topics were discussed in the session on Auditing and Accounting. First, the seminar discussed the need for audit committees and the difference between auditing and accounting standards.


Second, the process of selection of auditors by companies. Third, the changes needed for consolidated financial reporting for group companies to take place. First, auditors present at the seminar pointed out that all listed companies should have an audit committee to oversee the preparation of accounts internally and to choose an auditor. They stated that adoption of accounting standards is not enough by itself if companies do not spend the money to have properly trained people prepare accounts. Second, companies do not look to hire high quality auditors and often just look at which auditor will complete the audit for the lowest fee. ICAB has made audit fees an issue of its focus. However, other participants pointed out that ICAB, as a self-regulating organisation, should be able to control audit rates if all members agree not to quote rates below a standard. Third, the need for consolidated accounts for group companies was discussed in some detail. Specific suggestions were made regarding changes that would bring about consolidated financial reporting for group companies:

A change to the tax law to provide tax benefits to a group when there is a loss in one subsidiary of which more than 51% is owned by the group. That is, a loss in a subsidiary (a member of the group of companies) could be used to reduce taxes for the group as a whole.

A change to the Companies Law to require consolidation when a company owns 51% of the equity of another company. Currently, consolidation is not required.

Other important comments were provided regarding ICAB and SEC. A former chair of the SEC commented that, in his experience, ICAB punishments are too light and that ICAB should work harder at enforcing quality requirements. In addition, a number of participants commented that there are not a sufficient number of SEC personnel to check company accounts, nor do SEC personnel have sufficient technical knowledge to do so thoroughly. SEC personnel may have MA’s or MBA’s but these are not technical certifications, they are professional certifications. However, the representative from the SEC did not agree to this assertion. The Regulatory and Legal Environment The discussants and participants agreed that one of the biggest problems with regards to the legal and regulatory environment is implementation of the current laws and statues. To improve implementation, there should be some improvement in judicial processes and also education and training. Education is required for businesspeople and barristers regarding the proper use of the Bankruptcy Court. Furthermore, training should be provided for judges on corporate and securities laws. Minority shareholder rights under Section 233 were also discussed. The discussant pointed out that it is difficult and expensive to exercise shareholder rights under Section 233 and it is difficult to prove directors are at fault. Although the opinion was expressed that the 10% shareholding bar should not be lowered for most companies, the discussant pointed out that Section 233 could be adjusted to require a smaller percentage of shares for large companies. Summary of the Seminar In most cases the seminar participants, discussants, and guests supported the findings of the diagnostic study. The role of audit committees and internal corporate procedures in ensuring well-prepared financial accounts was one issue that received more emphasis in the seminar proceedings than the draft report. After the seminar, these issues were incorporated into this final report. In addition, the seminar highlighted the need to focus on particular areas of corporate governance where improvement is likely or forthcoming. Without such focus, the problems of corporate governance may appear too complex and unwieldy to change. Executive Summary


This report is a diagnostic assessment of the corporate governance regulations and practices in Bangladesh. The assessment is measured against international norms and current practices as recognized by the OECD Guidelines on Corporate Governance. The report identifies critical areas where institutions, regulations, or other economic factors in the corporate sector could be strengthened to improve corporate governance (CG). As such, the authors identify strengths and weaknesses of legal requirements, regulations, and corporate practices. To identify the current strengths and weaknesses, the authors drew heavily on a review of laws and a survey of businesses organisations carried out by the research team as well as a series of interviews with key stakeholders. This analysis will serve as a basis on which further study can build. In fact, this report comprises the first stage of a three-stage project; Stage 2 will frame detailed recommendations to strengthen corporate governance in Bangladesh and Stage 3 will formulate implementation strategies. Companies and Corporate Laws To begin to understand the corporate environment in Bangladesh, a review of legal requirements relating to corporate entities is necessary. The analysis compares statutory provisions to actual corporate practices, as revealed by the project’s survey of business organisations and stakeholders. The Companies Act 1994 is the law which governs incorporated domestic entities in Bangladesh. It governs the creation, functioning and dissolution of companies, the relationship of shareholders to a company, periodic disclosure and audit requirements, the functions of the Registrar of Joint Stock Companies, and the jurisdiction of the courts in relation to companies. Other relevant laws include:

• Securities and Exchange Ordinance 1969 • Bangladesh Bank Order 1972 • Bank Companies Act 1991 • Financial Institutions Act 1993 • Securities and Exchange Commission Act 1993 • Bankruptcy Act 1997

The Companies Act 1994 (the Act) defines the rights of both majority and minority shareholders. Shareholders are not intended to, and do not in practice get involved in the day-to-day management of a company. However, the Act provides for certain supervisory functions to be undertaken by the shareholders in the form of these rights to attend meetings, appoint and remove directors and to obtain financial information as well as approve the balance sheet annually. The law also provides for various mechanisms for shareholders to enforce these rights, the principal among them being a suit for minority protection under Section 233 of the Act. The Act has some inbuilt protection for shareholders in requiring companies to file periodic returns with the RJSC, failing which the directors and management of the defaulting company are liable to various penalties such as fines, and in some cases, imprisonment. The right to dividends is perhaps the right that most concerns shareholders, and has recently been in public focus. In accordance with the law, dividends are declared by the shareholders in a general meeting but may not exceed the amount recommended by the directors. However, in recent years the annual general meetings of several high-profile companies have been disrupted with shareholders demanding larger dividends than that recommended by the board of directors. The meetings have been held up until the directors have met and resolved to recommend a higher dividend, which is then approved and declared by the shareholders. This practice is not strictly legal. The SEC has had occasion to take action against companies in whose meetings these events have taken place. The Act has specific provisions targeted at protecting the interests of minority shareholders. Minority shareholders holding at least 10% of the shares may seek remedies in Court if they feel the affairs of the company are being conducted in a manner prejudicial to one or more of its members, or the company is


acting in a manner discriminatory towards any member or debenture holder. If the Court is of the opinion that the interest of the applicant(s) are being prejudicially effected it may pass any order it deems fit including cancelling or modifying any resolution or transaction, regulating the affairs of the company in future as specified in the order or amending any provision of the memorandum or articles of the company. Minority protection actions are filed in court in Bangladesh with some regularity, although a large number of these are later found to be vexatious or not in fact relating to issues covered under the rubric of minority protection. While Section 233 of the Companies Act and other provisions offer adequate protection for minority shareholders, many shareholders are not aware of Section 233 and the minority protection regime. The primary avenue for companies to communicate with their shareholders is the annual general meeting (AGM). A company must hold at least one general meeting of its shareholders, normally called the AGM, in every calendar year. If an AGM is not duly called then the RJSC or the Court may authorize the holding of the meeting out of time. In some circumstances, a number of shareholders specified in the Articles of Association, or holders of not less than 10% of the shares of a company can require an extraordinary general meeting to be called and held. In an AGM, the agenda must include the following items, and may include other items as necessary:

• Approval of the annual report and audited accounts of the company • Appointment of auditors • Resignation by rotation and appointment of directors (as required).

The perception of AGMs amongst the non-banking listed companies surveyed seems to be a combination of a necessary evil and a statutory requirement. Only 38% of the non-banking listed companies see it as an effective forum for shareholders. Generally, shareholder demands concentrate either on higher dividends or trivial demands like better quality food and gifts at the AGM, and transportation allowances. In the survey, banks claim to have more positive experiences at their AGMs. While one bank referred to the usual problem of “managed AGM” pressures, three mentioned that this problem is not as acute as in the corporate sector. One function of the AGM is to elect the companies’ board of directors. The members of a company elect the directors of a company from among their number in the general meeting. There are no further requirements of law regarding the composition of the board of directors, although the Securities and Exchange Commission (SEC) has recently been imposing a condition on public issues of shares that directors be elected in proportion to shareholdings of institutional investors. In an overwhelming majority (i.e. 73%) of the non-bank listed companies surveyed, the board is heavily dominated by sponsor shareholders, usually belonging to a single family. The boards are usually actively involved in management - in 50% of the companies, there is more than one executive director on the board. One issue in establishing good corporate governance is the inclusion of independent directors on the board of directors. In the context of Bangladesh, directors who would fit the definition of independent in Bangladesh are often current or former government officials or bureaucrats. They are appointed to help the company get licenses or as payback for previous favours. When boards need an independent opinion they rely on employing outside consultants or advisors. Therefore, in the context of Bangladesh, independent directors do not usually serve as an advocate for minority shareholders or as a source of new and different ideas. Once elected to a board, the Act imposes certain responsibilities and rights upon directors. Directors who are interested in any contract or arrangement entered into by or on behalf of the company are required to disclose their interest and, in some cases, to desist from voting on any such decision. However, the penalty for contravention is a fine not exceeding Tk.5,000, a fine which cannot be considered to be a sufficient deterrent to such actions.


The Board of Directors of the company are obliged to submit to shareholders a balance sheet together with the profit and loss account at every AGM. The company’s auditor must audit the financial statements and the auditor’s report must be attached. The Board’s report must also be included and it should provide information regarding the company’s affairs, the amount the Board proposes to reserve in the balance sheet, the amount recommended to be paid out as dividend and any material change and commitments which may change the financial position of the company. The information that is required to be disclosed by a company to its shareholders and to members of the public in accordance with the law is practically the only tool shareholders and investors have to judge the performance of a company and monitor the activities of the directors and management. These provisions are of cardinal importance, and should be subject to strict enforcement. Due to various reasons, including lack of knowledge on the part of the persons responsible to maintain the records, shareholder apathy, lack of proper monitoring by the RJSC, lack of quality auditing services, often the disclosures are not accurate or complete. A company’s auditors, as per the Companies Act, must be Chartered Accountants and are appointed in the AGM. The auditors should have access to all books and papers whether kept at the registered office or elsewhere. The scope of inquiry of the auditors has been elaborately spelt out in the Companies Act as well as the nature of the certification the auditors must provide. An auditor must specifically state whether, in his opinion and to the best of his information and according to the explanation given to him, the said accounts provide a true and fair view of the company’s affairs. A common point of concern among stakeholders was that audit reports, except for those of multinational companies and very reputable local companies, do not reflect a true and fair view of the state of the company’s financial affairs. Barring a few firms with international ties, audit firms do not fully know, understand or apply the Bangladesh Standards on Auditing. It was a widely held view among stakeholders that rigorous auditing practices would improve corporate governance in large measure almost immediately. Financial Sector Financing for commercial purposes in Bangladesh is largely obtained by borrowing, mainly from banks and financial institutions, rather than through equity or capital market products. The capital market is not a preferred source of funds for corporations and, in any case, does not have the depth or breath necessary to serve as an enforcer of corporate governance standards. The debt market is non-existent and insurance market is not a major force in the financial sector. Therefore, the primary stakeholders in corporate governance are creditors, particularly lenders. The banking sector can serve as a motivation for better corporate governance through its requirements and procedures for approving and monitoring loans. Unfortunately, these procedures to date have not provided sufficient oversight of credit assessment and asset management. This can be seen most clearly in the statistics on classified loans; classified loans as a percentage of total loans outstanding for NCBs, PBs and foreign banks at the end of 2001 were 45%, 26%, and 4% respectively. Even these figures may not reflect the true nature of the problem; apart from lax requirements to report on loan classification, banks are reluctant to write-off bad debts under the misconception that they would lose rights to legally pursue borrowers for recovery. Beginning in the calendar year 2001, banks were required to comply with the International Accounting Standard-30 (IAS-30). The accounting standard requires banks to disclose the classification of their loan portfolio (as sub-standard, doubtful, or bad) based on their default activity and make a loan loss provision specifically for classified loans, as well as make a general provision for loans that are unclassified. Full and accurate compliance with the disclosure requirements of IAS-30 will begin to provide more information to bank stakeholders and hopefully create a consensus for reform.


Bangladesh Bank (BB) is the central bank of Bangladesh and the primary regulator of banks and non-banking financial institutions. BB has taken a number of recent steps to improve the health of the banking sector, but the central bank still suffers from a lack of personnel possessing adequate formal training and education in banking and central bank functions. Recently, the Governor has been a professional from the private sector and, for the first time, an outsider and a former CEO of a foreign bank has been appointed as a Deputy Governor. These steps are measures to inject experienced professionals into Bangladesh Bank and gradually instil appropriate managerial skills in running what is essentially a bank. Although BB has introduced a Lending Risk Analysis (LRA) procedure for loans above a certain amount, smaller loans do not require mandatory credit assessment before sanction or disbursement of credit facilities, which is a recognised factor contributing to difficulties in recovery of defaulted loans. To facilitate informed credit decisions by banks, a separate department was established at BB, the Credit Information Bureau (CIB), which centralises information on borrowers and their existing credit. The effectiveness of CIB reports is hampered by delays in updating information and disclosure only to requesting banks. Survey results also reveal that cash incentives are often required to obtain CIB reports in the normal course of business. Weaknesses in the CIB system often lead to delayed loan approval. Bangladesh Bank has recently displayed increased activism in the administration of banks by exercise of its statutory powers of removal of chairman, directors or chief executive officers of banks, which have survived judicial review. The bank has also been steadily issuing circulars outlining the duties and responsibilities of directors of banks. To facilitate more effective regulation, a suggestion has been made for statutory recognition of directors' duties for all companies, with emphasis on their individual and collective accountability. Although there are dedicated courts for debt recovery by banks and financial institutions, Money Loan Courts, as well as Bankruptcy Courts, the implementation of creditor’s rights in Bangladesh remains weak. Money Loan Courts suffer from a shortage of judicial officers and delays in executing decisions. The Bankruptcy Act 1997, established a further set of dedicated courts, Bankruptcy Courts, but these courts are not a favoured option for banks. It is a common strategy for banks to prefer that borrowers continue to remain commercially viable to generate funds for repayment rather than cripple or extinguish their opportunities for further business by adjudication of bankruptcy. The stigma attached to being declared “bankrupt” is misunderstood, and has been the primary cause of resistance to an effective structuring and enforcement of the 1997 Act. Since the Money Loan and Bankruptcy Courts do not provide effective means of protecting their exposure, banks often insist on blanket personal guarantees from company directors before giving out loans. This requirement completely violates the principle of limited liability and, in essence, acts as a barrier to enterprise development as well as a disincentive to board membership. In Bangladesh, the fundamental spokes of an efficient capital market wheel are not in place. The average non-controlling shareholder in this country is an individual who does not possess sufficient level of education, understanding and sophistication required to exert pressure on a company to change behaviour. Institutional investors like mutual funds and pension funds are too small or disinterested to adopt a strong activist position. As a result, a share price does not necessarily incorporate a penalty for poor corporate practices; since market prices fail to have any kind of disciplining impact on management, companies have no incentive to be transparent. Due to weaknesses in the stock market, companies see few benefits in becoming a public company and listing on the stock exchange. Capital can be more easily raised through bank financing since companies with good reputations face few problems in obtaining adequate capital from banks. Companies that


cannot obtain adequate bank financing may go to the equity markets, which means, in effect, that listed companies are often the weaker companies. Our survey revealed that equity requirements had been the prime motivator for only 10% of the public companies interviewed - the remaining companies had cited reasons like tax advantages and legal compulsion for going public. At present, the capital market includes no bond, fixed-income, or other debt instruments. Government savings schemes provide a fixed income investment vehicle, but the instruments are not traded. The high level of interest paid on government savings schemes discourages corporate debt offerings. In spite of the obstacles, a few organisations are attempting debt offerings. If the debt markets can develop, investors in corporate bonds and other debt instruments could become an important pressure group for encouraging and enforcing corporate governance principles. Accounting Standards and Disclosures Accounting practices in Bangladesh suffer from two major weaknesses. First, accounting standards are not in compliance with international standards in a number of material aspects. Second, corporate compliance with Bangladesh Accounting Standards (BAS) is inconsistent. First, accounting standards are not in compliance with international standards in a number of material aspects. The Institute of Chartered Accountants of Bangladesh (ICAB) has adopted 22 of the 41 International Accounting Standards (IAS) as BAS. However, in many cases the IAS has been adopted in its original form and subsequent amendments have not been adopted. As a result, IAS and BAS differ in a number of material aspects. Accounting standards in Bangladesh allow for considerable discretion by the company and do not require disclosure of all the financial and non-financial details necessary for a full assessment of a company’s operations, financial situation, and prospects. Standards regarding accounting for investments in subsidiaries/ associates and the lack of consolidated accounts are particular shortcomings. Second, a review of available literature and annual reports suggests that compliance with disclosure requirements under the relevant laws and BAS is inconsistent. Also, the consequences for non-compliance are virtually non-existent and weak auditing and regulation allows this situation to continue unabated. Even companies that do comply with the statutory requirements often do not provide other relevant and material information. Even though the elements necessary to move to full international harmonisation of accounting standards are present in Bangladesh, there are few indicators that this will happen in the near future. Voluntary compliance with IAS (or more stringent standards) is more likely to occur before mandatory standards are strengthened. Voluntary IAS compliance will likely happen either through a demonstration effect or if banks or other investors demand it. If companies which voluntarily comply with more demanding accounting standards are seen to gain an advantage in the markets or in lending rates, others may follow their lead. Independent Regulators The primary independent regulators relevant to CG in Bangladesh include government and non-government entities. Government regulators include the RJSC, the SEC, and Bangladesh Bank. Non-government regulators include ICAB, CSE, and DSE. Government regulators particularly do not provide efficient services or easily enable companies to fulfil their regulatory or statutory requirements. As is the case with many government agencies, government regulatory agencies do not have a sufficient number of qualified, experienced personnel to oversee companies’ actions. Regulators also have expanded their scope of authority and actions, either through regulation or practice, which companies feel has led to misuse of their powers and to unfair harassment. Observers also point out that regulators pass arbitrary rules and rulings and that there are few avenues for appeal. For instance, dealings of the RJSC often


overreach the statutory functions of the Office, though its staff openly admit that they are not trained on company law and the role of the RJSC. The SEC’s interventions have forced listed companies to be much more regular in holding annual general meetings, declaring dividends, and disseminating price sensitive information. However, this has involved the SEC expanding its purview by impinging on business decisions, for example SEC regulations for A, B, and Z category companies require the payment of dividends, which is a key business decision regarding the distribution of profits. For instance, the SEC categorizes companies on the basis of their regularity in holding AGMs and the regularity and rate of dividends; such classification results in particular treatment by the regulator. Further, directions issued by the SEC recently have appeared to be targeted at specific companies, or in instant reaction to emerging situations, without bearing in mind the overall impact of the provisions. The ICAB is a non-governmental regulatory agency which certifies and oversees accountants and auditors. ICAB must ensure that accountants and auditors prepare and audit financial statements that provide full and true disclosure of a company’s financial position and operations. The ability of ICAB to carry out these functions has been seriously called into question. The auditing function in particular would seem to represent a vicious circle. Auditors are not perceived to be independent and do not provide quality audits. Therefore companies and shareholders are not willing to pay high fees for an audit. The low fee structure, in turn, does not provide an incentive for auditors to provide quality personnel and audits. The Judiciary As a support mechanism to enforce or impose regulations or rulings that support corporate governance, the judiciary suffers from a large backlog of cases and a lack of specialist knowledge of financial laws and corporate concerns. There is a Company Bench at the Supreme Court, which serves as the company court and attends to cases under the Companies Act. There is also a Money Loan Court to hear cases of loan default. Proposals continue to be made for a separate bench at the High Court Division level to dispose of financial cases and their appeals. General opinion is against the transfer and vesting of such jurisdiction to a statutory body, which may compound the bureaucratic issues with existing government authorities and bodies involving officers with inadequate knowledge on administering financial matters. State-owned Enterprises In Bangladesh, state-owned enterprises (SOEs) do not see themselves as corporate enterprises and therefore see no need for corporate governance norms. The state-owned sector is characterized by negative net worth, high leverage, negative profit margins, and technical insolvency. Although considered autonomous units, SOEs report to their respective sector ministries. Therefore, operations in SOEs are primarily politically motivated and lack a commercial focus. Modern business management and corporate governance structures have not been implemented, which makes most SOEs unable to compete in a liberalized market. The inability to restructure SOEs and improve their management practices makes the process of privatisation difficult. The primary shareholder in SOEs, the government, is not an active or effective monitor on the results and operations of SOEs. The primary agency for oversight of SOEs is the Office of the Comptroller and Auditor General (CAG), which reports to the Public Accounts Committee (PAC) of Parliament. Neither the CAG nor the PAC effectively completes their tasks due to lack of accountability and mismanagement. As a result, action is rarely taken against irregularities in the state-owned sector and wrongdoers are not penalized. Therefore, SOEs are subject to little or no financial or managerial oversight from their majority shareholder. Without privatisation or a shift to a commercial focus, appreciation of corporate governance is not likely to develop in the SOE sector.


Existence and Role of Pressure Points External pressures that often demand information and more transparent corporate governance practices are lacking in Bangladesh. First, there are few financial media outlets or knowledgeable financial journalists. Apart from a few enterprising journalists, the financial press consists mainly of press releases from companies. Second, shareholders do not join together in shareholder associations to demand better company performance or to assert their shareholder rights. Third, in Bangladesh there are only a few institutional investors, most of which are state-owned enterprises (SOEs). The few private investors do not have enough clout to force large scale changes in the corporate sector. Fourth, most companies are not candidates for significant foreign investment, so there is no push from the international economic community for better corporate governance. Conclusion The report is a diagnostic tool from which a consensus can emerge regarding the way forward for corporate governance in Bangladesh. At this stage, only very broad recommendations are provided, identifying institutions or sectors that should be studied further. Specific recommendations will be framed in subsequent stages of this project. Further work should concentrate on the following areas to develop specific recommendations for reform:

• Registrar of Joint Stock Companies • Security and Exchange Commission and the capital market environment • Institute of Chartered Accountants of Bangladesh and the auditing profession • Adoption of International Accounting Standards • Examining the requirements for and qualifications of directors, including independent directors • Shareholder education and awareness of corporate governance • Strengthening banking practices and encouraging the inclusion of corporate governance issues in

credit analysis Each corporate governance stakeholder plays an important part to creating an environment where transparency and accountability are encouraged, enforced, and rewarded. For Bangladesh, the first step in strengthening the role of stakeholders in corporate governance is raising their awareness regarding these issues. This report attempts to start that process. For companies to have sufficient motivation to disclose information and improve governance practices, the relevant stakeholders must place a value on that information and there must be consequences for corporate governance practices. In many cases, the current system in Bangladesh does not provide sufficient legal, institutional, or economic motivations for stakeholders to encourage and enforce good corporate governance practices. As a result, there are few rewards for companies that institute good corporate governance practices and no penalties for failing to do so. Targeted reforms in institutions or sectors can begin to provide the internal and external motivation for transparency and accountability that will lead to better corporate governance. Companies, corporate laws and practice Insofar as corporate governance is a function of regulation of corporate bodies through legislation or self-regulatory mechanisms such as those of stock exchanges, a brief outline of the legal framework surrounding corporate entities may be helpful in setting the scene for the more detailed discussion of corporate governance in Bangladesh. The principal laws which are relevant are:

• Companies Act 1994 • Bangladesh Bank Order 1972


• Bank Companies Act 1991 • Financial Institutions Act 1993 • Securities and Exchange Ordinance 1969 • Securities and Exchange Commission Act 1993 • Bankruptcy Act 1997

Companies Act 1994: This is the law under which all domestic companies in Bangladesh are incorporated, and is the main statue governing companies, their relationship to shareholders, periodic disclosure and audit requirements, the functions of the Registrar of Joint Stock Companies, and the jurisdiction of the courts in relation to companies. Bangladesh Bank Order 1972, Bank Companies Act 1991, and the Financial Institutions Act 1993: The Bangladesh Bank Order 1972 set up the central bank (Bangladesh Bank), which regulates the banking activities of bank companies which operate under the Bank Companies Act 1991. The provisions of the Bank Companies Act 1991 are in addition to the provisions of the Companies Act 1994. Similarly, non-banking financial institutions are governed by Bangladesh Bank (BB) in terms of the provisions of the Financial Institutions Act 1993. The latter two legislations delimit the scope of activities of bank companies and non-banking financial institutions, respectively. They provide for the regulatory steps which may be taken by Bangladesh Bank, including powers to license and give directions to such companies in the public interest, in the interest of monetary and/or banking policy, in order to prevent the affairs of such companies being conducted in a manner detrimental to the interest of the companies or depositors, and to ensure their proper management. Securities and Exchange Ordinance 1969 and the Securities and Exchange Commission Act 1993: These two laws form the basis of the issuance of securities and capital market regulation in Bangladesh. The latter sets up the Securities and Exchange Commission (SEC) with broad licensing and regulatory powers over capital market stakeholders and intermediaries such as stock exchanges, brokers and dealers, merchant banks and portfolio managers, while the issue of securities is regulated by the provisions of the former. The Securities and Exchange Ordinance provides the power to the SEC to make the issuance of securities subject to any condition as it may think fit to impose, notwithstanding anything contained in the Companies Act, 1994 or any other law in force, which is a very wide-ranging power. Much of the powers of the SEC under these laws are aimed at proper disclosure to investors, which is at the heart of good corporate governance. Bankruptcy Act 1997: This law replaces the out-dated Bankruptcy Act 1920. Insofar as companies are concerned, it makes provisions additional to the winding up provisions of the Companies Act, where the winding up is as a result of the insolvency of the company rather than for any other reason. In addition to these laws, there are provisions in many other laws such as the Income Tax Ordinance, 1984 which contain provisions for disclosure, audit and penalties for contravention of fiscal and revenue matters, which relate to corporate governance. Numerous subordinate legislative instruments such as orders, rules, regulations and circulars are issued by the Government, Bangladesh Bank, SEC, National Board of Revenue and other agencies of the Government, stock exchanges, chambers of commerce and industry and other self-regulatory agencies in the private sector also form a part of the legal and regulatory framework for corporate governance. Legal Requirements and Practice The basic legislation governing companies is the Companies Act, 1994. Joint-stock companies in Bangladesh were originally governed by the provisions of the Companies Act 1913. On January 1, 1995


the new Companies Act, 1994 came into effect. This long awaited piece of legislation was not an entirely new piece of legislation. The Act of 1913 was subjected to major amendments in India in 1956, apart from minor amendments from time to time, and in Pakistan in 1984 the Company Law Ordinance was enacted. These laws were enacted to take into account the new business and corporate environments. Similar needs were felt in Bangladesh, and the Company Law Reforms Committee was formed in 1977. After a detailed study of the subject, the Committee handed in its Report in 1981. The 1994 Act embodies many of the recommendations of the Committee. The recommendations were incorporated in the Act of 1994 (referred to as the “Act”) to provide more accountability and openness in the management of companies, leading to greater confidence in the corporate culture. Formation of a Company As in most other common law jurisdictions, the Act provides for the formation of companies with unlimited and limited liability of shareholders. Non-profit companies may also be formed under the Act. For incorporation a company must have a minimum of two members, with different lower and upper limits for different types of companies. The prescribed number of persons may form an incorporated company by subscribing their names to a memorandum of association and otherwise complying with the requirements of this Act in respect of registration. No company can be registered with a name similar to that of a company already in existence. The Government has been given the power to prohibit registration of undesirable names. Once a certificate of incorporation is given by the Registrar of Joint Stock Companies and Firms (RJSC) it is conclusive evidence that all the requirements of the Act have been complied with and that the association is a company authorized to be registered and duly registered under this Act. Shareholders It is interesting to note that while the term “member” is defined in the Act as a subscriber to the memorandum of a company and every other person who agrees to become a member and whose name is entered in the company’s register of members, the term shareholder is not defined. It is accepted that a person who holds shares of a company in his/its name is a shareholder of the company. On his name being entered on the register of members, a shareholder acquires some specific rights on the company of which he becomes a member. Shareholders are not intended to, and do not in practice get involved in the day-to-day management of a company. However, the Act provides for certain supervisory functions to be undertaken by the shareholders in the form of these rights to attend meetings, appoint and remove directors and auditors and to obtain financial information as well as approve the balance sheet annually. The law also provides for various mechanisms for shareholders to enforce these rights, the principal among them being a suit for minority protection under Section 233 of the Act. The Act has some inbuilt protection for shareholders in requiring companies to file periodic returns with the RJSC, failing which the directors and management of the defaulting company are liable to various penalties such as fines, and in some cases, imprisonment. The members of a company elect the directors of a company from among their number in the general meeting. However, this basic proposition of the Act has been eroded by the provisions of the Bank Companies Act, 1993, the Securities and Exchange Commission Ordinance 1969 and rules and orders issued thereunder.6 One case in example is that since October 1999 the SEC has been imposing a condition on each and every consent on prospectus for public issue of shares as follows:

6 See sections on Independent Regulators and the Financial Sector.


Directors from ‘sponsor group’ shall be proportionate to their actual shareholding in the paid-up capital of the company. The directors shall be elected from amongst the institutional investors proportionate to their holding of shares. If holding is more than 5% but less than 10% it will have at least one director in the Board. Representative of the general investors who do not fall under above categories shall elect their director in the Annual General Meeting proportionate to their shareholdings.

However, no official notification to the above effect has been issued by the SEC and the condition is imposed under powers assumed through insertion of section 2CC in the Securities and Exchange Commission Ordinance 1969. This requirement would appear to be in violation of the right of members to elect directors as they see fit. The Act provides for the removal of a shareholder-director by shareholders by extraordinary resolution before the expiry of his period of office. The shareholders appoint the auditor(s) at each annual general meeting of the company. Shareholders may remove an auditor before the expiry of his term only by a special resolution taken in a general meeting. The shareholders are given the power, acting in general meeting, to alter the memorandum of the company; to increase, decrease, consolidate or divide all or any of its shares, to convert paid-up shares into stock and reconvert stock into paid-up shares, as well as subdivide shares. The shareholders may also cancel shares which have not been taken or agreed to be taken by any person. Different classes of shares may be provided for in the articles of association of the company. Companies may issue shares with special rights attached to them. Investors in public limited companies are able to find out about the voting rights attached to it through the prospectus, which is published before the initial public offering (IPO). Such rights may only be varied upon an affirmative vote by the holders of that particular class of shares; the variation is subject to challenge in court by holders who do not agree to it. The right to dividends is perhaps the right which most concerns shareholders, and recently has been in public focus for many reasons. In accordance with the law, dividends are declared by the shareholders in the general meeting but may not exceed the amount recommended by the directors. No dividend shall be paid otherwise than out of profits of the year or any other undistributed profits. The declared dividend must be paid within two months of such declaration. However, in recent years the annual general meetings of several high-profile companies have been disrupted by shareholders demanding larger dividends than that recommended by the board of directors. The meetings have been held up until the directors have met and resolved to recommend a higher dividend, which is then approved and declared by the shareholders. This practice is not strictly legal. The SEC has had occasion to take action against companies in whose meetings these events have taken place.7 On the other hand, the SEC has also forced directors to commit to personally pay dividends to shareholders when profit has failed to reach a certain level.8 This would appear to be in violation of the requirement that dividends only be paid out of profits and would seem to exhibit a fundamental misunderstanding of the concept of equity ownership. In either case, the SEC is interfering in an arena that should be within the decision of company managers, not a regulator. General Meetings General meetings of a company are the fora where shareholders can raise their concerns and make their influence felt over the management of a company. A company must hold at least one general meeting of 7 The 2001 AGM of BEXIMCO Pharmaceuticals Ltd. is one example. 8 Prospectus of Meghna Condensed Milk Industries Limited. June 28, 2001, page 6 and the Daily Janakantha.


its shareholders, normally called the annual general meeting (AGM), in every calendar year. If an AGM is not duly called, then the RJSC or the Court may authorize the holding of the meeting out of time. In some circumstances, holders of at least 10% of the shares of a company can require an extraordinary general meeting to be called and held. For a general meeting (AGM or EGM) to be valid all members of the company must be served with the notice of the meeting. The location of the meeting is decided by the directors, but should normally be at the registered office of the company, so that all the books and records are at hand. In Bangladesh, space constraints mean that general meetings are often held other than in the registered office of the company. The quorum requisite is generally provided in the articles. There are usually no veto provisions regarding company meetings. Unless otherwise specified in the Act or the articles, decisions are by a simple majority. In an AGM, the agenda must include the following items, and may include other items as necessary:

• Approval of the annual report and audited accounts of the company • Appointment of auditors • Resignation by rotation and appointment of directors (as required)

Special majorities of three-fourths of the shareholders present and voting are required for passing special and extraordinary resolutions. These special majorities give a measure of protection to shareholders, particularly in widely held companies, in that there is a lower possibility of decisions being forced through by brute majority. A special resolution is required for the following reasons, among others:

• To change provisions of the objects clause of the memorandum of the company • To alter or add to the articles of association of the company • To reduce share capital • To reserve capital • To remove a director from office • To remove an auditor before the expiry of his term • On winding up through the Court

An extraordinary resolution is required for the following reasons, among others:

• For a voluntary winding up because of excess liability • To sanction all arrangements between a company and a creditor

Votes are counted by a show of hands by the Chairman of a general meeting. Shareholders present may demand a poll on any question other than election of the Chairman of the meeting or the adjournment thereof. If a poll is demanded the number of votes is counted on the basis of the voting shares held by each person present and voting on the issue. This allows a single person holding a large number of shares (or proxy) to have adequate weight in the decision-making process in proportion to his investment in the company. All the companies interviewed for the survey held AGMs regularly in the last three years and nearly all public listed companies claimed that they allow non-members to be proxies at AGMs. This flexible proxy policy more easily allows shareholders to exercise their voting rights. Although all these provisions of the Act are intended to allow shareholders a voice in companies, most companies in Bangladesh, whether private or public limited, and in fact many listed companies, are closely held. Small groups of shareholders own or control the majority of shares, and by using that


majority, control the decision-making processes of the companies. This is no different from company law regimes in most other countries. It has been seen recently that the SEC is keen to ensure the rights of minority investors, but sometimes disproportionately at the cost of the majority shareholders in listed companies. The perception of AGMs amongst the non-banking listed companies surveyed seems to be a combination of a necessary evil and a statutory requirement. A moderate number, i.e. 38%, see it as an effective forum for shareholders. Generally, shareholder demands concentrate either on higher dividends or trivial concerns like better quality food and gifts at the AGM and transportation allowances. In reaction, the SEC has recently made any distribution other than dividend at AGMs, including food and gifts, illegal. This, however, landed one company in trouble as their distribution of shares in specie was initially refused consent from SEC and delayed, purportedly since it went against the rules. The main incentive for attendance is the meal served at an attractive hotel and, surprisingly, trading activity increases prior to AGMs to reflect that interest. There are, in reality, a very limited number of people going to AGMs who actually understand the financial statements being presented and, consequently, have little to contribute in terms of relevant inputs. In fact, other than one company (which received concrete recommendations regarding accounts preparation) and one bank (which received insightful questions on branch locations and staff benefits), none of the CEOs could recall receiving relevant feedback from their shareholders. There is widespread justifiable suspicion that the directors or controlling shareholders of, usually, under-performing listed companies, employ hand-picked friendly shareholders, who are often stock exchange members holding nominal shares in the companies, to intervene in the proceedings in order to “manage” favourable comments and passage of resolutions. Another method of interference is by groups of musclemen who routinely try to force companies to grant them contracts for advertisements and services and offer to arrange peaceful AGMs in return. If the companies do not comply, these people infiltrate AGMs, often by purchasing one share, and disrupt the proceedings. There are some common faces sighted in almost every AGM that are quite vocal in either fomenting or suppressing dissent, as the case may be. The SEC has now banned any distribution of food or gift item at the AGMs and made video recording of the proceedings mandatory, but the effectiveness of these steps remains to be seen. The banks interviewed claim to have more positive experiences at their AGMs. While one bank referred to the usual problem of “managed AGM” pressures, the other three mentioned that this problem is not as acute as in the corporate sector. Directors The directors of a company are entrusted by law with the management of the business of the company. The principle of separation of ownership and management underlies this provision. However, since companies are usually closely held in Bangladesh, most of the directors are also substantial shareholders. This can and often does result in holders of less than 10% of the shares being left out in the cold, and discourages small investors from investing in shares. The members of a company elect the directors of a company from among their number in the general meeting. There are no further rules about the election of directors in the Act. However, recent SEC rules have required that institutional shareholders having at least 5% of shares hold a seat on the board. This provision may have the same effect as a cumulative voting rule. Every public company and a private company which is a subsidiary of a public company must have three directors. The law provides for directors to hold qualification shares, and for disqualification of persons from being directors. The Act makes it void for the articles of the company or any contract with the company to make any provision indemnifying any director, manager or officer against any liability which by virtue of any rule of law would otherwise attach to him in respect of any negligence, default, breach of duty or trust.


Moreover, the Act provides for restrictions regarding the making of any loans, guarantee or security by a company in connection with a loan made to a third party where any director of the company is also a director or managing agent of the third party. Exceptions are made, among others, in the case of a banking company or a private company not being a subsidiary of a public company, or a holding company in relation to its subsidiary, and if the loan is sanctioned by the board of directors of the lending/guarantor company and approved by the general meeting and in the balance sheet there is a specific mention of the loan. However, in no case shall the loan exceed 50% of the paid up value of the shares held by such director in his own name. A fine and imprisonment are prescribed as penalties for contravention of these provisions, and a loss of directorship may also result. But, experience would appear to show that these are more honoured in the breach than observance. Directors who are interested in any contract or arrangement entered into by or on behalf of the company are required to disclose their interest and, in some cases, to desist from voting on any such decision; their presence would not be counted towards a quorum for that purpose. However, the penalty for contravention is a fine not exceeding Tk. 5,000. It is not clear whether such contracts would be treated as void or not. Companies are required to keep a register in which particulars of all such contracts or arrangements shall be entered and which shall be open to inspection by any member of the company at the registered office of the company during business hours. Again, contravention results in a fine not exceeding Tk. 1,000. These fines cannot be considered to be a sufficient deterrent to such conflicts of interest. The term managing director has been defined in this Act as a person entrusted with the main powers of management of a company under a contract with the company, or any decision of the general meeting or Board of the company or by the provisions of its Memorandum or Articles, which powers he would otherwise have been unable to exercise. The appointment of managing directors is regulated for the first time in the Act. In the case of public companies, a person cannot be appointed as a managing director if he is the managing director of another company. Even then such appointment requires the consent of the company in general meeting. The government, however, is empowered to relax this prohibition if it is satisfied that the companies should for their proper working be operated as a single unit and have a common managing director. The term of office of a managing director cannot exceed five years at a time. The company in a general meeting may extend the term not exceeding a further five years. Stringent provisions have been introduced prohibiting compensation to directors for loss of office, so as to prevent collusive arrangements between companies and individuals resulting in unjust enrichment of the latter. In an overwhelming majority (i.e. 73%) of the non-bank listed companies interviewed in the survey, the board is heavily dominated by sponsor shareholders who generally belong to a single family – the father as the Chairman and the son as the MD is the norm. The boards are usually actively involved in management - in 50% of the companies, there is more than one executive director on the board. Only one of the MDs interviewed is not a voting board member. One noteworthy trend seen in the survey was that even in companies where the MD is a sponsor shareholder, he is well educated with good qualifications. What this reflects is an increased level of sophistication, awareness, and knowledge of sound business practices in the second generation of business leaders. Most of the day-to-day operational functions are delegated by the board to management – the only powers retained by the board are extraordinary decisions of write-offs, dividends, auditor selection, new business/investment activities, etc. A majority of the companies interviewed have neither alternate directors nor provisions for them. The board is mandated by law to hold at least one meeting every quarter, but no legal sanctions are provided for failure to hold meetings. Companies interviewed in our survey all claimed to hold board meetings quarterly.


Suggestions from survey participants as to how board performance can be improved ranged from increasing the frequency of board meetings to holding training sessions, to imposing punitive penalties for violation of laws to implementation of a well-defined selection process for board members. In cases where the government or financial institutions send nominee directors, this is even more important. Opinion was mixed on the necessity of directorship ceilings. Those favouring a ceiling recommended a number in the range of five to ten. People who advocated against a ceiling cited reasons like “companies should themselves judge whether they want a person on the board” and “boards of subsidiary companies are often symbolic so there shouldn’t be any limits.” Independent Directors

In developed countries, scholars often think of good corporate governance as revolving around such matters as subtle variations in the independence of directors, or the constraints on the corporate control market. In developing countries, corporate governance can be much more basic. We need honest judges and regulators before it make sense to start worrying too much about independent directors.9

This comment perfectly summarizes the general corporate scenario in Bangladesh. In fact, there have been several examples (including SABINCO mentioned later in this report) where independent/non-executive directors themselves engaged actively in underhand dealings and insider trading for personal gains. Of course, debate rages on what constitutes an ‘independent’ director, and why any person who did not stand to benefit from the performance of the company (a person who stands so to benefit would in all probability no longer remain truly independent) would accept the onerous responsibilities placed upon a director by the company law. In the context of Bangladesh, directors who would fit the definition of ‘independent’ in Bangladesh are often current or former government officials or bureaucrats. They are appointed to help the company get licenses or as payback for previous favours. Very few independent directors are appointed for their expertise and the priority in appointing directors is usually their personal connections to company management or having connections that can be used for the company in the future. When boards need an independent opinion they rely on employing outside consultants or advisors. Therefore, in the context of Bangladesh, independent directors do not serve as an advocate for minority shareholders or as a source of new and different ideas. The Act also does not provide for or recognize ‘independent’ directors, since a minimum number of shares is required to be held by any director other than the MD. Participants in BEI’s seminar on Strengthening Corporate Governance also expressed concern about defining an independent director and stated that there should be guidelines for inclusion of independent directors on the boards of listed companies. Furthermore, as mentioned later in the Banking Sector section of this report, it is common for banks to require personal guarantees of directors. Persons serving as independent directors should be recognized professionals but they should not be required to provide personal guarantees for loans. Seminar participants also thought that independent directors should be indemnified from any civil or criminal proceedings arising out of their role as an independent director.

Chittagong Cement Clinker Company

In October 2002, the Securities and Exchange Commission (SEC) served a show cause notice on 9 Black, Bernard “The Legal and Institutional Preconditions for Strong Stock Markets: The Nontriviality of Securities Law”, Corporate Governance in Asia, OECD, 2001.


Chittagong Cement Clinker & Grinding Company Limited on charges of violating securities law in appointing an auditor for a publicly traded company who had been engaged in other affairs of the company. Hoda Vasi Chowdhury, the auditor, had previously acted as the valuation consultant as well as financial advisor to the company. In his defence, AK Chowdhury, managing partner of Hoda Vasi Chowdhury & Co, said there is no such legal bar. "And since there is no bar, so no offence has been committed," Chowdhury added. Chittagong Cement has had its share of problems in the recent past. In June 2002, Chittagong Cement informed the SEC that the company would take over Scancement International Ltd and Scancem Bangladesh Ltd through process of amalgamation. Heidelberger Zement AG owns both Scancement International Ltd and Scancem Bangladesh Ltd - and also has 51 per cent holding in Chittagong Cement. The proposed amalgamation will be accepted if two third shareholders of the company approve it at the EGM. The SEC soon after directed the company to inform its shareholders that Chittagong Cement could be burdened with Tk 129.2 million in liabilities after this amalgamation - potentially benefiting the controlling shareholders at the cost of minority shareholders. The SEC also launched an investigation into the affairs of the company where the committee observed that the amalgamation of "Scancem Bangladesh Ltd, with no assets backing [it] but with a liability equivalent to a huge negative net worth of Tk 129.2 million, would go against the interest of the investors. Moreover, Scancem Bangladesh Ltd's historical profitability from normal operational activities was negative." Earlier, during January to February 2000, newspapers reported that the sponsors/directors of the company were engaged in insider trading – they had sold large amounts of their holdings driving market prices down, and had subsequently bought back shares and resold 26% of total equity to a foreign institution yielding a huge net gain of Tk 520 million for the sellers. A detailed, confidential enquiry report accessed by the CG Team showed the following findings:

• An MoU regarding the transfer of shares in the company by the major shareholders was not released to the stock exchanges for five months after execution. The persons who had signed the MoU were in the position of chief executives (Chairman / Managing Director / Director), yet had failed to comply with the following listing regulations of both the DSE and CSE: A listed company shall supply the Exchange with immediate effect any proposed change in the general character or nature of business of the company or of any subsidiary thereof and particulars of any offer or proposals for the purchase or sale of any controlling interest or any substantial part of the assets of the company or of any subsidiary thereof and of the decisions of the Board in that regard.

• The chief executives had failed to obtain prior approval from the SEC, through the DSE/CSE, regarding their planned share transfer as per the following regulation: All shares of public companies listed with the Exchange shall be sold on the trading floor of the Exchange. Provided however where the transaction of such shares are intended to take place under exceptional circumstances in private or are to be transferred by way of gift, the broker, member, or seller shall apply through the Exchange to the SEC for prior approval.

• The stock exchanges had failed to ensure compliance of these regulations and to penalise the contraventions.

This case highlights two key problems in the corporate governance framework. First, regulators failed to act to protect investors, even though there would appear to be adequate evidence of wrongdoing. Second, the auditor in this case was not independent from the company being audited, but no action was taken to ameliorate the situation. There has been no known action by the regulators on the basis of the enquiry report. It should be mentioned that the people involved in this case were all well respected leaders of the


business community. (Source: Financial Express, Daily Star newspapers) Prospectuses The provisions relating to prospectuses have been streamlined in the new Act. The provisions in the body of the Act spell out the responsibilities and liabilities of persons regarding misstatements or omissions in a prospectus, as well as the contents in a broad outline. Under the previous law, civil and criminal liabilities for misstatements in a prospectus were dealt with very generally, and were virtually limited to actions for fraud which the aggrieved person had to prove. The new Act has an interpretation clause whereby a statement will be a false statement if the manner and context in which it is included in the prospectus is misleading, and if deliberately to mislead something is omitted from the prospectus, then the prospectus will be treated as containing a false statement regarding the omitted matter. Criminal liabilities are specified for misleading statements as well as for fraudulently inducing a person to invest money in a company. Most, if not all, of the provisions as regards to issue of prospectus as appearing in the Companies Act 1994 have since been altered or made redundant through the SEC (Public Issue) Rules 1998 and various other notifications from time to time, as well as the arbitrary imposition of other conditions on a case to case basis. In fact the SEC Rules override the Act in many instances.

Modern Food Products Limited Modern Food Products Limited, an herbal food producer with a poor reputation in the market, invited public subscription during July 16-30, 2000 for Tk. 30.0 million. The issue gained SEC approval with amazing alacrity, despite noises about the authenticity of some information furnished in the prospectus. On July 7, a non-bank financial institution came with a claim of default loan of over Tk. 10.0 million due from the company, which was intentionally underreported in the prospectus. The SEC seemed to have failed to obtain a CIB report from the central bank regarding the company’s default loans. After the default situation came to light, the SEC was compelled to withhold the approval on July 12 and then cancel it on July 30 and ask the company to reimburse the pre-IPO money to the investors. The auditors also claimed that the company did not comply with the BAS-4 and BAS-16 regarding fixed assets. The issue never went to the market, but some investors are yet to be reimbursed for their pre-IPO subscription money. Modern Food Products illustrates the inability of the regulatory authorities to fully verify and confirm disclosures provided in a prospectus. In this case, involved parties made additional information available to the public, but the example begs the question of how many other similar cases are not caught. Protection of Minority Shareholders The Act enables minority shareholders to seek remedies in Court and also enlarges the powers of the Court to pass appropriate orders. A member or debenture holder of a company may either individually or jointly bring to the notice of the Court by application that the affairs of the company are being conducted in a manner prejudicial to one or more of its members. However, such an application must be brought by members holding not less than one-tenth of the shares issued in the case of a company having a share capital and not less than one-fifth in number in the case of a company not having a share capital. If after hearing the parties the Court is of the opinion that the interest of the applicant(s) are being prejudicially effected it may pass any order it deems fit including cancelling or modifying any resolution or


transaction, regulating the affairs of the company in future as specified in the order or amending any provision of the memorandum or articles of the company. The requirement of one-tenth of the shares as a threshold for bringing a minority protection action has been much discussed. A threshold is certainly required to prevent persons with very small stakes in a company from holding the company and larger investors to ransom by bringing vexatious actions in court. Minority protection actions are filed in court in Bangladesh with some regularity, although a large number of these are later found to be vexatious or not in fact relating to issues covered under the rubric of minority protection. In certain circumstances, a shareholder may also be able to bring an action in court to wind up the company on the ground that it is just and equitable to do so. This, of course, is an extreme measure, and the burden of satisfying the court is high. It is, however, often seen that shareholders do not know all the rights provided to them by the company law, and are unaware of the enforcement provisions. In particular, many shareholders do not know about Section 233 and the minority protection regime. Disclosure The information disclosed by a company to its shareholders and to members of the public in accordance with the disclosure requirements of the law is practically the only tool shareholders and investors have to judge the performance of a company and monitor the activities of the directors and management. Therefore, these provisions are of cardinal importance, and should be subject to strict enforcement. Due to various reasons, including lack of knowledge on the part of the persons responsible to maintain the records, shareholder apathy, lack of proper monitoring by the RJSC, lack of quality auditing services, often the disclosures are not accurate or complete. Every company has the obligation to keep proper books of account with respect to all sums of money received and expended by the company, all sales and purchases of goods, the assets and liability, and other overhead costs of the company. The books of account should be kept at the registered office of the company and should be available for inspection during office hours for directors and any authorised Government officials. Failure to comply with these provisions makes the relevant persons liable to imprisonment and/or fine. The Board of Directors of the company are obliged to lay before the company a balance sheet together with the profit and loss account at every AGM. The balance sheet together with the profit and loss account is to be audited by the auditor of the company and the auditor’s report is to be attached thereto and read before the company in general meeting. Moreover, the Board’s report is to be attached to the balance sheet and is to provide information regarding the company’s affairs, the amount the Board proposes to reserve in such balance sheet, the amount to be paid out as dividend and any material change and commitments which may change the financial position of the company. The balance sheet must contain a summary of the property and assets and of the capital and liabilities of the company as at the end of the financial year. Every balance sheet as well as the profit and loss accounts shall be signed on behalf of the Board of Directors by its managing agents or secretary and by not less than two directors, one of whom must be the managing director. Every member is entitled to a copy of the balance sheet including profit and loss account, the auditors’ report and every other document required by law fourteen days before the meeting free of charge. The RJSC is empowered to call for information, explanation or to produce such books or papers, as the Register deems necessary. The Government may also appoint inspectors to investigate into the affairs of


the company upon application of members holding at least 10% of the shares. These provisions are seldom invoked. Auditors The Board of Directors of a company is required to appoint auditors within one month of the registration of a company. Thereafter, auditors are appointed in general meeting. Only Chartered Accountants may be appointed as auditors. The auditors shall have access to all books and papers. The scope of inquiry of the auditors is elaborately spelt out in the Act, as well as the nature of the certification the auditors must provide. Apart from the general power to audit the auditors are now required to specifically investigate the following matters:

• Whether advances or loans have been properly secured, and whether the terms on which they have been given are harmful to the interests of the company or its shareholders;

• Whether the book-transactions of the company are harmful to the interest of the company; • Whether the assets of any company other than an investment or a banking company have been sold

at a value lower than that paid through shares, debentures or other securities through which they were purchased;

• Whether loans given by the company and advance deposits made by the company have been shown in the accounts;

• Whether personal expenditure has been included in the revenue account; • Where any books of the company show that shares have been allotted for a cash consideration,

whether that consideration has in fact been received in cash, and if so whether this has been properly reflected in the accounts and the balance sheet.

These are in line with the modern practice worldwide for certification. The auditors now have the right to receive notices and attend all general meetings of the company and not only the general meeting in which the accounts are placed. This is intended to allow the auditors to more closely supervise the affairs of the company. An auditor must certifying that, to his knowledge and from the explanations provided to him, he is satisfied that the Auditor's Report contains all the information required by law and that the balance sheet and profit and loss accounts present a true and proper picture of the affairs of the company as at the end of the financial year. The auditor must also state whether to his best knowledge and belief he received all the information and explanation which were necessary for his examination, whether in his opinion all the necessary books and records as required by the law have been properly maintained, whether he obtained adequate information from the branches or parts of the company he did not audit, and whether the balance sheet and profit and loss accounts audited by him bear any relation to the actual accounts books and records of the company. It needs to be emphasized that the auditor must now specifically state whether, in his opinion and to the best of his information and according to the explanation given to him, the said accounts give the information required by the Act in the manner so required and give a true and fair view – in the case of the balance sheet, of the state of the company’s affairs as at the end of its financial year; and in the case of the profit and loss account, of the profit and loss for its financial year. While the Act prescribes that books of accounts shall be maintained by companies, and balance sheets and profit and loss accounts prepared, there are no specific provisions in the body of the Act or the schedules providing detailed guidelines on what information should be included in these books, and how various incomes and expenditures should be booked. In the case of publicly listed companies, the Securities and Exchange Rules 1987 provides in detail for the contents of the annual report and profit and loss accounts


required to be submitted by issuers of listed securities as required by the SEO 1969. It includes provisions on the classification of the assets and liabilities of the company, distinction between tangible and intangible fixed assets under several sub-heads, investments, loans, advances, current assets, capital and reserves etc. The provision of such details and maintenance of books and records accordingly by all companies would assist the auditors to conduct proper audits. It would also assist other persons to ascertain the actual state of affairs of the company concerned. Furthermore, there is no requirement under the Companies Act for boards to have an audit committee that will oversee the external auditors. (See Role of Audit Committees and Risk Management Arrangements under the Independent Regulators.) Throughout the survey of the stakeholders, the common point of concern was that audit reports, except for those of multinational companies and very reputable local companies, do not reflect a true and fair view of the state of the company’s financial affairs. The auditors, except for the very few reputed chartered accountancy firms with tie-ups with international auditing firms (which of course after the Arthur Andersen affair is no longer a fool-proof guarantee of quality and probity), do not fully know, understand or apply the Bangladesh Standards on Auditing, let alone the International Standards on Auditing (ISA). In any event, the Bangladesh Standards on Auditing, although certain ISA norms have been included over a period of time, are not a fully satisfactory set of standards to be followed. Lawyers and accountants carrying out due diligence of local companies for mergers, acquisitions or other purposes are more often than not presented with unsubstantiated books of accounts (where there are any at all). It was a widely held view among stakeholders that rigorous auditing practices would improve corporate governance in large measure almost immediately. Court and Government The Court having jurisdiction under this Act is the High Court Division of the Supreme Court of Bangladesh. The Court comes into the picture, as has been mentioned above, in the confirmation of amendments to the object clause of the memorandum of association of a company, rectification of the share register, confirmation of reduction of share capital, and very importantly, in the exercise of its jurisdiction to protect the interest of the minority under Section 233 of the Act. Other than these, the Court has extensive powers in an application for winding up a company by the Court, which may be done in the following circumstances:

• If the company has by special resolution resolved that the company be wound up by the Court; • If default is made in the filing of the statutory report or in holding the statutory meeting; • If the company does not commence its business within a year from its incorporation, or suspends

its business for a whole year; • If the number of members is reduced, in the case of a private company, below two, or in the case

of any other company, below seven; • If the company is unable to pay its debts; or • If the Court is of opinion that it is just and equitable that the company should be wound up.

The Court has a judicial discretion as to whether it will wind up a company on any of the above grounds. The ground of a company being unable to pay its debts is a potent one invoked by creditors when all else fails in getting a company to pay sums due and owing. The “just and equitable” ground give the Court a wide discretion in winding up a company, and judicial decisions abound in identifying when it may be just and equitable to wind up a company. The Court will consider the interests of the shareholders as well as the creditors, and has to form an opinion as to the equity involved. Equity holders with less than 10%


of the equity, who would not have standing under Section 233 of the Act, may apply for winding up a company, subject to having held shares for a specified period of time. Petitions for winding up of a company on the ground of its inability to pay its debts are subject to extreme scrutiny at the preliminary hearing for admission of such petitions, as such petitions are often perceived as a method to coerce a company into paying a particular debt or debts owing to the petitioner. The first petition for winding up a financial institution, an insurance company, was admitted for hearing in 2001 but settled out of court, and was followed by another petition for winding up of another insurance company admitted for hearing in 2002. The admission of the two petitions reflect a significant and welcome shift in judicial approach to petitions for winding up of inability to pay debts of financial institutions on equal footing with other companies. The Government has the power, under the Act, to authorize a Government officer to inspect the books of account and other books and papers of every company. It is the duty of every director and other officer of the company to give to the inspecting person all reasonable assistance in connection with the inspection. The Government also has specific powers under the Act of inspection and audit; it may appoint inspectors to investigate and report on the affairs of any company, on the application of members not having less than 10% of the shares issued. In the case of companies without share capital, government investigation can be triggered by the application of not less than one-fifth in number of the persons on the register of members and, in other cases, on a report by the Registrar. The Government must be satisfied on evidence that the applicants have good reason to ask for such inspection. The company may also, by a special resolution, make such an application. Such an investigation and audit may lead to criminal prosecution, winding up, proceedings for recovery of damages or property, etc. However, these powers have rarely been invoked in Bangladesh. Financial sector scenario and governance This section addresses and is limited to the issues the Project Proposal. It focuses on forces within the banking sector, capital market, and insurance sector that have the most effect on corporate governance. An analysis of all aspects of the financial sector relating to loan disbursement, classification and recovery is not within the scope of this study. The Banking Sector Financing for commercial purposes in Bangladesh is largely obtained by borrowing, mainly from banks and financial institutions, rather than through equity or capital market products. Therefore, the primary stakeholders in corporate governance are creditors, particularly lenders. Factors influencing the effectiveness of regulation of lending institutions, access to finance and recovery of debts can be better understood with an appreciation of the participants in the financial sector. Types of Lending Institutions Lending institutions are broadly categorised into two types: (i) banks, which conduct banking business, and (ii) non-banking financial institutions, which conduct financing business within a more specific domain than commercial banks. Non-banking financial institutions are prohibited from accepting deposits payable on demand by cheque or otherwise. This category includes leasing and housing finance companies. Banks are broadly classified as: (i) nationalised commercial banks (NCB), banks transferred to the government upon the independence of Bangladesh; (ii) specialised banks, banks established by statute; (iii) private commercial banks (PB), privatised NCBs and new banks established after the independence of Bangladesh; (iv) foreign banks, which are branches of banks incorporated outside Bangladesh; and (iv) co-operative banks. (See Appendix K for a list of financial institutions.)


Type of Financial Institution Number of Institutions

Non-Bank Financial Institutions 28 State-owned commercial banks 4 Specialised and Development banks 11 Private commercial banks 26 Islamic Private commercial banks 2 Foreign commercial banks 10

Apart from NCBs and specialised banks, lending institutions are public companies with limited liability and a certain portion of their shares are required to be listed on a stock exchange in Bangladesh. NCBs are burdened with outstanding debts that were existing at the time of expropriation and are also mandated by the government to lend to specified sectors, regardless of risks involved or likelihood of recovery. PBs are patronised by political figures, and their family members or favoured business associates compose the boards of directors. Many PBs serve as house banks to domestic business groups of the promoters (sponsors), and financing extended by PBs to sponsors or their preferred customers is customarily in default for extended periods of time. Although the Bank Company Act 1991 restricts the proportion of shareholders belonging to a "family", shares held on trust as nominee of another person ("benami") are difficult to detect, with the result that through indirect influence the management of most banks is effectively under the control of a few persons. Foreign banks maintain far more restrictive lending approaches than PBs. Credit assessment at foreign banks is based on their global credit policies and conditioned on the inadequate legal environment for debt recovery and enforcement of collateral. Such requirements form the basis of their reluctance to extend long-term or project financing facilities. Central Bank Fiscal and monetary regulations and policies in Bangladesh are introduced and overseen by the Ministry of Finance. Lending institutions are regulated by the central bank of Bangladesh, Bangladesh Bank10, established by the Bangladesh Bank Order 1972 (P.O.127 of 1972). Although regulated by the Ministry of Finance, Bangladesh Bank has reputedly a large measure of autonomy compared with other government bodies. Recently, Bangladesh Bank has been granted additional autonomy, with the Governor accountable to a parliamentary standing committee instead of the Ministry of Finance.11 The Board of Directors of Bangladesh Bank is nominated by the Government from officials in the service of Bangladesh Bank or other banks, and the Board is comprised of a Governor, one Deputy Governor, four Directors nominated by the Government from the private sector with relevant experience and three Government officials, presently of the rank of Secretary. The Governor functions as the chairman of the Board and chief administrative officer. Recently, the Governor has been a professional appointed from the private sector and, for the first time, an outsider and a former head of a branch of a foreign bank in Bangladesh has been appointed as a member of the Board. These steps are measures to inject experienced professionals into Bangladesh Bank and gradually instil appropriate managerial skills in running what is essentially a bank. The Deputy Governor and Executive Directors are recognised as possessing abilities to understand modern banking concepts, having attended leading western universities. The remaining majority of officers lack adequate formal training and education in banking and central bank functions, but exert a large measure of indirect influence in that members of the Board are reluctant to take decisions or actions contrary to comments of these officers. Bangladesh Bank regulates the operation of banks and financial institutions on the basis of powers vested by the Bangladesh Bank Order 1972 and the Bank Company Act 1991 (as amended to date), and through

10 http://www.bangladesh-bank.org 11 “Cabinet okays limited BB autonomy” Daily Star, January 7, 2003.


directives, circulars and circular letters which are issued independently by its various divisions.12 However, there is a dearth of public information regarding current circulars and directives. Circulars are distributed only among banks and financial institutions and are not published for public information.13 For instance, a compilation of guidelines for foreign exchange transactions published by Bangladesh Bank is neither legally effective nor enforceable, and such transactions are controlled by specific circulars.14 The result is that prospective customers are not independently informed of Bangladesh Bank rules and banks are at times served with notices from Bangladesh Bank for violations of old circulars. Recent proposals by the International Monetary Fund and World Bank for reforming the operations of Bangladesh Bank, which are still under consideration by the Government, include measures such as, requiring members of the governing board of Bangladesh Bank to be appointed by Parliament, a requisite of ten years’ banking experience of the members of the governing board, and granting full autonomy to Bangladesh Bank to counter political interference. The World Bank as part of its reform package has also suggested downsizing the large workforce, making senior officer positions redundant and automation at Bangladesh Bank; this has met with resistance by the unions.15 Bank Requirements, Problems, and Reforms Although Bangladesh Bank has introduced a Lending Risk Analysis (LRA) procedure for loans above a certain amount, smaller loans do not require mandatory credit assessment before sanction or disbursement of credit facilities, which is a recognised factor contributing to difficulties in recovery of defaulted loans. To facilitate informed credit decisions by banks, the Bank Company Act 1991 includes provisions for distribution and publication of lists of loan defaulters. When the initial publications of such lists occurred, the lists were criticised and allegations of libel made against the publishing newspapers. As an alternative, a separate department was established at Bangladesh Bank, the Credit Information Bureau (CIB), which centralises information on borrowers’ credit limits, security, and any defaults. The effectiveness of CIB reports is hampered by delays in updating information and disclosure only to requesting banks. This makes it difficult to discover and correct mistakes; corrections have, at times, required judicial orders. Survey results also reveal that cash incentives are often required to obtain CIB reports in the normal course of business. Weaknesses in the CIB system often lead to delayed loan approval, if not outright loan rejection. The Bank Company Act 1991 has had a measure of impact on the disbursement of loans in requiring the approval of Bangladesh Bank for loans above a certain percentage of a bank's capital and for rescheduling above certain amounts. But confusion continues to exist on the methodology for calculation of a bank's capital and circulars have imposed additional conditions on the statutory lending limits, which is beyond its powers. A popular debate is centred on the rates of interest and charges levied by banks for transactions. Allegations of pressure tactics for pecuniary benefits for processing transactions and sanctions are quite common. This is a factor hampering timely settlement of loan liabilities, as a fairly good percentage of the amount disbursed may be allocated for such extra payments. The result is that although foreign banks have higher rates and charges, borrowers prefer to pay the premium for quicker transaction turnaround rather than spend extra time in dealing with local banks. The challenge is in the ability to gain entrance into foreign banks which have more strict credit controls. Furthermore, there are no statutory provisions on duties of directors of companies, bank companies or financial institutions, nor on their qualifications other than shareholding. Bangladesh Bank has been

12 Banking Regulation and Policy Division (BRPD), Exchange Control Division (ECD) 13 Circulars from 1990 stated to be available at the website of Bangladesh Bank, http://www.bangladesh-bank.org, are not readable. 14 Guidelines to Foreign Exchange Transactions as of December 31, 1996. 15 The Financial Express, October 23, 2002.


steadily issuing circulars outlining the duties and responsibilities of directors of banks, in recognition of their fiduciary duties as directors and protection of the interests of depositors. Bangladesh Bank has recently displayed increased activism in the administration of banks by exercise of its statutory powers of removal of chairman, directors or chief executive officers of banks, which have survived judicial review. To facilitate more effective regulation, a suggestion has been made for statutory recognition of directors' duties for all companies, with emphasis on their individual and collective accountability. Bangladesh Bank has further proposed that the number of directors be limited to eleven and that BB appoint two independent directors to each bank board to represent depositors; amendments to implement these new rules will be considered by Parliament in 2003. The proposals regarding bank boards have been met with opposition from the Bangladesh Association of Banks, which considers them to be in violation of the rights of shareholders and the Companies Act.16 Other areas in which Bangladesh Bank has been increasingly active include the selection of auditors, accounting standards, and actions taken after investigations. First, in 1998, Bangladesh Bank required that the auditors of banks be changed every three years, in a move appreciated by banks, to serve as a check on auditors' performance. Second, Bangladesh Bank has pursued investigations into bank affairs and transactions and taken action against offending bank personnel. But investigations by Bangladesh Bank into affairs or transactions of banks are often perceived as politically motivated. There are instances when investigations result in junior officers being forcibly removed and statutorily barred from working in a bank again, while executive officers with decision making powers are permitted to resign and continue to serve in the banking sector. Third, a significant step has been taken by Bangladesh Bank to begin to rationalize the banking sector and improve financial reporting by banks. From December 31, 2000 banks and financial institutions were required to comply with the International Accounting Standard-30 (IAS-30).17 The accounting standard requires banks to disclose the classification of their loan portfolio (as sub-standard, doubtful, or bad) based on their default activity and make a loan loss provision specifically for classified loans. Banks must also make a general provision for loans that are unclassified. The new standard requires disclosure of loans and advances to directors and executives, as well as more information about the various characteristics of the institution’s outstanding loans. Additional reporting is also required with regard to banks’ equity, which may begin to clarify the capital situation of banks in the country. Banks and financial institutions are now required to provide a statement of equity disclosing changes in equity throughout the year.18 Full and accurate compliance with the disclosure requirements of IAS-30 will begin to provide more information to bank stakeholders (including management, boards of directors, customers, regulators, and borrowers) and hopefully create a consensus for reform. The financial sector can serve as a motivation for better corporate governance through its requirements and procedures for approving and monitoring loans. Unfortunately, the financial sector has not demanded better financial performance or better corporate governance from the enterprises to which loans are extended. This can be seen most clearly in the statistics on classified loans; classified loans as a percentage of total loans outstanding for NCBs, PBs and foreign banks at the end of 2001 were 45%,

16 “Private banks smell a rat about govt move to change rules,” Financial Express, March 1, 2003. 17 BRPD Circular No.3, March 18, 2000. 18 Saha, Dr. Sujit and Md. Saidur Rahman. “Implementation of International Accounting Standard in Banks and Financial Institutions – Step Towards Sound Governance System.” Presented at the Management Forum 2002 on Institutional Governance: Failure in Building Infrastructure for Socio-Economic Growth” Organized by AMDB on July 25-26, 2002.


26%, and 4% respectively.19 Writing off long outstanding bad loans is also not a common practice of the commercial banks and development financial institutions and consequently such loans are carried on the books for indefinite periods of years, ostensibly in a somewhat misconceived fear that once written off it would eliminate all avenues of recovery. Bangladesh Bank issued a circular in January 2003 instructing banks to write off bad debts over five years old, but clarified that banks can and should still pursue recovery of the bad debts.20 Rescheduling of loans is another option which banks have utilized to deal with classified loans. Bangladesh Bank has also issued guidelines on rescheduling loans, instructing banks to analyse the reasons for default and past record of the borrower. This is attempting to avoid the common case of habitual defaulters repeatedly rescheduling loans. BB also issued a circular in December 2002 directing banks not to reschedule a loan of a borrower on a bilateral basis when the borrower has default loans from multiple banks totalling at least Tk. 500 million. In such cases, decisions on rescheduling should be taken jointly by a committee made up of all the concerned banks and based on the repayment performance of the borrower. Bangladesh Bank has suggested a permanent committee be formed of CEOs/MDs of all commercial banks and the Bangladesh Bank Deputy Governor to draw up guidelines for large loan rescheduling.

Al-Baraka: Fraught with Irregularities In late September and early October 2002 numerous allegations against Al-Baraka Bank (now Oriental Bank Ltd) were published in the mainstream media. Headlines read “Loans without risk analysis, sanction letters in a flash” and “Shady shoddy deals.” Al-Baraka Bank was accused of perpetuating poor lending practices which resulted in 33% of its loan portfolio being classified loans (Tk. 3.2 billion out of Tk. 9.9 billion). Of the classified loans, Tk. 3.1 billion was bad debt. Regular procedures of risk analysis and document scrutiny had been bypassed in the past; loans amounting to millions of Taka had been advanced against accounts opened with as little as Tk. 10,000 on the very same day. Proper analysis of the capacity of the borrowers to repay was not completed. For instance, credit analysis was not corroborated by factory visits, stock checking, or collateral verification. In addition, credit facilities were extended to business houses with prior history of huge loan defaults. Repeated rescheduling of loans outstanding against one renowned businessman cost the bank Tk. 1.1 billion in terms of lost income and the businessman was only paying 44% of his current liability to the bank. Other dubious organisations got their credit limits extended from Tk. 15 million to Tk. 49 million in two months without putting up any additional collateral. Loans were also extended to sister companies of groups that were already in default and were in areas outside the bank’s supervision. As a result of poor lending policies and mismanagement, accumulated losses of the bank amounted to Tk. 864 million on December 31, 2001. Uncharacteristic share transfers in early 2002, purportedly the evidence of acquisition by above mentioned defaulter under guise of a foreign investor, also left the bank in a precarious situation. A Hong Kong based investor bought out the shares held by the Jeddah based Al-Baraka Investment and Development Company (34.67%) and five local companies jointly purchased another 27.16% previously held by a major shareholder. Together, these transfers have given the loan defaulter total board control. In spite of the grave allegations regarding Al-Baraka, the stock price of the bank actually rose over the

19 Sayeed, Yawer. “Bangladesh: Strategic Issues and Potential Response Initiatives in the Finance Sector: Banking Reform and Development (BRD)”, Asian Development Bank, July 22, 2002. 20“Bad for five years, write them off,” Daily Star, January 14, 2003.


period of discussion. The newspaper’s exposé began on September 29, 2002. In the days preceding and following the publication of the allegations against the bank, the stock price actually increased from Tk. 1,085 on September 25, 2002 to a high of Tk. 1,240 on October 2, 2002. Thereafter the price declined, but by mid-October it was still higher than it had been before the newspaper’s allegations. This lack of reaction to negative publicity demonstrates the problem of manipulation in the Bangladesh stock markets. It is possible that investors already knew the facts publicized in the newspapers and that the stock price had already incorporated the news, but in all probability some front buyers were arranged to jack-up the price. One would expect that the shares of a bank, for which public confidence is key to successful operations, would fall on the publication of such damaging information. When contacted for this study, Al-Baraka Bank officials attributed these instances to “genuine mistakes made by the board and situations that arose because third-parties, like survey companies, misled the bank.” They were vehement in the fact that such mismanagement will not recur in future because a) Bangladesh Bank is now more stringent in its monitoring and b) CEOs can now take a more firm stand against the board (as CEOs of financial institutions cannot be removed without Bangladesh Bank approval). Legal Framework for Loan Recovery and Bankruptcy A primary problem in improving the functioning of the banking system is the legal framework for pursuing defaulters, enforcing security interests, and declaring bankruptcy. Dedicated courts for debt recovery by banks and financial institutions, Artha Rin Adalat (Money Loan Court) were established in 1990.21 However, they have not yielded the expected accelerated results due to a shortage of judicial officers and the requirement to enforce judgements by separate judicial (execution) proceedings. A trend of challenging decisions of the Money Loan Court by judicial review has recently been judicially disallowed, but appeals against such decisions to the Supreme Court are to wait in queue. The results of the corporate survey underscore the ineffectiveness of the Money Loan Court. One private bank’s managing director pointed out the discrepancy between the practice and the law, saying that “the law mandates disposal of cases in six months, but a case may even take ten years. One judge deals with too many cases and therefore is not efficient.” Survey results revealed that there is a widespread culture of default on bank loans, and the use of the Money Loan Court or Bankruptcy Court by banks pursuing loan defaulters does not yield satisfactory results, particularly with respect to executing judgements against defaulters. Recent directives by the Bangladesh Bank regarding rescheduling instalment loans also have the effect of condoning delays in loan repayment.22 To protect their exposure, banks insist on blanket personal guarantees from company directors before giving out loans, which disregards the separate legal personality of companies without legislative or judicial sanction to lift the corporate veil and acts as a barrier to enterprise development. The Securities and Exchange Commission (SEC) has followed suit, and in one instance compelled the directors of a publicly listed limited liability company to provide an undertaking on the prospectus to the effect that if the company fails to generate a net profit of Tk. 150 million the directors shall pay for the shortfall from their personal sources.23 Such an approach detracts from concentration on sourcing debt repayments from a company's revenue streams and properly evaluating a company's assets for securitisation.

21 Artha Rin Adalat Ain (Money Loan Court) (Act No.IV of 1990) 22 Sayeed, Yawer. “Bangladesh: Strategic Issues and Potential Response Initiatives in the Finance Sector: Banking Reform and Development (BRD)”, Asian Development Bank, July 22, 2002. 23 Prospectus of Meghna Condensed Milk Industries Limited. June 28, 2001, Page 6 and the Daily Janakantha


The main obstacles to enforcement of security interests by banks include: inadequate expertise in valuation of property, lack of complete and centralised public information on charges on property of all types of debtors, maintenance of manual records at existing dispersed registries, lack of legal provisions for immediate possession and/or sale of secured property without judicial order, delay in obtaining final judgments for enforcement of security interests, and the enforcement of judgments by separate judicial (execution) proceedings by controversial auctions through court. The result is protracted legal proceedings with remote likelihood of recovery from secured property, if any is left, by the time of enforcement of judgment. Two specialised banks possesses statutory powers of sale of mortgaged property without judicial order24, but such proceedings are subject to the existence of valid title and mortgage, and are often defeated for lack of verification of title and perfection or of the mortgage. Additional factors cited for protracted legal proceedings are poor legal advice and poor documentation. It is customary in banks to require the submission of various types of loan and security documentation, often for different transactions or products, without proper appreciation of their significance. A trend continues in most banks to require submission of such documents undated and to conveniently date the same before filing legal proceedings within applicable limitation periods; such documents are often challengeable based on later developments, such as when the signatory is no longer in office or is deceased, stamp duty is inadequate, the signature differs, and the like. A different strategy for debt recovery by bankruptcy was reawakened by the enactment of the Bankruptcy Act 1997, which established a further set of dedicated courts, Bankruptcy Courts. The stigma attached to being declared “bankrupt” is misunderstood, and has been the primary cause of resistance to an effective structuring and enforcement of the 1997 Act. A draft of the 1997 Act was critically reviewed by business bodies, which had strong political clout, and many stringent provisions were removed. This demonstrates the failure of imposing internationally accepted standards and concepts into the Bangladesh banking sector. The Bankruptcy Act is applicable to both individual debtors and to companies, which creates some overlap with the liquidation procedures of the Companies Act 1994 (for further details, see the section on Companies, Corporate Laws and Practice of this Report). Under the Act, debtors are liable to be sent to civil prison pending adjudication and a debt must be at least Tk. 500,000. A provision for the publication of notices of claims of bankruptcy under the 1997 Act continues to generate claims of defamation, and legal proceedings challenging the constitutionality of such notices are pending disposal. Overall, proceedings under the Bankruptcy Act 1997 are not a favoured option for banks. It is a common strategy for banks to prefer that borrowers continue to remain commercially viable to generate funds for repayment rather than cripple or extinguish their opportunities for further business by adjudication of bankruptcy. Banking Sector Summary The banking sector in Bangladesh is recognised as fairly large, but inefficient, in comparison to the size of the economy. It has been estimated that the cost of banking inefficiency to the Bangladeshi economy is 1.18% of GDP (using independent estimates of recapitalization requirements).25 There have been many well-publicized examples of bank mismanagement (see box on Al-Baraka Bank), which provide concrete examples of the problems in the banking sector. One can see from the above that the situation of the banking sector continues to be a mixed bag. Although some promising reforms have been instituted, the health of the banking sector is highly questionable. New reform initiatives have yet to be fully implemented and enforced. Further advances are also required providing adequate creditor’s rights. The

24 Bangladesh Shilpa Bank and Bangladesh Shilpa Rin Sangstha 25 Sayeed, Yawer. “Bangladesh: Strategic Issues and Potential Response Initiatives in the Finance Sector: Banking Reform and Development (BRD)”, Asian Development Bank, July 22, 2002.


situation of the banks in Bangladesh clearly illustrate that they have not fulfilled their role as successful adherents of corporate governance principles. The Insurance Sector The insurance sector is characterized by two state-owned companies, Sadharan Bima (SBC) and Jiban Biman (JBC), and a proliferation of private insurance companies. Overall, there are 37 general insurance companies and 14 life insurance companies. (See Appendix K for a full list of insurance companies operating in Bangladesh.) Generally, private insurance companies provide a narrow range of products and generally the service quality is low. Default amounts on unpaid insurance claims are high for both general insurance and life insurance companies. Defaults are blamed on the delayed or erroneous survey reports, delays from SBC in settling reinsurance claims, and funding shortfalls by the companies. Furthermore, insurance companies have limited actuary data on which to base premiums and have limited investment outlets for insurance funds. The Chief Controller of Insurance under the Ministry of Commerce currently regulates insurance companies. Section 27 of the Insurance (Amendment) Act 2000, states that at least 30% of the funds of life insurance companies shall be invested in government securities and the balance can be utilized for any other investment, including capital market investments. The Chief Controller of Insurance specifies a list of eligible investments other than government securities. (Notification dated July 28, 2002) Only ICB’s unit funds, not private mutual funds, are allowed. As for share investments, insurance companies are allowed to invest in shares and debentures of companies which are at least 25% owned by the Government or public listed companies that have a record of dividend payments of more than 10% in at least five out of seven years preceding the date of investment. Reform of the insurance sector is much discussed by the both the Government of Bangladesh and multilateral donors. The Government recently formed a Insurance Reform Committee, which has issued a number of significant recommendations, including dissolution of the Office of the Chief Controller of Insurance. The Committee also recommended increasing the paid-up capital of SBC, selling 49% of SBC to the public, and limiting its business to reinsurance. Finally, the Committee recommended that private sector companies should provide government insurance policies. The insurance industry has recently come under focus of the World Bank and Asian Development Bank (ADB), which has suggested measures for reform to eradicate unfair practices exercised in the sector; as with the banking sector, political interference is the primary challenge. Such practices include inadequate or non-existent assessments for insurable risks, issuance of policies without payment of premium, payment against false claims, failure of payment against genuine claims, personal cash incentives demanded for processing documentation, tax evasion on underwriting and the like. Independent shareholder intervention in insurance companies is difficult with major shareholders controlling a minimum of at least forty percent of equity. The Department of Insurance lacks sufficiently trained staff and infrastructure, providing no leadership or incentive to take a more active role in monitoring and intervention in its supervisory capacity. To improve the situation, World Bank and ADB studies have suggested halting issuance of further licences to insurance companies, amendment of the company law to facilitate merger or amalgamation of the numerous and largely non-profitable insurance companies, introduction of internationally accepted corporate governance principles and vesting the Chief Controller of Insurance, the chief regulator of the insurance industry, with the power of enforcing the same. It has also been recommended to bring the insurance industry under the control of the Ministry of Finance from the Ministry of Commerce, and thereby integrating the regulation of the banking, securities markets, insurance and tax sectors under one


ministry. No mention has been made of the regulation of companies, which remains under the Ministry of Commerce.

SABINCO Saudi-Bangladesh Industrial & Agricultural Investment Company (SABINCO), a Saudi and Bangladesh government joint venture, has been operating in the country as a private limited company since July 1985. It obtained a license to operate as a Non-Bank Financial Institution (NBFI) from Bangladesh Bank in February 1995. In April 2000, an inspection report prepared by a team at the Bangladesh Bank outlined a host of irregularities including:

• Investing in shares of other companies beyond the allowable limit of 25% of paid-up capital and reserve

• Paying dividends without retaining 20% of net profit as required • Continuously appointing the same person as the managing director for more than 15 years • Engaging in day-to-day management of two other companies, Bangladesh Catfish and Saudi-

Bangla Fish Feed, beyond its normal scope of operations The team also found that 65% of the loan portfolio was classified – a situation deemed detrimental for the future of the company. Subsequently in July 2000, investigative reporting by a vernacular newspaper revealed that SABINCO artificially induced a bull run in the stock market in collusion with leading brokers and causing severe fluctuations in the prices of a few select companies. Indeed, the DSE General Index in July 2000 rose sharply from 793 on July 2 to a high of 884 on July 29. SEC investigations unearthed collusive trading by the company chief, his friends and some stockbroking houses for personal profiteering. In an unprecedented move, the then SABINCO Managing Director spent a huge amount of company funds printing out an open protest letter in all the major daily newspapers. He wrote, “Through this letter, I request the Government to institute a judicial enquiry composed of High Court Judges to investigate into the whole thing around the capital market starting from SEC, stock exchanges, financial intermediaries and everybody concerned and find out who play[ed] what role.” The long-reigning MD was eventually forced to resign on September 11, 2001 amidst board pressure and the SEC filed a case against him for violation of Sections 17 and 25 of the Securities & Exchange Ordinance 1969. It should be noted that SABINCO had three nominated directors on behalf of the Bangladeshi government at that time: two were serving as Secretaries and the third was none other than a Director-General of the Bureau of Anti-Corruption. Other directors were Saudi nationals appointed by its government. This is a classic example of all that could go wrong when the government appointed board members take a detached and disinterested role and an all-powerful CEO is given a free hand. The Capital Market A Bird’s-Eye View The capital market in Bangladesh is a weak link in the movement towards strengthening CG in Bangladesh. The SEC was set up in 1993 and has enacted myriad rules and regulations to structure and develop the capital market – but the end result is still stagnation. After the surge of events in the mid 1990s – starting from a general upturn in 1994 and leading to a boom that eventually crashed in 1996 –


there have been various piecemeal and ad hoc attempts to rejuvenate the market and bring back the investors, without much success in sight. As of the end of 2002, there are 239 listed companies on the country’s main stock exchange, the Dhaka Stock Exchange. Market capitalization was Tk. 68,677 million (US$1,184 million) in 2002, an increase of only 0.68% over 2001. DSE market capitalization amounted to 2.52% of GDP at the end of 2001. The DSE’s performance over the last year has been lacklustre as well: the DSE All Share Price Index gained only 2.27% between 2001 and 2002. There were eight IPOs during 2002, a decline from eleven in the previous year. The number of companies holding AGMs was similar over the last two years: 79% of the total listed companies held an AGM regularly in 2002, compared to 77% holding an AGM in 2001. During 2002, there were a number of reform measures undertaken at the DSE. The DSE included twelve non-brokers as members of its policy-making Council, but there is no representation from investors or issuing companies on the DSE Council. The CEO of DSE was also dismissed at the insistence of the SEC after he installed defective on-line transaction surveillance software which generated false information.

Dhaka Stock Exchange Select Statistics Dec-99 Dec-00 Dec-01 Dec-02 ‘01-‘02 change No. of Listed Companies 221 230 231 239 3%

Market Capitalization ($ Mill)

870

1,165

1,176

1,184 0.68% Market Capitalization as % of GDP 2.04% 2.65% 2.52% DSE All Share Price Index 647.95 853.75 829.61 848.41 2.27%

Source: AIMS of Bangladesh Overall performance measures of the stock exchange show low trading volume, intermittent and very few new offerings, and declining valuations. The lack of depth in equity market makes it less transparent. When asked in the survey, sponsor shareholders of public listed companies, in several instances, admitted to holding a significant percentage of the public shareholding under false/relatives’ names – which means that the companies are more closely held than what registers reveal. Pseudo names, combined with low trading volumes, make it difficult to monitor for insider trading. The stock market scandals in 1996 further eroded investor confidence in the market. In essence, the equity markets in Bangladesh do not react significantly to company performance and therefore do not reward firms for providing full and accurate corporate disclosure through a higher stock valuation, neither does the market generally tend to punish enterprises that fail to disclose material information.


Dhaka Stock Exchange General Index, January 1997 to December 2002

Source: AIMS of Bangladesh Limited

In Bangladesh, the fundamental spokes of an efficient capital market wheel are not in place. The average non-controlling shareholder in this country is an individual who does not possess sufficient level of education, understanding and sophistication required to exert pressure on a company to change behaviour. Institutional investors like mutual funds (there are only two asset management companies in the country: one government and one private) and pension funds are too small to adopt a strong activist position. Takeover is also not perceived as a serious threat. Hence a share price does not necessarily incorporate a penalty for poor corporate practices; since market prices fail to have any kind of disciplining impact on management, companies have no incentive to be transparent. The state-owned investment company, Investment Corporation of Bangladesh (ICB) has not been required to publish the net asset value of its mutual funds or submit performance reports to the SEC as private mutual funds must do by law. ICB mutual funds are run by different rules than a private mutual fund, including rules for valuation, reporting, disclosure, borrowings and investment controls. For instance, ICB funds regularly borrow to finance equity investments, which is not allowed for private funds. The end result is that the largest institutional investor, ICB, has few incentives to demand good performance from its investments and it therefore does not utilize its power as an institutional investor to enforce changes. Furthermore, the growth of private sector institutional investors, which would be more likely to play an activist role, is stunted due to the uneven playing field and associated high costs. Equity Market: No Incentive to Going Public Due to the above-mentioned weaknesses in the stock market, companies see few benefits in becoming a public company and listing on the stock exchange. The capital market does not appear to offer adequate incentives to become a public company and enlist on the stock exchange. On the cost side, listing involves the expenses of filing the appropriate documents, bureaucratic obstacles, and additional disclosure requirements. SEC requirements for proportionate board composition are a further impediment to multinationals. As far as benefits are concerned, capital can be more easily raised through bank financing since companies with good reputations face few problems in obtaining adequate capital from banks. Bank financing is readily available as result of excess liquidity and extensive competition in the banking sector due to the fact that new private bank licenses had been issued mostly on a political basis; banks therefore are reluctant to enforce additional requirements or strict conditions in lending. This phenomenon is substantiated by our survey which revealed that equity requirement had been the prime motivator for only 10% of the public companies interviewed - the remaining companies had cited reasons like tax advantages and legal compulsion, for going public. All the private companies interviewed


expressed their dissatisfaction with the state of the capital market and hence preferred to continue as private companies. Companies that cannot obtain adequate bank financing may go to the equity markets, which means, in effect, listed companies are often the weaker companies. There is an optimum level of debt in a company’s capital structure after which point debt should become more expensive and the risk of committing to fixed debt payments becomes too high. This equation appears not to hold true in the case of Bangladesh. Banks do not increase lending rates for enterprises that carry high debt loads and there is little hazard in high levels of leverage. Companies are comfortable with high fixed debt payments because they know that the penalties for default are not necessarily severe. Banks, as consequence, end up with high levels of non-performing loans and there is a low demand for equity financing. Debt Market: Yet to Develop At present, the capital market includes no bond, fixed-income, or other debt instruments of significance. Government savings schemes provide a fixed income investment vehicle, but the instruments are not transferable and traded. The high level of interest paid on government savings schemes discourages corporate debt offerings. In spite of the obstacles, there is some progress being made in this sector. BRAC, the largest non-governmental organisation in the world, is currently working with AIMS of Bangladesh Limited to issue the first asset backed securities in Bangladesh. The securities will be backed by BRAC’s outstanding micro-credit loan assets. The Credit, Bridge and Standby Facility at the Central Bank, under the ongoing Financial Institutions Development Project of the World Bank for non-bank financial institutions, is also contemplating issuing collaterized loan obligations (CLOs) of leasing companies. The SEC has recently approved, in principle, a credit rating company. If the debt markets can develop, investors in corporate bonds and other debt instruments could become an important pressure group for encouraging and enforcing corporate governance principles. Sources interviewed for this report believe that a market for debt and fixed-income securities is more likely to yield results in capital market development and as a tool for improving CG. If government savings schemes are phased out or their rates are rationalised, investors would likely prefer an investment vehicle that matches the risk and return profile of the schemes to which they are accustomed. Bond and other debt instruments can provide a fixed return with a low level of risk. Outlook for Change Within the capital market sector, there are some stakeholders that could use their power to force companies to improve CG, but this power is often left unexercised. Large investors and financiers prefer to complete their own analysis of a company, even if a company’s CG practices are good. Non-bank financial institutions are also large investors but usually follow bank policies and primarily lend to repeat clients. However, multilateral donor and lending agencies appear as major power block or change agent in almost all regards in Bangladesh. For instance, the adoption of IAS-30 was strongly advocated by the World Bank and the ADB is financing a capital market development agenda. In addition, some such agencies are also institutional investors and can use their ownership shares to encourage specific companies to be leaders in CG; ADB, International Finance Corporation (IFC), the Commonwealth Development Fund, and the Aga Khan Fund all have substantial holdings in Bangladeshi companies and in some cases hold a seat on the board. Accounting Standards and Disclosures There are two ways of examining accounting standards: (i) the statutory, legal disclosure requirements and (ii) the level of disclosure provided in everyday practice, or the compliance with the requirements. Both methods of evaluating accounting standards are utilized here.


The Institute of Chartered Accountants of Bangladesh (ICAB) has currently adopted 23 of the 32 effective International Accounting Standards26 (IAS) as Bangladesh Accounting Standards (BAS). (See Appendix I) However, in many cases the IAS has been adopted in its original form and subsequent amendments by the International Accounting Standards Committee (IASC) have not been adopted by ICAB. As a result, IAS and BAS differ in a number of material aspects. Survey results show that this discrepancy is not an issue in the preparation of accounts for most organisations, since they do not need to comply with IAS that have not been incorporated in BAS. A recent IAS adopted by ICAB is applicable specifically to banks and financial institutions, which were required to comply effective December 31, 2000. IAS-30 was first adopted by ICAB and then enforced by the Bangladesh Bank by an amendment to the Bank Company Act, 1991. Although complete adoption of IAS would be a significant step forward in financial disclosure, the U.S. Financial Accounting Standards Board (FASB) standards require an even higher level of disclosure. No FASB standards are in effect in Bangladesh. Accounting standards in Bangladesh allow for considerable discretion by the company, which can lead companies to choose the accounting conventions that show more favourable results and can prevent investors or other stakeholders from gaining a true assessment of the company’s situation. BAS do not require disclosure of all the financial and non-financial details necessary for a full assessment of a company’s operations, financial situation, and prospects. Specifically, shortcomings exist in the following areas:

Investments in subsidiaries are generally accounted for using the equity method or the cost method.

Deferred tax assets and liabilities are not recognized.

The classification rules for leases allow significant scope for discretion.

Methods for foreign currency translation and depreciation are not prescribed; notes to the financial statements are expected to explain the methods used, but do not always do so.

Outside the financial sector, segment reporting is not required and detailed classification of revenues and expenses are not necessary.

Details about the qualifications of board members, their remuneration and their attendance record do not need to be reported.

IAS on business combinations, accounting for investments in associates, and reporting interests in Joint Ventures (IAS 22, 28, 31 respectively) are not in effect in Bangladesh.

Consolidated financial statements are not provided.

In spite of the adoption of IAS-27 on Consolidated Financial Statements and Accounting for Investments in Subsidiaries, fully consolidated statements are not prepared. This stems from (i) the company ownership practices common in Bangladesh and (ii) a lack of clarity regarding definitions in relevant laws and accounting standards. Groups of companies in Bangladesh usually have common shareholders, but no parent company owns shares in each of the companies of the group and therefore the group of companies is not required to prepare consolidated statements. To achieve consolidated accounts the Companies Act should be consistent with BAS, SEC requirements, and the Bank Companies Act. Specifically, the definitions and requirements regarding holding companies, group companies, and

26 International Accounting Standards (IAS) are developed by the International Accounting Standards Board of the International Accounting Standards Committee (IASC), an independent organisation made up of professional accounting bodies from around the world. The IASC mission is (i) develop a single set of high quality global accounting standards, (ii) promote the use of those standards, and (iii) bring about convergence of national accounting standards and IAS.


consolidated financial statements should be examined. For instance, the Company Act does not require a consolidated balance sheet for a holding company, even though this should be required under accounting standards. This lack of consolidation in financial statements is a significant failing in the Bangladeshi context; transfer pricing is rampant in those enterprises that are not reflected on the accounts of the group companies. Transfer pricing is used to drain profits from a company, to the disadvantage of the common shareholders. Both the requirements and the incentives should provide a reason for consolidation. Observers have pointed out two changes that would encourage preparation of consolidated accounts. First, a change to the tax law is required to provide tax benefits to a group when there is a loss in one subsidiary of which more than 51% is owned by the group. That is, a loss in a subsidiary (a member of the group of companies) could be used to reduce taxes for the group as a whole. Second, the Companies Law could be changed to require consolidation when a company owns 51% of the equity of another company. Currently, consolidation is not required. A review of available literature and annual reports would suggest that compliance with disclosure requirements under the relevant laws and BAS is not consistent. Statements may comply with the letter of the laws and regulations, but not the spirit of the laws; even companies that comply with the statutory requirements often do not provide other relevant and material information. A study in the Bangladesh Accountant found that companies failed to comply with the Companies Act, the SEC Rules, and BAS in the following areas, among others27:

• Detailed itemization/classification of sales, revenues, production costs, investments, foreign exchange earnings, and extraordinary items

• High miscellaneous/general expense without explanation

• Accounting policies for inventories, depreciation, and research and development costs

• Overstated valuation of assets (especially Property, Plant, and Equipment)

• Contingent liabilities and future prospects

• Provision of the auditor’s report, a financial report in English, and timely provision of the Annual Report prior to the AGM

The Directors’ Report is also an area in which disclosure could be improved. Most comply with the basic requirements of the Companies Act, but best practices would mandate a more complete report. More progressive companies do include additional information, including a discussion of financial and operating results and risk factors. However, most Directors’ Reports fail to explain post-Balance Sheet developments and future prospects for the company’s core businesses. While compliance with the relevant laws and regulations on disclosure is not strong, further voluntary financial or non-financial disclosure is even less prevalent. In spite of the evidence to the contrary, an overwhelming majority, 75%, of the companies surveyed view voluntary disclosure positively. A few companies in the survey are still apprehensive about disclosing information that can be used by competitors. Moreover, possible boomerang effects like fear of harassment by tax authorities act as a major deterrent to disclosing company-specific information. The individual line-item disclosure of the salary and allowances paid to the MD of Eastern Bank provides an interesting example of voluntary disclosure.28 Since the salary and allowances were quite high (Tk. 1,380,000 in 2000 and Tk. 3,600,000 in 2001), shareholders complained about his compensation at the AGM. In spite of possible repercussions, the MD is personally committed to full disclosure and plans to continue the practice. 27 Imam, Shahed. The Cost and Management (Journal of the ICMAB), September-October 1999 28 Eastern Bank Annual Report 2001. Profit and Loss Statement.


However, other companies looking at Eastern Bank’s example might conclude that the additional voluntary disclosure would not be appreciated by shareholders or potential investors and would only cause them problems. In most economies, a company’s motivation for complying with accounting standards and providing quality financial disclosures comes not only from legal or regulatory requirements, but also from the market. Firms that produce financial statements that comply with the spirit and letter of the law receive better equity valuations, more credibility, and additional opportunities to raise capital in the equity markets. Alternately, the market usually punishes companies that do not provide full disclosure. In Bangladesh, companies are neither punished by the market, nor by the agencies tasked with regulating their behaviour. Furthermore, as discussed earlier, access to equity markets is not necessary to raise capital and a firm’s credibility is gained through other avenues. The necessary elements for the corporate sector to move toward international harmonisation of accounting standards are present in Bangladesh, but there is little momentum behind mandatory harmonisation. Further adoption of accounting and auditing standards will likely be lead by progressive companies taking a lead in voluntary disclosure and in adopting more rigorous accounting standards. If these progressive companies are seen to gain an advantage from banks in their lending positions or in the equity markets, other companies will voluntarily follow. If banks or other important investors start demanding full IAS compliance, companies will begin to comply. The motivation for adoption of more rigorous accounting standards must include an element of positive reinforcement along with more strict regulatory or legal requirements. Independent Regulators In the financial sector, the primary regulator is the central bank of Bangladesh, Bangladesh Bank, whose role has been discussed above. In the corporate sector and the capital market, the principal regulators are the Registrar of Joint Stock Companies and Firms and the Securities and Exchange Commission. The Dhaka Stock Exchange and the Chittagong Stock Exchange are two self-regulatory organisations with key responsibilities in the capital market. Registrar of Joint Stock Companies and Firms The regulator dealing with company law is the companies’ registry, the Registrar of Joint Stock Companies and Firms (RJSC)29, which is administered by the Ministry of Commerce. The functions of the RJSC are governed by the Companies Act 1994 in relation to the formation of companies, filing of statutory returns and power to call for information or explanations. Companies Rules 1941, introduced during the time of British India, containing guidelines and forms relating to the filings with the RJSC were not re-issued on the independence of Bangladesh. The power of investigation into the affairs of a company is vested with the Government. The records of the RJSC are maintained manually, except for its recent online check for the availability of names of companies for incorporation, and proposals for computerization are pending financial sanction. Records available with the RJSC should be open for inspection by members of the public. Forms that must be filed at the RJSC are based on those provided in the schedules to the Act and the old Companies Rules 1941. The forms are available for purchase through vendors sponsored by the RJSC, but are not available at the RJSC or at its website. (See Appendix H for a list of forms to be submitted to the RJSC and other regulatory bodies.) Dealings of the RJSC often overreach the statutory functions of the office, though staff admits that they are not trained on company law and the role of the RJSC. For 29 http://www.registrarofcompaniesbangladesh.com


example, although the law provides for a company to file a satisfaction of mortgage with the RJSC and for the RJSC to issue requisite notices to the mortgages before recording the satisfaction, the RJSC requires counter-signature of the mortgages prior to filing the satisfaction, which is entirely without lawful authority. This creates difficulties in that mortgages, once paid, typically have no incentive to go through their internal procedures and provide such counter-signature. Another example of exercise of discretion in an unfettered and uninformed manner by the RJSC relates to the rendering of subjective opinions on the acceptance of a company’s name for registration, and referrals are made to other bodies in the absence of any requirement to this effect. An amusing instance given to the CG Team by the erstwhile Deputy Registrar was their refusal to allow a company to be incorporated with the name of “E=MC2” without permission from the Atomic Energy Commission of Bangladesh. Official filings fees and stamp duties for certified copies are nominal. Retrieval of the manual records at the RJSC for inspection is time consuming and, as a result, services of consultants are used to obtain certified copies of any particular filing, which are available at increasing premiums. Bangladesh Bank, lending institutions and regulators require companies to submit certified copies, but in obtaining such copies the RJSC conducts a review of the entire records of a company for “acceptance” by it of all filings, including balance sheets, though there is no such power or requirement in the Act. This practice continues, despite case law that has described the functions of the RJSC akin to a post office in that the RJSC is for filing of statutory returns, and that members of the public may inspect the same and obtain certified copies thereof; the RJSC has no power to accept or reject any filings. Although the RJSC is meant to function as a depository of documents to be available to the public, it consistently overreaches its scope and makes it difficult for companies to complete statutory requirements and difficult for the public to access such documents. The RJSC deals with the registration of about 2,500-3,000 new companies each year. At present, there are about 50,000 registered companies. Exact figures are not available. The RJSC has just above 50 staff members to handle the workload generated by these companies, which, in the absence of electronic data management systems, is a difficult task. In addition, it was noticed during a visit to the office of the RJSC that several staff members were engaged in activities not strictly within the purview of the office, such as creating lists of companies classified into different fields, whereas no records exist as to how many private and public companies are there, or how many companies are limited by shares rather than guarantees. The imprecise wording of the law in relation to the actual scope of authority of the RJSC, and its lack of appreciation of such scope combine to make it a bottleneck in corporate compliance and often ineffective as a source of notice and information. Securities and Exchange Commission In the early years after the end of the British Raj, the public issue of securities was controlled by the Controller of Capital Issues (CCI) under the Capital Issues (Continuance of Control Act), 1947. The legal regime was expanded in 1969 through the promulgation of the Securities and Exchange Ordinance, 1969 (SEO 1969). Finally, in 1993 the CCI was replaced by the Securities and Exchange Commission (SEC) upon promulgation of the Securities and Exchange Commission Act, 1993 (SECA 1993). SEC: The Institution The SEC came into being in 1993 under the provisions of the SECA 1993. Initially, it had provision for a Chairman, two full time members, and two part time members. Later, the law was amended to provide for four full time members. Right from the beginning, the SEC suffered from a lack of an adequate number of staff properly trained in capital market affairs. That lack still continues. The SEC does not


have a full time Corporate Accountant in place. The current Chairman and members are not from a capital market background, and neither have most past chairmen and members been so; Commission members are usually retired public servants. The Corporate Accounts department consists of one cost accountant, two persons who have intermediate qualifications in chartered accountancy and one person who has a degree in accountancy. This department does not have the capacity to review the half-yearly accounts of the listed companies. The SEC, like other regulators dealing with corporate accounts, has to depend to a large extent on the performance of the auditors of these companies, of which much has been said elsewhere in the report. Likewise, the Commission does not have a full time corporate lawyer on board. The surveillance and investigations units are also not adequately staffed or trained. Therefore, the quality of the monitoring activities of the SEC remains open to question. A description of the powers of the SEC is given below. Since its inception, the SEC, in exercise of its powers, has brought back a measure of discipline in the corporate sector (but, obviously, limited to listed companies) in the holding of AGMs, declaration and issuance of dividends and disclosure of price-sensitive information. However, in doing so, it is seen as having at times overreached its authority or exercised it in an un-evenhanded manner. Securities and Exchange Commission Act, 1993 The SECA 1993 provides that the Commission is responsible for assuring the proper issuance of securities, protection of the rights of the investors and the development and regulation of capital and securities market. In pursuance of these goals, the SEC is empowered to take any or all of the following measures, among others:

• Regulation of stock exchanges and the securities market; • Regulation of stock-brokers, bankers to an issue, issue managers and trustees, underwriters,

registrars, portfolio managers, investment advisers and other intermediaries related to the securities market;

• Registration, regulation and management of mutual funds and similar joint investment arrangements;

• Prevention of fraudulent and corrupt trading in securities; • Provision of training in investment and the securities market; • Prevention of insider trading; • Acquiring shares or stocks of a company or taking control, and “takeover and regulation of

companies”30; • Inspection, investigation, audit, obtaining information from issuers of securities, stock exchanges

and other similar self-regulatory organizations; et cetera. No stock broker, sub-broker, share-transfer agent, banker to an issue, portfolio manager, investment advisor, underwriter or any other intermediary who may be connected with the securities market is allowed to sell or carry out business in securities except in accordance with the regulations or conditions attached to a registration certificate obtained from the SEC. The SEC is empowered to suspend or cancel any registration certificate in accordance with regulations issued under the SECA 1993, subject to providing the persons concerned a reasonable opportunity for hearing. In recent years this provision has been used quite often, and some would also say it has been over-used, in an arbitrary fashion. Numerous writ petitions are pending in the High Court Division challenging orders of suspension and

30 This may be the result of a typographical error in the Bangla text of the Act, and perhaps the correct reading would be the “regulation of takeovers of companies”.


cancellation issued by the SEC, purportedly under this provision. In most cases the ground of contention is that the SEC does not provide any adequate and reasonable opportunity for a hearing, and that SEC’s orders are non-speaking orders, inasmuch as they merely say that the explanations provided by the persons concerned are not acceptable, without stating why they are not acceptable. For purposes of illustration, a translation of the relevant portions of an SEC order is quoted below31:

Whereas a complaint has been made to the Commission against [X], a member of the Dhaka Stock Exchange for not handing over shares due to [Y], its customer, in view of which a written explanation was called for and subsequently a personal hearing was accorded; and whereas the written explanation of [X], and the statements made by it at the time of hearing are not satisfactory and the complaint of the investor appears to the Commission to be correct; … and whereas it is a principal objective of the Commission to protect the interest of the investors; … Now therefore the Commission, by virtue of the powers given under Section 20A32 of the Securities and Exchange Ordinance, 1969, directs [X] for the above reasons to repay the dues of its customer with [Z%] interest by [date].

It may be seen from this order that there is no discussion of why the explanations given by X were not found to be satisfactory, and no discussion of how the complaint of Y was found to be proven. In the notice to show cause issued to X by the SEC, which is not quoted here, X was required to show cause as to why its registration certificate as a dealer would not be cancelled, but the penalty imposed was for repayment of money together with interest, without stating the amount to be repaid. This example illustrates some of the difficulties firms face in dealing with the SEC. Under the SECA 1993, the Government reserves the power to give directions in writing to the Commission in furtherance of the Act, which it must abide by. Any person who violates the provisions this Act will be liable to not more that five years imprisonment or a fine of not more than Tk. 500,000. The SECA 1993 provides for an appeal to the SEC by any person dissatisfied and aggrieved by any order of any Member or official of the SEC, in accordance with the regulations issued in this regard. It is interesting to note that the SEC has issued an “Appeal Regulation” in 1995, which provides for certain time limits and procedures for filing such appeals. At the same time, there are other appeal provisions, for example, the Securities and Exchange Commission (Stock Dealer, Stock Broker and Authorised Representative) Regulations 2000 provide for different time limits and procedures, and these are conflicting provisions which have not been rationalized or reconciled.

Powers Under the Securities and Exchange Ordinance 1969 Securities and Exchange Ordinance 1969 (SEO 1969 or the “Ordinance”) provides the basic set of laws governing the capital market. SEO 1969 gives the SEC control over the issue of capital by companies in Bangladesh. No company incorporated in Bangladesh shall, except with the consent of the SEC make an issue of capital outside Bangladesh. Further, no company, whether incorporated in Bangladesh or not, shall, except with the consent of the SEC make an issue of capital in Bangladesh, make any public offer of securities for sale, or renew or postpone the maturity or repayment of any security maturing for payment in Bangladesh. SEC has exempted certain classes of companies from the application of certain provisions of the Ordinance The SEO 1969 has been amended several times recently to give the SEC more and more apparently unfettered rights to issue directions to capital market stakeholders. Two of the important provisions in

31 The names and figures are withheld for reasons of confidentiality 32 The text of Section 20A is given below.


this respect are Sections 2CC and 20A. By using these provisions, the SEC is creating inroads into the company law regime contained in the Companies Act, 1994. An anomalous and potentially undesirable situation is being created whereby a regulatory agency is in effect amending the provisions of an Act of Parliament, without any further reference to the legislature, and often in swift reactions to emergent situations in the capital market. Directions issued by the SEC recently have appeared to be targeted to specific companies, or in instant reaction to extreme situations, without bearing in mind the overall impact of the provisions. Section 2CC of the SEO 1969 which was introduced in 1995 deserves to be quoted in full:

Notwithstanding anything contained in the Companies Act, 1994 (Act 18 of 1994), or in any other law for the time being in force, or in any contract or any Memorandum and Articles of Association of any company, any consent or recognition accorded under section 2A, section 2B or section 2C, whether before or after the commencement of this section shall be subject to such conditions, if any, whether for immediate or future fulfilment as the commission may, from time to time, think fit to impose.

The width of this provision is almost unprecedented, and matched only by the width of Section 20A, introduced in November 2000, which is as follows:

Power of Commission to issue directions in certain cases. Where the Commission is satisfied that in the interest of investors or securities market or for the development of the securities market it is necessary so to do, it may, by order in writing, issue such directions as it deems fit to any Stock Exchange, stock broker, stock dealer, issuer or investor or any other person associated with the capital market.

The SEC has issued a series of regulations in pursuance of its regulation-making power conferred by the Ordinance. Using the powers granted under the above quoted sections of the SEO 1969, during 2001 the SEC instituted a categorization of companies on the basis of their regularity in holding AGMs and the regularity and quantum of dividends. Stocks were classified as Category A, B, or Z. Category A stocks are companies that held their AGM during the last year and declared dividends above 10%. Category B companies held an AGM during the last year, but declared dividends less than 10%. Those that either did not hold an AGM or did not declare dividends are considered Category Z companies. New issues are also placed in categories based on earnings per share. SEC notifications declared that companies which remain in the Z Category for over one year must reconstitute their board by holding an EGM within six months, the MD and Chairman should be appointed with the SEC’s approval, and new directors must appointed in proportion to groups of shareholders. The Bangladesh Association of Public Listed Companies (BAPLC) has protested the Z categorization. In January 2003, the High Court issued show cause notices, in a case brought by Shinepukur Holdings, to the SEC, DSE, and CSE questioning their legal authority to classify companies in the Z category.33 It is unusual for a securities and exchange commission, strictly speaking, to interfere directly or indirectly in a company’s business decisions, which categorization based on dividend performance is. That is the concern primarily of the shareholders and the stock exchanges. The reason often cited is the undeveloped and uninformed nature of the investors in Bangladesh. However, such measures will never lead to a more informed and developed set of investors who will be responsible for the consequences of their own investment decisions. Ensuring transparency is certainly very important, and one of the very basic necessary pre-conditions of a well-organized capital market. However, interference by the regulators on an arbitrary basis will deter even good companies from entering the capital market, which can only be detrimental to its long-term health. 33 “HC issues rule upon SEC, DSE, CSE”, The Independent. January 20, 2003.


The use of dividend payout ratio to regulate companies is an example of the SEC using performance as a proxy for compliance. There are other such examples. For instance, SEC staff explained to researchers that, when reviewing financial statements, they look for large negative changes in profits, revenues, or net income. Companies with such negative results are then investigated – the premise being that fraudulently obtained results cannot be maintained indefinitely and poor performance could indicate non-compliance with accounting standards in the past. However, there are many reasons a listed company could post poor performance besides non-compliance. In fact, performance is more likely to be a lagging indicator of non-compliance than a leading indicator. The focus on performance is an example of misunderstanding the primary role of the SEC, as well as an indication of inadequate levels of qualified staff to fully check accounts of listed companies. If one looks back at the institutional strength, or rather the lack thereof, of the SEC, the dangers of giving such wide powers to it become immediately apparent. One must assume that the legislature was fully aware of the impact of these provisions, when amending the existing laws, but the measure of confidence reposed in the SEC by the legislature may be open to discussion. There are no inbuilt safeguards against excessive and arbitrary use of these powers, and so court cases proliferate. In many cases, however, the persons against whom these powers are arbitrarily used capitulate rather than challenge the action, given the powers of SEC to “make their lives miserable.” The SEC, rather than assisting stakeholders in improving their record-keeping and other compliance measures (which is what Bangladesh Bank, commendably, does with banks), reportedly uses minor lapses to impose punitive measures. This has not been conducive to creating a healthy interrelation and any measure of predictability between the regulator and the regulated. The SEC also has powers to call for information and carry out investigations into the activities of market intermediaries and listed companies. Any officer authorised by the Commission for the purpose of inquiring into the correctness of any statement made in an application for consent or recognition to an issue of capital may order the company to submit to him such accounts, books or other documents or to furnish to him such information, as he may reasonably think necessary. The Commission also regulates the stock exchanges in Bangladesh, which must be registered under the Ordinance. The Commission has the power to inspect the books of accounts and other documents of every stock exchange. Moreover, every stock exchange must submit to the Commission an annual report and periodical returns relating the Stock Exchanges’ affairs. Where the Commission is of the opinion that a Stock Exchange or any member, director or officer thereof has neglected or failed to comply with the provisions of this Ordinance or any rule or regulation made thereunder, the Commission may suspend or cancel the registration of the Stock Exchange and/or remove the person in authority concerned. Recently, the SEC has required the Dhaka Stock Exchange to remove its Chief Executive Officer for the use of faulty software. However, that order is under challenge in the Supreme Court, again because the SEC apparently did not comply with the requirements of the law relating to due process, among others. An issuer of a listed security must furnish to the Stock Exchange, to the security holders and to the Commission an annual report of its affairs and such statements and other reports as may be prescribed. The Commission may, on its own motion or in the case of the issuer of a listed security, on representation of holders of not less than five percent of equity securities at any time by order in writing cause an enquiry to be made into the affairs of any Stock Exchange or the business or any transaction in securities by any member, director or officer of the Stock Exchange or of any issuer, or of a director or officer thereof. If any person fails to provide any document or information requested by the Commission it is empowered to fine the concerned person a sum not less than Tk. 100,000. Any person who is found to be carrying out


fraudulent acts as specified in Section 17 of this Ordinance shall be punishable with imprisonment for a term, which may extend to five years or with fine, which may extend to Tk. 500,000 or with both. There have been a spate of cases recently where the SEC has started with issuing notices to stockbrokers on the basis of complaints by investors regarding non-payment of proceeds of sale of shares or non-delivery of share certificates, to show cause why they should not dispose of the complaints, and has ended up fining, suspending or even cancelling the registration of the stockbroker for lapses in record keeping, without actually ever disposing of the complaint of the investor. It is a fact that, as mentioned earlier, the SEC’s interventions have forced listed companies to be much more regular in holding annual general meetings, declaring dividends, and disseminating price sensitive information. It is also undeniable that the weak self-governance of the stock exchanges in relation to their members, brokers and listed companies has often forced the hands of the SEC, or provided the handle for it to act in an apparently high-handed manner. Yet, after the stock market debacle of 1996-97, how far these measures have succeeded in restoring investor confidence in the market remains to be seen.

Raspit Data Management and Telecommunications Limited Raspit Data Management and Telecommunications Limited was the first IT company in the country's capital market. It invited public subscription on September 25, 2000 with a view to expanding lines of business by raising public money. The offering immediately sparked a wave of debate in the capital market due to its so-called disclosure-based prospectus, which provided inadequate and vague information on many important aspects of the company, even though the prospectus had been approved by the SEC. In addition, information valuable to the investors was blatantly missing. Disclosure that was provided also raised concerns; for instance, technical experts and investors were alarmed at a disclosure that the company was spending over Tk. 3.8 million to install an undisclosed number of telephone connections in a rented house, which would be used as an office premise for the company.

Complaints were lodged with the SEC and reported in the press claiming that the prospectus was ‘misleading to the investors, fabricated, ill motivated and lacked authentic information’. The complaints also cited anomalies in asset valuation, planned use of IPO proceeds, advance deposits and prepayments. These complaints forced the SEC to postpone the IPO and ask the company to clarify its position, obtain a report on technical feasibility verification from the Bangladesh Computer Council and re-audit their accounts. Amazingly, instead of appointing an independent chartered accountants firm itself, the SEC allowed the company to appoint a firm of its own choice. The newly appointed firm submitted audited accounts similar to the one submitted earlier that had won the SEC approval. After approval of the ‘re-audited accounts’ from the SEC again, subscription of the IPO came to the market on the first week of November 2000, six weeks after the scheduled subscription opening date. As usual for DSE, the issue was oversubscribed. At present, the scrip is traded within the range of Tk. 15-16 in both the bourses of the country, but it is learnt that the company had already abandoned its business of Internet Service Provider (ISP), for which the subscription was invited from the investors and the money spent on procuring telephone lines. The example of Raspit demonstrates that even when the SEC intervenes (i.e. requiring a new audit of the company), it may not always be carried out in a way that successfully protects the interests of investors. Institute of Chartered Accountants of Bangladesh The accounting profession can be a major proponent of better corporate governance practices. Through enforcement of accounting standards that demand further and better disclosure, investors and regulators can gain the information they need to press for change. In Bangladesh, Chartered Accountants and


auditors are regulated by a self-regulatory organisation, the Institute of Chartered Accountants of Bangladesh (ICAB). Although accountants and auditors could be better advocates for corporate governance, currently, auditors are not considered independent or sufficiently qualified to attest to the validity of a company’s statements. As evidence, it is not difficult to find examples of audited statements that clearly do not comply with the relevant standards. The Securities and Exchange Rules of 1987 require that a Chartered Accountant (CA) audit the financial statements of listed companies. The ICAB certifies Chartered Accountants and adopts and amends the BAS. ICAB Bye-laws require compliance with BAS by Chartered Accountants. However, the Companies Act does not require compliance with BAS. ICAB would like the Companies Act to be amended to provide additional legal requirements and penalties to encourage compliance with BAS. There is also an Institute of Cost and Management Accountants of Bangladesh (ICMAB), which does not as yet have a similar compliance function. The number of accountants in Bangladesh is lower than would be expected for the number of companies in Bangladesh. According to ICAB, of approximately 700 members only 250 are practicing as Chartered Accountants in Bangladesh.34 A recent World Bank critique of the accounting profession in Bangladesh highlighted the need for better accounting training.35 The report blames the low supply of accountants on the lack of training facilities and support for trainees and the low demand for accountants. Although the number of trainees is in the thousands, only 20-40 Chartered Accountants obtain their certification each year. There is also a low demand for accountants in the country because firms do not see the value in an accountant over other types of financial professional (MBA, commerce graduate, etc.). Similarly, there is little value placed on an audit and audit fees are quite low. Our survey supports the assertion that audit quality is not sufficient for firms to place a higher value on their auditors. ICAB believes a primary problem with the current audit system in Bangladesh is the low level of fees paid to auditors. ICAB has recently issued a recommended fee schedule for audit fees based on the category of company and the size (based on assets/turnover). The minimum recommended audit fee for a listed company is Tk. 60,000 for a company with gross assets not exceeding Tk. 10 million. Current audit fees can be as low as Tk. 10,000 to Tk. 15,000 for such a company. Current fees are at a level that can barely cover an auditor’s costs and it would seem almost impossible that a proper audit could be completed for such a low fee. Audit fees for a company are set by the Board of Directors and approved by shareholders, but shareholders are usually against paying higher fees for the audit. Shareholders believe auditors are aligned with the Board of Directors and are not representing the shareholders’ interests and are therefore unwilling to pay more or consider other factors in auditor selection besides fees. This perception is supported by our survey; CEOs and Managing Directors said that auditors are not independent of the company they are auditing and often try to serve the interests of the person recruiting them. The auditing function would seem to represent a vicious circle; auditors are not perceived as independent and do not provide quality audits, therefore companies and shareholders are not willing to pay high fees for an audit. The low fee structure, in turn, does not provide an incentive for auditors to provide quality personnel and audits. To improve the situation, auditors must start to provide high quality audits, but simultaneously shareholders should be educated regarding the function of an audit and should know what to expect from an auditor. Companies in our survey also believed that if regulators emphasize the importance of audit, remuneration for auditors and audit standards would improve.

34 Institute of Chartered Accountants of Bangladesh. List of Members and Firms 2002-2003. 35 World Bank. Bangladesh: Financial Accountability for Good Governance, 2002


One way audit quality can be improved is through more stringent enforcement of audit and accounting standards by ICAB. ICAB can discipline its members for violations of its Bye-laws and Code of Ethics, but to date the self-regulation function has been largely ineffective. In September 2002, ICAB suspended Haider Ahmed Khan for a period of three years for auditing violations36, but prior to this suspension disciplinary actions have been rare. The disciplinary process is initiated when a complaint is received against a CA. ICAB then institutes a hearing process, during which a CA may still practice but the fact of an allegation against him or her is publicly available. As a quasi-governmental regulator, ICAB encounters a similar problem with its enforcement mechanisms as other governmental regulators; ICAB decisions can be appealed to the courts and the judicial process delays the implementation of a judgement. The recent suspension of an ICAB member is currently in the courts, so the suspended member still has the ability to practice. Overall, ICAB has not proven to be an effective body for enforcing accounting and auditing standards on its members. Another possible reason for the lack of compliance with BAS is a lack of training and education regarding BAS and IAS. In 2002, ICAB began requiring members to attend at least twelve hours of Continuing Professional Education seminars each year. The seminar topics include accounting standards, as well as other profession topics like communication skills. In cooperation with the World Bank, a recently completed project has focused on the application of IAS, both those adopted as BAS and those not yet adopted. These types of seminars will hopefully improve the knowledge of CAs regarding accounting standards, but this measure is very recent and strong enforcement will still be necessary to improve the quality of financial statements. The CG survey found that audit quality is a source of major discontent amongst most firms; 62% of organizations expressed dissatisfaction with external audits. Firms cited a range of problems including: inexperience of the auditors, a lack of professionalism and objectivity, and a mismatch between the fees they are charging and the actual value they are adding. A new law from the SEC states that auditors must be changed every three years but the requirement can be waived if a company has a high dividend yield. This rule confuses the successful operation of with the auditor’s performance; a good audit can be completed on a failing company and indeed a poor audit can boost a failing company’s financial performance, at least on paper. Audit firms have recently begun to ask firms for an indemnification from liability before certifying accounts. Indemnification is in direct conflict with the legal requirements of an audit and removes the motivation for an audit firm to accurately and fully certify financial statements. It was a widely held view among stakeholders that rigorous auditing practices would improve corporate governance in large measure almost immediately. In interviews and the literature review a number of suggestions for improvement in auditing were put forward. First, additional classification or standardization of auditors may be a prerequisite for audits to become a trusted tool for better CG. Regulatory bodies and investors already have their own list of quality auditors and companies are encouraged to use those firms for their audits. For instance, additional training and certification, beyond the CA qualification, could be required for auditors of listed companies. Second, the World Bank has encouraged the adoption of a sub-professional accounting qualification. Sri Lanka has successfully introduced an Accounting Technician qualification to increase the supply of quality accounting personnel. A similar sub-professional qualification in Bangladesh could provide an opportunity for talented individuals who do not have sufficient educational background to complete the full Chartered Accountancy certification and could reduce the dropout rate of trainees. Significant improvement in the perception and practices of Chartered Accountants and the accounting institutes is needed before they will become a trusted pillar of CG in Bangladesh. 36 Institute of Chartered Accountants of Bangladesh. List of Members and Firms 2002-2003.


Mark Bangladesh Shilpa & Engineering Company Limited Mark Bangladesh Shilpa and Engineering Company Limited (Mark), a leather shoemaking company, invited public subscription for Tk. 60 million during April 6-15, 1997 amid a wave of controversial press reports and commercials claiming that a number of reputed shoemakers were ‘regular’ buyers. The claims were instantly denied by those buyers. The issue was able to gain approval from the SEC, with amazing speed, and the company collected a subscription of over Tk. 390 million against an offer of Tk. 60 million in an overheated market. As soon it transpired that much of the information furnished in the prospectus was not only inadequate and vague, but also materially misleading, the SEC was forced to review the revaluation of Mark’s assets and found that the prospectus showed assets worth Tk. 190 million, which were actually worth no more than Tk. 50 million. There was clearly negligence in the due diligence carried out. The Tk. 100 share (with Tk. 100 premium) now sells at Tk. 26 in the bourses. The SEC has reportedly initiated legal action against the issue and the auditor of the company.

Role of audit committees and risk management arrangements The problem of financial statements that accurately reflect the position of a company cannot be laid solely at the feet of auditors, although strengthening of the auditors’ function could produce significant dividends in investor confidence. Auditors are an important watchdog for investors and the general public, but are not involved in actual process of drawing up the accounts. Internal process at companies must also ensure that accurate accounts are presented to auditors and that accounting standards are followed in the process. At the BEI seminar conducted in January 2003, participants commented that the regulatory framework for corporate organisations should provide guidelines that oblige finance and accounting personnel to follow the relevant accounting standards when drawing up accounts. One method that the Board of Directors can use to ensure that accounts are prepared properly is an audit committee of the Board. An audit committee oversees the internal audit process and should have enough financial experience to evaluate the quality of internal and external audit processes. The OECD Principles of Corporate Governance do not explicitly call for an audit committee but a key function of the board is “ensuring the integrity of the corporation’s accounting and financial reporting systems, including the independent audit, and that appropriate systems of control are in place, in particular, systems for monitoring risk, financial control, and compliance with the law.”37 Audit committees are not widespread amongst public listed companies in Bangladesh and do not exist at all in private companies. Only three companies in the survey had audit committees. Nominee and remuneration committees are also non-existent in the companies interviewed. The check-and-balance mechanism in 33% of the organizations is in the form of internal audit in light of the general lack of confidence on external auditor capabilities as mentioned above. Banks have a much more stringent risk management procedure in place – audits are performed at three levels by external audit, Bangladesh Bank, and internal audit teams. However, audit committees of bank boards of directors are still uncommon. A draft circular requiring audit committees on bank boards has been issued by the Bangladesh Bank; the BB is currently receiving comments on the proposal. The Judiciary The judiciary in Bangladesh is largely based on the structure established during the period of British India and later formalised under the Constitution of Bangladesh 1972, as comprising of the Supreme Court of Bangladesh, with two divisions: the High Court Division and the Appellate Division, the latter serving as 37 OECD Principles of Corporate Governance, p 43.


the last court of appeal, and subordinate courts. The several levels of subordinate courts possess jurisdiction based on monetary amount of claims or subject matter. The courts adjudicating debt recovery matters are presently ranked as Joint District Courts, which at the highest level of the lower courts. Appeals from such courts lie to the Supreme Court of Bangladesh. The quality of subordinate courts is the focus of numerous judicial capacity building projects. Such projects are topic specific, and structural reforms are awaiting the long-proposed separation of the judiciary from the executive arm of government, which is currently vested with the power to appoint judges and perceived to thereby exert political influence. Projects for judicial capacity building have not focused on the outdated curricula of legal education institutions to include financial laws nor does the vocational training of lawyers include the peculiarities of the specialised courts, such as the Artha Rin Adalat [Money Loan Court] for debt recovery by banks and financial institutions, the Bankruptcy Court and a court of the High Court Division conventionally referred to as the “Company Court”. The Company Court is vested with original jurisdiction on matters referred under the Companies Act 1994 in addition to jurisdiction for hearing other matters, and is consequently beleaguered with the disposal of backlog of cases on various subjects. Proposals continue to be made for a separate court in the High Court Division to dispose of financial cases and their appeals, including those related to debt recovery and securities laws. General opinion is against the transfer and vesting of such jurisdiction to a statutory body, which may compound the bureaucratic issues with existing government authorities and bodies involving officers with inadequate knowledge on administering financial matters. The High Court Division in the exercise of its jurisdiction for judicial review hears petitions challenging the actions of regulators such as the SEC and Bangladesh Bank, which are considered to have been taken without lawful authority or in improper exercise of their legal authority. State-Owned Enterprises The state-owned sector in Bangladesh is large and a discussion of corporate governance would not be complete without an examination of the prospects for this sector. The non-financial enterprises owned by the GOB are administered through 38 corporations. The 38 corporations are active in manufacturing, utilities, transport and communication, trade and commerce, agriculture and fisheries, construction and real estate, and various other services. In addition, there are governmental commercial agencies: Bangladesh Railway, Bangladesh Telephone and Telegraph Board, the Post Office, Bangladesh Television, Bangladesh Sangbad Sangstha (news organisation), Radio Bangladesh, and others. Besides the non-financial corporations and agencies, there are a number of state-owned banks, specialized development banks, specialized financial institutions, and insurance companies. The state-owned sector, particularly in manufacturing, is characterized by negative net worth, negative funds flow, high leverage, negative profit margins, and technical insolvency. Although considered autonomous units, state-owned enterprises (SOEs) report to their respective sector ministries. Therefore, operations in SOEs are primarily politically motivated and lack a commercial focus. Modern business management and corporate governance structures have not been implemented, which makes most SOEs unable to compete in a liberalized market. The inability to restructure SOEs and improve their management practices makes the process of privatisation difficult. The primary agency for oversight of SOEs is the Office of the Comptroller and Auditor General (CAG). It audits all statutory corporations and commercial enterprises in which the government owns 50% or more of the shares. CAG audit reports are passed on to the Public Accounts Committee (PAC) of Parliament. The PAC is responsible for taking action on the basis of the CAG audit reports. Neither the CAG nor the PAC effectively complete their tasks; both entities display a lack of properly trained


personnel and/or misallocation of skilled personnel, corruption, long delays, and a scope limited only to the accounts and not to overall financial management or performance. As a result, action is rarely taken against irregularities and wrongdoers are not penalized.38 Therefore, SOEs are subject to little or no financial or managerial oversight from their majority shareholder, the government. Poorly performing non-financial SOEs are also a drain on the state-owned financial sector. The state-owned banks often have to extend new loans to defaulting SOEs based on requests routed through the Ministry of Finance. In 1999, a list of the top 20 loan defaulters included eight SOEs - the SOEs constituted an astonishing 67% of the total default amount of the top defaulters. The situation has not improved since.39 The burden of non-performing loans has been an obstacle to privatisation of state-owned banks, since few private buyers are interested in taking on that potential liability. Recently, there seems to be some consensus from the government that these non-performing long-term “assets” cannot be transferred to private buyers, although there has been no official decision. If the government separates the non-performing and/or classified loans from the state-owned banks, they could be transferred to an independent entity for collection and management. Improvement in CG in SOEs is likely only with privatisation or closure of loss-making SOEs. There has been some privatisation or closure SOEs, but the progress has been slow. The Privatization Board was established in 1993 and tasked with the disposal of government shares in SOEs. Later the Privatization Board was changed to a Privatization Commission. An analysis of the privatisation process by AIMS of Bangladesh Limited found that individual privatisation transactions are lengthy and that tenders are often repeated seeking satisfactory results. Sales are also bogged down in litigation concerning title to assets, title to land and claims by the relevant ministry even after acceptance of a tender offer. The report by AIMS identified a number of reasons for the delays in the privatisation process. First, there are significant conflicts of interest by ministries that would like to retain control of the SOEs and ministries often interfere in the privatisation process. Second, repeated tenders by the Privatization Commission seeking a higher price lead to delays. Third, the PC does not carry out proper analysis of an enterprise to prepare it for sale and valuation reports are not adequate for a realistic, independent business assessment. Fourth, several companies have liabilities that exceed asset values and cannot be sold without debt write-off or restructuring. Fifth, the Privatization Commission addresses issues of valuation, debt restructuring, and identification of privatisation candidates in an ad-hoc, case-by-case manner. The Commission needs a strategic plan for the privatisation process, which will create policies for dealing with these common problems. Sixth, as is the case with many government agencies, the Privatization Commission is politicised and staff do not have the skills or experience for the task.40

Our survey included interviews with two SOEs: Bangladesh Chemical Industries Corporation and Bangladesh Textile Mills Corporation. Both were formed in 1972 as direct consequence of Presidential Order 27 (Bangladesh Industrial Enterprises Nationalisation Order 27 of 1972). These organisations are accountable to their respective Ministries – budgets are approved by the Ministry of Finance and the approved budget becomes the primary tool for subsequent year’s financial targets. The check-and-balance mechanism exists in the form of three audits: internal audit, government commercial audit, and external audit. Performance is evaluated through preparation and discussion of monthly performance reports showing achievement against pre-determined targets and variances.

38 Transparency International Bangladesh, Office of the Comptroller and Auditor General (CAG), Executive Summary and Working Paper, September 2002 and Standing Committee on Public Accounts, Executive Summary and Working Paper, September 2002. 39 Sayeed, Yawer. Bangladesh: Strategic Issues and Potential Response Initiatives in the Finance Sector: Banking Reform and Development (BRD), Asian Development Bank, July 22, 2002 40 AIMS of Bangladesh Information and Marketing Services, March 2002.


Senior officials in these organisations mentioned a number of significant drawbacks to better performance in SOEs. First, there is no reward or penalty for non-performance; therefore employees have no genuine incentive to strive for better achievement. To achieve greater accountability, managers need to have the ability to delegate and assign full responsibility. Second, the quality of people is also a major impediment to performance. Third, procedures are very system-based even if the system is not effective; for instance, after conducting a tender, there is no guarantee that the option selected is the most economic one in the long run. Finally, government interference in the form of price controls hinders the enterprise from being commercially run. In summary, appreciation of corporate governance is not likely to develop in traditionally run SOE sectors, at least in the medium term without privatisation or a focus on commercial objectives. A shift towards achieving commercial targets and improving overall financial management will make the privatisation process easier. However, if incentives are not aligned with performance, the acceptance of anything new by the people down the ranks will never occur. Existence and Role of Pressure Points The drive for better corporate governance can come from shareholders, investor associations, institution investors, and the financial press. Each of these potential actors is weak in Bangladesh. First, the financial press is weak and the constituency for detailed financial reporting is limited. Furthermore, the numbers of journalists who have the knowledge and expertise for such reporting are limited. Even if there were knowledgeable financial reporters and a market for their analyses, the information provided by companies and regulatory bodies is inadequate. Apart from some high-profile investigative reports, many of which are summarized in this report, a majority of the financial stories in the media consist of company press releases. Second, public shareholders do not join together in shareholder associations to demand better company performance or to assert their shareholder rights. Even in cases where the public holds a majority of shares, the treatment of shareholders is poor. Given that majority shareholders have not asserted their rights, minority shareholder rights are not a priority to most public corporations. Third, there are only a few institutional investors in the country and they often do not exercise the power that they hold. In most capital markets, institutional investors like insurance companies, pension funds, and mutual funds hold power over substantial sums of investment capital and demand strong performance and transparent corporate governance. In Bangladesh, there are only a few institutional investors, most of which are state-owned enterprises (SOEs). State-owned institutional investors have no performance motivation to force companies to improve performance, voluntarily disclose information, or improve corporate governance. The few private investors do not have enough clout to force large scale changes in the corporate sector. As a corollary, the venture capital industry also does not exist. Most companies do not think they are candidates for foreign investment, so there is no push from the international economic community for better CG. No Bangladeshi company is listed on exchange outside the country. Moreover, Bangladesh does not have a Sovereign Credit Rating (SCR) provided by any of the international rating agencies; rather other international bodies that do pass judgement on Bangladesh’s creditworthiness, rate it poorly. For instance, the Economist Intelligence Unit gives Bangladesh a country risk score of 65 out of 100 – the worst rating in South Asia. An earlier approach to the finance ministry to have the country rated by an international rating agency in 1998 was not successful.41 At that time, it was anticipated that Bangladesh would be rated “B”, not a bad reflection since Pakistan and Turkey were rated 41 IDCOL Newsletter, August 24, 2001


“CCC” and “B” then respectively. But the government had felt that such a rating had the potential to become a “double-edged sword” politically. On a positive note, interestingly, multinational companies have emerged as a positive force in the general business environment creating pressure for others to conform. For instance, companies like British American Tobacco and Lever Brothers Bangladesh have proactively come forward with their own findings and statistics on tax evasion by competitors in their respective sectors. Driven by their own self-interests, they have succeeded though in bringing about redress at the National Board of Revenue. Conclusion As is documented in this report, failings in institutions, government agencies, legal enforcement, and market behaviour have resulted in weak corporate governance in Bangladesh. The report is designed as a diagnostic tool from which a consensus will emerge regarding the way forward for Bangladesh. The authors hope that this report will start a dialogue amongst stakeholders about specific measures that can be taken to improve the transparency and accountability of the corporate sector and strengthen institutional support for good corporate governance. At this stage, only very broad recommendations are provided, identifying institutions or sectors that should be studied further. Specific recommendations will be framed in subsequent stages of this project. Corporate Governance is a term that describes the interaction of government regulators, shareholders, boards of directors, independent observers, auditors, accountants and managers to provide quality information to shareholders, the market, and society at large. Each stakeholder plays an important part to creating an environment where transparency and accountability are encouraged, enforced, and rewarded. For Bangladesh, the first step in strengthening the role of stakeholders in corporate governance is raising their awareness regarding these issues. This report attempts to start that process. For companies to have sufficient motivation to disclose information and improve governance practices, the relevant stakeholders must place a value on that information and there must be consequences for corporate governance practices. In many cases, the current system in Bangladesh does not provide sufficient legal, institutional, or economic motivations for stakeholders to encourage and enforce good corporate governance practices. As a result, there are few rewards for companies that institute good corporate governance practices and no penalties for failing to do so. Targeted reforms in institutions or sectors can begin to provide the internal and external motivation for transparency and accountability that will lead to better corporate governance. The institution or sectors that should be examined further to develop reform recommendations are explained below. Independent Regulators Independent regulators in Bangladesh relevant to corporate governance consist primarily of the RJSC, SEC, Bangladesh Bank, CSE, DSE and ICAB. The RJSC and SEC are two government agencies which should be studied further to develop recommendations for reform. They exhibit many of the failings of government agencies. On the whole, they lack sufficient staff and expertise to carry out their assigned functions in a consistent and thorough manner. However, both the RJSC and the SEC often impose requirements that are beyond their legal scope and use their power to produce arbitrary rules and rulings. Although the SEC has been successful in forcing companies to hold AGMs and provide disclosures, it has gained a reputation for filing unwarranted complaints against companies and also has focused on financial indicators that are outside its purview (i.e. declaration of dividends). The RJSC is meant primarily to be an agency in which documents are deposited and from which the public can obtain information. However, companies and the public must often go through outside consultants to obtain forms or documents that should be provided directly from the RJSC. Of the government regulators, the RJSC and SEC have the most potential for strengthening and require further study.


ICAB and the auditing profession must also be key participants in any effort to improve corporate governance. Both government regulators and shareholders rely on auditors to ensure the accuracy and authenticity of financial accounts. Due in part to the accounting standards and disclosure requirements that are behind international standards, audited financial statements in Bangladesh do not provide a clear and true picture of a company’s position. Companies do not feel that auditors provide a value-added service and therefore do not pay high fees for an audit. To improve the situation, ICAB’s ability to train accountants and auditors and enforce auditing standards should be strengthened. Also the fee structure for auditors should be examined by companies and other stakeholders; current auditing fees are too low to expect that quality personnel and sufficient time are allocated to complete a thorough audit. In addition to the auditing profession, a full study of accounting standards should identify priorities for adoption of international accounting standards. Currently ICAB has adopted about half of the international accounting standards. The process of adoption of current IAS should be accelerated since the lack of adoption creates loopholes for companies to hide affiliations and liabilities. One particular accounting practice that is particularly lacking in Bangladesh is that of consolidation of accounts of related companies. Company Directors As the other pillars of corporate governance begin to strengthen and provide support for better corporate governance practices, the role of corporate boards of directors and the directors individually must play a key role. Currently, most corporate directors do not know their legal responsibilities and therefore do not carry out their duties with sufficient diligence, nor do they act as advocates for shareholder interests. In fact, there is virtually no forum for directors to carry out their proper function. Board meetings are not usually substantive and all board members are not expected to make real contributions to the running of the company. For a variety of reasons, AGMs are not a useful forum for communication between boards and shareholders. There are a number of roots of this weakness in the corporate boards. Part of the problem lies in the expectations of a company regarding its board. Also, there is a lack of qualified, independent directors. Furthermore, there are currently no professional qualification requirements or prerequisite training for directors, although Bangladesh Bank has begun to introduce some requirements. A common requirement by banks that all directors, not just managing directors, guarantee bank loans provides a major disincentive to qualified persons serving on boards. In addition, there are no requirements that boards include independent directors. Independent directors that do serve on boards rarely serve as advocates for minority shareholders or provide an outsider’s assessment of the company. Finally, shareholders also lack information about their directors; directors’ qualifications, board meeting attendance, and nomination procedures are not required to be disclosed. The issue of directors’ qualifications and responsibilities and specifically whether independent directors would solve these problems deserves further attention. Shareholders and the Capital Markets One of the symptoms of the weak capital market in Bangladesh is the lack of active shareholders or institutional investors. There are only few private institutional investors, no shareholder associations, and no equity research houses. Therefore, the population of shareholders with sufficient knowledge and skills to understand company operations and hold management and the board of directors accountable is very low. Shareholders can be vocal on a few issues (for instance food at an AGM), but overall do not spend time or attention on issues of performance, business strategy, future business plans, disclosure, and process that could give them a greater voice in the policy decisions of a company. Correspondingly, there is very little awareness of shareholders’ rights and responsibilities. Generally, minority shareholder rights are sufficient to enable them to enforce corporate governance standards, but minority shareholders do not often exercise their rights. This institutional weakness in the capital market may slowly change as private mutual funds and insurance companies become a larger part of the market, if and when the existing bottlenecks are removed. However, there is some scope for immediately increasing the awareness and


knowledge of individual shareholders regarding corporate governance practices and shareholder rights. For instance, shareholders could become vocal supporters of companies adopting international accounting standards or establishing audit committees. Banking Sector Since the banking sector provides the primary source of capital to business organisations in Bangladesh, any examination of corporate governance practices must examine the role that banks can play in enforcing better corporate governance. Barring the few foreign banks, most banks do not have quality credit analysis and asset management practices in place. This, along with inadequate enforcement of creditor’s rights, has lead to high rates of classified loans and non-performing loans. There are designated Money Loan Courts for pursuing loan defaulters, but these have been slow to provide judgements and actual recovery rates have been low. New accounting standards and initiatives from Bangladesh Bank may begin to improve the situation of asset quality at banks, but there is still considerable scope for banks to include stringent financial requirements as well as corporate governance factors in their evaluation of companies. In addition to loan default, the combination of the bankruptcy law and its ineffective implementation make it nearly impossible for a company to close or declare bankruptcy. Court authorities prefer to try and salvage a sick company instead of allowing it to die and, therefore, inefficient allocation of resources is simply perpetuated. There is a need to examine the process for winding up and bankruptcy, specifically for reasons of overdue indebtedness. The combination of banking practices and legal inefficiencies with regard to financial issues has put the health of the banking sector in serious doubt. Each of the factors mentioned above should be examined with respect to strengthening the banking sector and improving corporate governance practices. Next Steps In short, further work should concentrate on the following areas to develop specific recommendations for reform:

• Registrar of Joint Stock Companies • Securities and Exchange Commission and the capital market environment • Institute of Chartered Accountants of Bangladesh and the auditing profession • Adoption of International Accounting Standards • Examining the requirements for and qualifications of directors, including independent directors • Shareholder education and awareness of corporate governance • Strengthening banking practices and encouraging the inclusion of corporate governance issues in

credit analysis This project aims to identify the areas where reforms could improve corporate governance by examining the experiences of companies in Bangladesh, international corporate governance guidelines, and the examples of other South Asian countries. The ultimate impetus for better corporate governance must come from domestic forces and institutions. Unlike some other developing countries, pressure from international portfolio investors or the hope of accessing international equity markets is not a realistic objective for a majority of corporate bodies in Bangladesh. Moreover, attracting international capital may prove to be an elusive goal until the domestic investor community itself shows confidence in the corporate sector.


Appendices Appendix A. Terms of Reference for Country Partners The Country Partner (CP) should refer to the Project Proposal as background to these ToRs. 1. Objectives 1.1 The CP’s objective in Stage 1 is to ensure that a firm foundation is provided for the work to be carried out in Stages 2 and 3 of the Project. The Project will aim to place CG on the agenda in Bangladesh, where it has yet to command significant attention; the Project will further aim to formulate broad recommendations for reform and, not least of all, present strategies for intervention in 2 areas; Each CP’s work should be conducted with these considerations in mind and their objective is accordingly to provide the necessary inputs. Regard should be maintained for the overarching scheme of the Project: Stage 1 Country Studies

Stage 2 Synthesis for Bangladesh

Stage 3 Design of Intervention

2. Scope of Work

The Scope of the Work is determined by considering the inputs necessary, ultimately, for the design of intervention strategies.

2.2 The CP will undertake the following work in relation to each of the areas identified in the Project Proposal and in the Key Issues and Areas section below, having regard to the OECD Corporate Governance Principles:

A review or survey of literature relating to CG in each country;

a) Identification of major features of the CG landscape in each country, including existing strengths and weaknesses; reviews of the operation of key existing institutions bearing upon the CG climate;

b) Identification of disparities between the theory – namely that to which law and institutions are stated to aspire - and what in practice takes place and an analysis of the causes of such disparities;

c) Examination of arrangements in place for enabling good CG; such analysis , and in particular, by way of case studies focussing on:

i) Successful arrangements, institutional or otherwise, and the incentive structures underpinning the success of such arrangements, bearing in mind that the mere existence of the ‘right’ laws or legal or institutional environment is not enough: the greater question is why such laws are adhered to; what incentives are in place or why and how do the institutional arrangements operate to create the right incentives?

d) Unsuccessful initiatives and the causes of continuing behaviour deviating from principles of good corporate governance.

e) Evidence (including anecdotal and circumstantial) of indicative improvements in company performance and increased investment resulting from better corporate governance.

f) In the case of the Bangladesh study, the CP in addition to the foregoing will further undertake a survey of a number of companies;


� the type of companies to be surveyed will include listed and non-listed public companies, family-owned, mixed enterprises, joint ventures and state-owned enterprises (where these are constituted as public-limited companies and have been prioritised for privatisation) and also private limited medium-sized enterprises which will constitute approximately 20 per cent of the overall number; financial institutions, including banks and insurance companies, will be included in the survey;

� the number of companies to be surveyed will be between 50 and 60;

(ii) A detailed mapping of the key existing institutions bearing upon the CG climate, assessing their effectiveness, assessing their susceptibility to change, identifying potential agents of/resistance to change within those institutions, identifying impediments to reform both historically and potentially;

(iii) A detailed mapping of the topical areas (see later) again with regard to susceptibility to reform;

(iv) A detailed mapping of the stakeholders, identifying where stakeholders incentives are aligned, where they are at odds and where opportunities may exist for constituency building. The task would be approached on a practical, not theoretical level, the ultimate purpose being borne in mind, namely to formulate a strategy for intervention;

(v) The drafting of preliminary and broadly worded recommendations for reform; here considerable assistance may be obtained from existing codes, guidelines and principles such as the OECD Principles of CG or the corresponding Commonwealth Secretariat guidelines.

3. Key Issues and Areas

In approaching the problem, it will be useful to define corporate governance in terms of aspects that are external to companies, and those that are internal to them.

3.1.1 External aspects. These deal with the corpus of corporate law and legal practices that govern the conduct of a company, the role of independent regulators, as well as the role of civil society.

(a) General corporate laws. This would involve analyzing the corporate legislations of the four countries, and what the legal framework has to say about the rights of shareholders, minority shareholders, portfolio investors, various types of creditors, voting rules, conduct of shareholder meetings, other stakeholders’ rights, disclosures, etc.

(b) Governance of banks and DFIs and the bankruptcy restructuring and liquidation processes. Given that the vast bulk of South Asian companies — especially the dynamically efficient SMEs — substantially rely upon funding from banks and development finance institutions (DFIs), it is critical to have a specially section devoted to the de jure and de facto corporate governance relationship between companies and their major debt-holders. This will involve two key areas:

(i) Procedures for sanctioning, disbursing and monitoring loans, including non-performing loan assets. An unfortunately oft-ignored aspect of corporate governance is that of banks and DFIs. The health of the corporate sector has much to do with the health and governance practices of financial institutions — the more so in countries that rely much more on debt financing rather than equity. Healthy procedures and norms help corporate and financial sector growth. The experience of the Asian crisis in 1997-98 clearly demonstrates what poor governance relations between borrowers and lenders can do for the health of both.


(ii) Bankruptcy restructuring and liquidation laws and procedures. No country can have good corporate governance standards with poor bankruptcy laws and processes. Poor recovery and bankruptcy processes debase the ex ante disciplinary role of debt, encourage poor evaluation of risk, misallocate capital, and eventually create a milieu of a sick financial sector which starves the needy because of the lack of recourse to proper bankruptcy. Most South Asian nations have relatively inefficient bankruptcy, foreclosure and securitisation processes. And it is very necessary that the study points out such drawbacks, and suggests methods of reform.

(c) Role of independent regulators. This will examine first the existence of independent regulators in South Asia; then evaluate their role in fostering corporate governance; and, using best practices, suggest the reforms that need to be carried out in the future. The regulators that ought to be considered are (i) the central bank, (ii) the capital or stock market regulator, (iii) the boards of stock exchanges, (iv) regulators dealing with corporate law and (v) the quality of the judiciary.

(i) Pressure points: the role of civil society. Undemocratic polities (political systems) usually tend to have poor corporate governance. Sustained corporate governance requires a strong financial press, active shareholder associations, and consumer rights bodies. How strong and relevant are these in the four South Asian countries? And what can be done to strengthen them? What evidence is there of organisations introducing corporate social responsibility policies and procedures?

(d) Internal aspects. These deal with matters that are internal to companies. The key areas that the study would need to focus on are:

(i) Role and composition of the board of directors. Directors are the chief fiduciaries of any company. What are the legal aspects that determine the role and composition of boards. More important, do corporate boards in South Asia do what they are expected to do?

(ii) Independent directors. The need for and the role of independent directors. What attributes are required? Do boards have an adequate representation of such directors? Is the lack of independence at the board level a ‘supply-side’ problem (lack of enough such directors) or a preference issue (no felt need for having such directors), or both? How trained are directors about their role, liabilities and fiduciary responsibilities? Is there a case for intervention through focused director training programmes? Use of corporate role models from the region.

(iii) Role of audit committees and risk management arrangements. The role and importance of audit committees. What should such committees do? Which companies have successful and recognized audit committees? How can one build a well performing audit committee of the board? What arrangements exist for effective risk management?

(iv) Conduct of board meetings. The frequency of board meetings. Quality of agenda papers. How early are the agenda papers sent to the directors? Quality of discussions on substantive issues? Attendance record of directors. Is there a case for video and teleconferencing?

(v) Disclosures at the board level — what should be the minimum, and what compares with best practices?

(vi) Conduct of shareholder meetings. How frequent are these? Is there proxy voting? Is there cumulative voting? Are shareholders sent notice of meeting well in advance? Do shareholders and institutional investors get the right to speak and/or dissent?

(vii) Extent and quality of financial and non-financial disclosures. The qualifications of board members, their remuneration and their attendance record. The quality of a company’s Management Discussion and Analysis. Distribution of shareholdings. Evaluation, quantification and explanation of


various risk factors. What are the accounting practices? Are the revenues properly recognised? Do companies follow consolidation? Are related party transactions fully disclosed? Is there adequate segment reporting? Is there provisioning for deferred tax liabilities or assets? Are contingent liabilities fully disclosed in a comprehensible manner? Are investments in and loans to group companies clearly highlighted? Are debt exposures highlighted with their corresponding maturities? What has been the utilization of public funds raised in the last three years? And much more.

(viii) Accounting standards. How do the four nations rank in terms of (i) accounting standards and (ii) quality of accounting professionals? Is there need for tighter standards? How can these be implemented? What is the need for additional training, and who can play the role of trainers?

4. Timing

The draft recommendations for reform will constitute a separate document from the remainder of the work which will be supplied in the form of Report. In the cases of Bangladesh, Pakistan and Sri Lanka, the deadline for all deliverables will be 10 October 2002. In the case of India the deadline for all deliverables will be sixty days from the start date of the Project.


Appendix B. List of Organisations Interviewed

Public & Public Listed

(Non-Financial Institutions) 1. Advanced Chemical Industries 2. Apex Tannery & Footwear 3. Bangladesh Lamps 4. Bengal Fine Ceramics 5. Beximco Pharma 6. BOC Bangladesh 7. GMG Industrial Corporation 8. Rahim Textiles 9. Renata 10. Singer Bangladesh 11. Square Group

(Financial Institutions) 12. AB Bank 13. Al Baraka Bank 14. Eastern Bank 15. Industrial Development Leasing Company (IDLC) 16. Infrastructure Development Company (IDCOL) 17. Reliance Insurance 18. Southeast Bank

Private

1. Elite Garments 2. Fortuna Garments 3. Daily Star 4. Grameen Phone 5. Holcim 6. Kafco 7. Lever Brothers 8. Navana Group 9. Pacific Telecom 10. Transcom Group

State-Owned

1. Bangladesh Chemical Industries Corporation (BCIC) 2. Bangladesh Textile Mills Corporation (BTMC)


Appendix C. List of Corporate Governance Stakeholders Interviewed Institution Person Interviewed

Securities & Exchange Commission Mr. Maniruddin Ahmad

Chairman

Bangladesh Bank Mr. A. M. Kazmi Executive Director

Metropolitan Chamber of Commerce & Industry Mr. Tapan Chowdhury President

Registrar of Joint Stock Companies Mr. N. M. Moniruddin Haider Registrar

Chittagong Stock Exchange Mr. Waliul Maroof Matin CEO

Ministry of Commerce, Government of Bangladesh Mr. Amir Khasru M. Chowdhury Commerce Minister

Foreign Investors’ Chamber of Commerce & Industry

Mr. Wali Bhuiyan President

Rahman, Rahman, Haque & Co. (Audit firm) Mr. Abdul Hafiz Chowdhury Partner

Institute of Chartered Accountants of Bangladesh Mr. MA Baree, FCA President


Appendix D. Questionnaire – Corporate Sector Name of respondent: Designation: Company name: Address: Telephone: E-mail: Type of company/organization: (Public/listed/private limited/SOE): Interview date: Interviewed by: Basic Information Q1. How long has your company been in operation in this country? If listed, how long has it been operating as a listed company? ------------ years in operation ----------------- years as listed company Q2. Percentage of general public and sponsor’s shareholding: Q3. What was the rationale behind the choice of the type of the company (i.e. private vs. public limited) Q4. Would you classify your company as a ‘closely held’ (family) or ‘widely held’ company ? Q5. Sales Turnover: Paid-up Capital & Reserves: Q6. Dividend pay-out ratio in last 3 years: Cash vs. stock: A. The Rights of Shareholders Q.7. a) How was information on the process of formation of the company obtained?

b) How was the company formed, and were the services of a contractor, lawyer, accountant or professional used?

c) Were formalities completed at a time or were requirements fulfilled after piecemeal requests from the RJSC?


d) Were payments on top of the usual government fees and charges required to be paid for registration of the company?

e) Were there difficulties in obtaining ‘certified’ copies of the Memorandum & Articles of Association of the company and other documents? What were the difficulties?

Q8. Did you encounter any difficulties in accounting for and reimbursement/payment of promotional/ initial expenses?

Q9. a) Where is the registered office of the company located? (Working premises or another place) Are meetings held at the registered office at any time?

b) Have any complaints been received regarding access to the registered office by any shareholder/director?

Q10. Any difficulty faced to change registered office (if applicable)?

Q11. a) As a listed company, could you kindly tell us the conditions/preconditions that you need to fulfil with regard to share structure for listing purpose?

b) What other preconditions do you need to meet for listing with the stock exchange? Q12. Do you think any of these preconditions is regressive, irrelevant or inappropriate? Yes No (IF YES) Which of these do you think are regressive, irrelevant or inappropriate? Why do you think so? Q13. What is the remedy in your opinion? Q14. Has the company encountered any difficulty with any shareholder claiming ownership of the company’s property? Does any shareholder/director use any company property for personal use (e.g. car, payment of house rent, personal travel, use of staff for personal work, others)?

Q15. Has the company encountered any difficulty in processing a transmission (after death)/transfer of shares? If so, describe. B. The Equitable Treatment of Shareholders Q16. What has your company’s experiences been in handling complaints/queries of minority shareholders? Q17. As you may be aware, rights of the minority shareholder are at times violated. What measures do you think can be taken to protect their rights? Q18. Are the insider trading/information regulations in the country adequate in your opinion ? If not, what changes do you suggest?


Q19. What measures would you suggest to prevent, detect and penalise insider dealings involving controlling shareholders, directors and management officials? Q20. Does your company allow non-members to be proxy at the AGM/EGM ? Q21. Frequency/date of AGMs in last 3 years. Reasons for deviation (if any) Q22. How do you view the holding of AGM : i) as a necessary evil ii) just a statutory requirement iii) effective forum for the shareholders to give direction in charting the objectives of the company ? C. The Role of Stakeholders in CG Q23. How much you are aware of the bankruptcy, liquidation, and debt recovery proceedings in Bangladesh? Are these adequate / appropriate? If not, any suggestions? Q24. Do you think creditors’ rights are adequately ensured? Do the present laws lead to effective and timely recovery of defaulted loans? If not, then what needs to be changed? Q25. Do you have any suggestions/comments/ideas on market-based solutions that can be used to address insolvency and debt recovery problems in Bangladesh? Q26. Do you have any comments on the general regulatory bodies that affect your business? (Income Tax/NBR, SEC, BOI, RJSC). Can you give two-three instances each of dealings with the Income Tax/SEC/RJSC (satisfactory or not satisfactory)? a) Income Tax/NBR: b) SEC: c) BOI: d) RJSC: Q27. Do the company's requests for loans from banks involve information and assessment of its board of directors? Banks often require submission of guarantees from the company's directors – have you ever faced any problems in this regard? D. Disclosure and Transparency Q28. Does the company specify what type of company (public vs. private) it is in its corporate documents? If not, what reference does the company use to confirm what type of company it is?

Q29. a) Are there any regulations that hinder compliance with the accounting and reporting standards or are not appropriate? What are they? b) Do you have any suggestions in improving these regulations or making them more appropriate and relevant? Q30. Do you have structured audit, nominee, and remuneration committees? Are these committees permanent or formed ad hoc? Do you have an internal audit department?


Q31. As you may be aware, there are complaints about non-compliance of accounting and reporting standards that a public limited company should achieve in our country. In this context, how would you react to establishing a supervising agency to regulate financial reporting practices and enforce financial reporting standards, which will be conclusive and acceptable to any government body including the tax authorities? Q32. How would you react to holding regular dialogues on reporting and disclosure issues amongst government agencies that are responsible for supervising corporate reporting and national accounting associations/auditors? Q33. What are your views/opinion on voluntary disclosure of company-related information? Do you prepare different sets of accounts using different accounting standards and what problems do you face? Q34. Were you or any director of the company ever asked by any regulatory authority to explain your/their position on corporate disclosure by your company or for any transgression of the Securities or Companies Act ? Q35. Are you satisfied with the capability/performance of your auditors? Why or why not? Has the company experienced any difficulty in removing or changing its auditor? Q36. a) Is your company part of a group of companies? Describe its relationship with the other companies (e.g. holding, subsidiary, affiliate). b) What difficulties have been encountered in being part of a group of companies and what remedies would you suggest? c) As you are aware, there is a requirement to disclose underlying ownership of shares held by nominees and holding companies and changes in such ownership. Do you have any comment or suggestion in this respect? d) Do you consolidate the accounts of the group of companies? Are the consolidated accounts distributed to all the shareholders of the different units of the group? Q37. a) Has your company issued any guarantee? If so, who are the beneficiaries (e.g. banks, other companies, others) and who is the principal on whose account such guarantees are granted (e.g employees, group company members, suppliers, others).

b) Would the company be able to meet demands under all guarantees if they were called on to pay all on one day?

c) Does the company evaluate its ability to pay before granting such guarantees?

d) Do public companies find the requirements of section 103 functional?

Q38. How does your company maintain its registers (manually or electronically)? Any difficulties with maintaining the registers and in maintaining the registers in the form they are? Q39. a) How does your company calculate three-fourths vote for passing an extraordinary resolution?

b) Any difficulty encountered in passing such resolution?


c) Are details of the resolution provided in the notice for the meeting? d) At what type of meeting are such resolutions passed (e.g. at any general meeting, AGM or EGM, or at EGMs only)? E. Responsibilities of the Board Q40. What has been the frequency of your company’s board meetings? Q41. What are the particular functions and powers delegated by the Board to the professional management as discretionary powers ? Does the management hold the power of ‘hiring and firing’ ? Is the Managing Director a shareholder of the company or a professionally hired expert ? Q42. a) How is the company’s board of directors comprised? What was the basis for the composition of the board (e.g. lender requirements, group company control, others)?

b) Is any director not subject to retirement? If so, what type of directors are they (e.g. permanent, nominee, managing director)?

c) Has the company encountered any difficulty in the composition of its board?

Q43. Does the company grant its employees/directors loans? Are they on commercial terms or concessional terms? What kind of assessments are made on such requests? What are the experiences in recovery of such loans, particularly from ex-employees and directors?

Q44. Does the company have any directors who conduct additional functions for the company beyond attending board meetings (e.g. committee of directors, bank account signatory, power of attorney, others)? Has any director acted beyond or abused such additional authority? If so, what difficulties were encountered?

Q45. Has any director been personally charged with any liability on account of the company or personally in relation to the company’s affairs (e.g. litigation, dishonour of cheques, notice of removal as director, others). Has the company compensated or reimbursed expenses in defending or protecting the director?

Q46. Are there any alternate directors of the company? Are there any restrictions on the appointment of such alternates (e.g. only another director, others)? Has the company encountered difficulties in dealing with alternates?

Q47. Has the company encountered any difficulty in obtaining recognition in the resignation of any director (e.g. approval of Bangladesh Bank/SEC)?

Q48. How can board member performance, in general, be improved? Q49. Should there be maximum limits on directorships? If yes, then what should that number be? What should be the split between executive and non-executive directors and why? Q50. Does the company feel satisfied with the type of company it is? If not, why not. Does it have any recommendations of any other type of company it would rather convert to, which is not currently registerable in Bangladesh?

Q51. Do you fully fund your P.F. obligations? Do you ever borrow from the P.F.?


Q52. Are you personally aware of all the reports that need to be filed periodically with the RJSC and/or SEC? Who in the company is responsible for filing these records? Do you verify these for accuracy before they are filed?


Appendix E. Questionnaire – Financial Sector Name of respondent: Designation: Company name: Address: Telephone: E-mail: Type of company/organization: (Public/listed/private limited/SOE): Interview date: Interviewed by: Basic Information Q1. How long has your company been in operation in this country? If listed, how long has it been operating as a listed company? ------------ years in operation ----------------- years as listed company Q2. Percentage of general public and sponsor’s shareholding: Q3. What was the rationale behind the choice of the type of the company (i.e. private vs. public limited) Q4. Would you classify your company as a ‘closely held’ (family) or ‘widely held’ company ? Q5. Sales Turnover: Paid-up Capital & Reserves: Q6. Dividend pay-out ratio in last 3 years: Cash vs. stock: A. The Rights of Shareholders Q.7. a) How was information on the process of formation of the company obtained?

b) How was the company formed, and were the services of a contractor, lawyer, accountant or professional used?

c) Were formalities completed at a time or were requirements fulfilled after piecemeal requests from the RJSC?

d) Were payments on top of the usual government fees and charges required to be paid for registration of the company ?

e) Were there difficulties in obtaining ‘certified’ copies of the Memorandum & Articles of Association of the company and other documents? What were the difficulties?

Q8. Did you encounter any difficulties in accounting for and reimbursement/payment of promotional/ initial expenses?

Q9. a) Where is the registered office of the company located? (Working premises or another place) Are meetings held at the registered office at any time? (Optional question)

b) Have any complaints been received regarding access to the registered office by any shareholder/director?


Q10. Any difficulty faced to change registered office (if applicable)?

Q11. a) As a listed company, could you kindly tell us the conditions/preconditions that you need to fulfil with regard to share structure for listing purpose?

b) What other preconditions do you need to meet for listing with the stock exchange? Q12. Do you think any of these preconditions is regressive, irrelevant or inappropriate? Yes 1 No 2 (IF YES) Which of these do you think are regressive, irrelevant or inappropriate? Why do you think so? Q13. What is the remedy in your opinion?

Q14. Has the company encountered any difficulty with any shareholder claiming ownership of the company’s property? Does any shareholder/director use any company property for personal use (e.g. car, payment of house rent, personal travel, use of staff for personal work, others)?

Q15. Has the company encountered any difficulty in processing a transmission (after death)/transfer of shares? If so, describe.

B. The Equitable Treatment of Shareholders Q16. What has your company’s experiences been in handling complaints/queries of minority shareholders? Q17. As you may be aware, rights of the minority shareholder are at times violated. What measures do you think can be taken to protect their rights? Q18. Are the insider trading/information regulations adequate in your opinion ? If not, what changes do you suggest? Q19. What measures would you suggest to prevent, detect and penalise insider dealings involving controlling shareholders, directors and management officials ? Q20. Does your company allow non-members to be proxy at the AGM/EGM ? Q21. Frequency/date of AGMs in last 3 years. Reasons for deviation (if any) Q22. How do you view the holding of AGM : i) as a necessary evil ii) just a statutory requirement iii) effective forum for the shareholders to give direction in charting the objectives of the company ? C. The Role of Stakeholders in CG Q23. How much you are aware of the bankruptcy, liquidation, and debt recovery proceedings in Bangladesh? Are these adequate / appropriate? If not, any suggestions? Q24a. Do you think the bank’s right as a creditor is adequately ensured? Do the present laws lead to effective and timely recovery of defaulted loans? If not, then what needs to be changed? Q.24b. Do you think that the depositors’ rights are adequately ensured? Please explain.


Q25. Do you have any suggestions/comments/ideas on market-based solutions that can be used to address insolvency and debt recovery problems in Bangladesh? Q26. Do you have any comments on the general regulatory bodies that affect your business? (Income Tax/NBR, SEC, BOI, RJSC). Can you give two-three instances each of dealings with the Income Tax/SEC/RJSC (satisfactory or not satisfactory)? a) Income Tax/NBR: b) SEC: c) Bangladesh Bank: d) RJSC: Q27a. Does a company's request for loans from your banks involve information and assessment of its board of directors? Banks often require submission of guarantees from the company's directors – have you ever faced any problems in this regard? Q.27b. Do you think you have the freedom of rescheduling and negotiating bank loans as appropriate? Why do you say so? Q.27c. Lending against fake names has been a major issue with regard to some banks. How do you take care of these problems? Q.27d. As you are aware, BB, SEC and Companies Act require the balance sheet in three different formats. How do you reconcile this? Q.27e. The Companies Act says, you can not sack an auditor, BB and SEC asks to change the auditor after every year/ three years respectively. How do you tackle this issue? D. Disclosure and Transparency Q28. Does the company specify what type of company (public vs. private) it is in its corporate documents? If not, what reference does the company use to confirm what type of company it is?

Q29. a) Are there any regulations that hinder compliance with the accounting and reporting standards or are not appropriate? What are they? (Optional question) b) Do you have any suggestions in improving these regulations or making them more appropriate and relevant? (Optional question) Q30a. Do you have structured audit, nominee, and remuneration committees? Are these committees permanent or formed ad hoc? Do you have an internal audit department? Q.30b. Do you have internal auditor? How do they operate? Q31. As you may be aware, there are complaints about non-compliance of accounting and reporting standards that a public limited company should achieve in our country. In this context, how would you react to establishing a supervising agency to regulate financial reporting practices and enforce financial reporting standards, which will be conclusive and acceptable to any government body including the tax authorities? Q32. How would you react to holding regular dialogues on reporting and disclosure issues amongst government agencies that are responsible for supervising corporate reporting and national accounting associations/auditors?


Q33. What are your views/opinion on voluntary disclosure of company-related information? Do you prepare different sets of accounts using different accounting standards and what problems do you face? Q34. Were you or any director of the company ever asked by any regulatory authority to explain your/their position on corporate disclosure by your company or for any transgression of the Securities or Companies Act ? Q35. Are you satisfied with the capability/performance of your auditors? Why or why not? Has the company experienced any difficulty in removing or changing its auditor? Q36. a) Is your company part of a group of companies? Describe its relationship with the other companies (e.g. holding, subsidiary, affiliate). b) What difficulties have been encountered in being part of a group of companies and what remedies would you suggest? c) As you are aware, there is a requirement to disclose underlying ownership of shares held by nominees and holding companies and changes in such ownership. Do you have any comment or suggestion in this respect? d) Do you consolidate the accounts of the group of companies ? Are the consolidated accounts distributed to all the shareholders of the different units of the group ? Q37. a) Has your company issued any guarantee? If so, who are the beneficiaries (e.g. banks, other companies, others) and who is the principal on whose account such guarantees are granted (e.g employees, group company members, suppliers, others).

b) Would the company be able to meet demands under all guarantees if they were called on to pay all on one day?

c) Does the company evaluate its ability to pay before granting such guarantees?

d) Do public companies find the requirements of section 103 functional?

Q38. How does your company maintain its registers (manually or electronically)? Any difficulties with maintaining the registers and in maintaining the registers in the form they are? Q39. a) How does your company calculate three-fourths vote for passing an extraordinary resolution?

b) Any difficulty encountered in passing such resolution?

c) Are details of the resolution provided in the notice for the meeting?

d) At what type of meeting are such resolutions passed (e.g. at any general meeting, AGM or EGM, or at EGMs only)?

E. Responsibilities of the Board Q40. What has been the frequency of your company’s board meetings? Q41. What are the particular functions and powers delegated by the Board to the professional management as discretionary powers ? Does the management hold the power of ‘hiring and firing’ ? Is the Managing Director a shareholder of the company or a professionally hired expert ?


Q42. a) How is the company’s board of directors comprised? What was the basis for the composition of the board (e.g. lender requirements, group company control, others)?

b) Is any director not subject to retirement? If so, what type of directors are they (e.g. permanent, nominee, managing director)?

c) Has the company encountered any difficulty in the composition of its board?

Q43. Does the company grant its employees/directors loans? Are they on commercial terms or concessional terms? What kind of assessments are made on such requests? What are the experiences in recovery of such loans, particularly from ex-employees and directors?

Q44. Does the company have any directors that conduct additional functions for the company beyond attending board meetings (e.g. committee of directors, bank account signatory, power of attorney, others)? Has any director acted beyond or abused such additional authority? If so, what difficulties were encountered?

Q45. Has any director been personally charged with any liability on account of the company or personally in relation to the company’s affairs (e.g. litigation, dishonour of cheques, notice of removal as director, others). Has the company compensated or reimbursed expenses in defending or protecting the director?

Q46. Are there any alternate directors of the company? Are there any restrictions on the appointment of such alternates (e.g. only another director, others)? Has the company encountered difficulties in dealing with alternates?

Q47. Has the company encountered any difficulty in obtaining recognition in the resignation of any director (e.g. approval of Bangladesh Bank/SEC)?

Q48. How can board member performance, in general, be improved?

Q49. Should there be maximum limits on directorships? If yes, then what should that number be? What should be the split between executive and non-executive directors and why? Q50. Does the company feel satisfied with the type of company it is? If not, why not. Does it have any recommendations of any other type of company it would rather convert to, which is not currently registerable in Bangladesh


Appendix F. Corporate Survey Findings In order to find the existing level of corporate governance in the country, a representative group of 30 corporate CEOs were interviewed for this study using a qualitative questionnaire. The questionnaire was structured to probe into issues shortlisted by the CG team as significant under the major headings recommended by the OECD guidelines. Following is a summary of the findings received according to the OECD guidelines. A. The Rights of Shareholders The questions asked in this section, i.e. questions relating to company formation and stock exchange listing, did not yield anything of significance for the majority of the entities as either the current CEO was not involved during formation stages or the company interviewed was part of an established group that could work its way through the system. The group of people who did have direct start-up experience reportedly used the RJSC, various chambers, and informal networks to acquire initial information. Impediments related to obtaining certified copies of Articles and Memorandum of Association ranged from the usual delays to unnecessary queries by the authority. Payments on top of the regular official registration fees had been a pre-requisite for all companies excepting two - indicating that such practices have become a common part of business operations. Only one company interviewed had faced problems with fake shares and forgeries in the past. None of the CEOs were concretely aware of the stock exchange listing requirements; this was a function regularly delegated to the finance director / company secretary. B. The Equitable Treatment of Shareholders AGM Perception The perception of AGMs amongst the non-banking listed companies surveyed seemed to be a combination of a necessary evil and a statutory requirement. Very few, i.e. 38%, viewed it as actually an effective forum for shareholders. Quality of shareholder profile has been on the decline since the 1996 crash and AGMs of approximately one-third of corporate houses are now hostage to a known group of extortionists who routinely try to extort money from companies in the form of contracts (for advertisements, services, etc.). If companies do not comply, this group creates unnecessary harassment and chaos during actual meetings. To cite an example, one renowned company was forced to suspend its AGM, hold an emergency board meeting and declare a higher dividend two years ago. In a well appreciated move, SEC has asked for all AGMs to be videotaped and submitted so as to identify this select group of agitators. Other than one person, who received concrete recommendations regarding accounts preparation, none of the other CEOs could recall ever receiving relevant feedback from shareholders. The banks interviewed claimed to have more positive experiences at their AGMs. While one bank referred to the usual problem of “managed AGM” pressures, the other three mentioned that this problem is not as acute as in the corporate sector. Minority Shareholders Experience with minority shareholders echoes the sentiment already mentioned. Generally, shareholder demands concentrate either on higher dividends or more basic requirements like better quality food and gifts at the AGM and transportation allowances. (Although food and gifts have recently been made illegal by the SEC.) The main incentive for attendance is the meal served at an attractive hotel and, surprisingly, trading activity increases prior to AGMs to reflect that interest. There is, in reality, a very limited number of people going to AGMs who actually understand/grasp the financial statements being presented and, consequently, have little to contribute in terms of relevant inputs. Again, the financial institutions interviewed revealed better experiences - with minority shareholders questioning balance sheet specifics, staff benefits, branches and loan defaults.


Recommendations regarding minority shareholder protection were rare – nearly all felt that the existing laws are adequate and giving them too much of an edge will cause them to be abusive. The only two suggestions received were awareness generation re rights and responsibilities and board representation. Provision for Proxies All the companies interviewed for the survey held AGMs regularly in the last three years and nearly all, i.e. 91%, of public listed companies claimed that they allow non-members to be proxies at AGMs. This flexible proxy policy allows shareholders to exercise their voting rights more easily. Insider Trading All the suggestions received from corporate entities re insider trading revolved around enforcing the laws already in place and improving SEC surveillance. The banks interviewed were especially vocal on this issue. One Managing Director commented, “To prevent insider trading, Bank Company Act specifically mentions that sponsors cannot hold more than 50% shares. However, what we see in practice is that banks giving no dividends for years still continue to have high share prices – this is the result of a large number of directors trading shares amongst themselves”. These particular banks have up to 30 directors even though Bangladesh Bank sets the ceiling at 30. Only the SEC and BB can effectively check these irregularities. C. The Role of Stakeholders in CG Comments on Bankruptcy, Liquidation, & Loan Recovery Procedures Generally, awareness of the legal framework governing bankruptcy, liquidation, and loan recovery procedures is low amongst corporate chiefs. Specific comments by the few who were knowledgeable were:

- The system is not strong and needs major overhaul; it should provide two-way exit - Very painful process; banks do not want to give up collateral even when the company wants

to pay back debt (this company had direct prior experience) Comments on Creditors’ Rights Comments on creditors’ rights currently existing in Bangladesh were:

- No legal mechanism for immediate relief other than drawn out processes - Rights are not adequately ensured – there is no bankruptcy court, no arbitration - Problem is at enforcement level; government needs to be able to track down an individual

first through Social Security No. etc. before the rights of creditors can be ensured - Banks are working to expedite the Corporate Debt Restructuring project whereby all banks

will jointly assess the exposure of large groups. - A few banks are also working together to put together a list of individual defaulters (CIB

provides information at company levels) Suggestions re possible use of market-based agencies to facilitate debt collection & insolvency

- Develop credit rating agencies - Financially incentivise bank officials to recover bad loans - Expedite exit of insolvent companies to partially recover debts - Promote companies that buy bad debts and subsequently attempt to recover. Banks have

already started using small outfits for collection of bad debts. An example is “People’s Management & Development Co”. However, one company thinks this is ethically wrong – they are basically musclemen.

General Comments on Regulatory Institutions


Comments regarding the general nature of the regulatory authorities, not surprisingly, emphasized the bureaucracy and corruption involved in the system. Specifically, opinion was as follows:

Agencies are corrupt to the core; honest officials have become the minority. Negative attitude, oppressive, and inefficient; authorities only try to create problems. Any kind of permission takes too long. No coordination amongst government bodies – for instance, SRO doesn’t come out for 8 months

after government declares an incentive; 52 signatures are still needed at the customs for clearance; VISA structure for foreign investors is dismal.

Comments re National Bureau of Revenue (NBR)

A mixed group - top people are good while rest are corrupt; a junior officer now comes in & make reversals of crores of taka in our books.

Not set up to look after business interest; not very transparent. Deliberately makes mistakes in SROs then companies have to pay a lot of money in bribes. This

increases the overall cost of doing business. Creates hassles, unnecessarily checks books, tax officials can come & say that they will not

accept losses – happens every year; they basically want personal shares in the taxes. Changes in the implementation level will could have created a level field for multinational

companies vis-à-vis domestic ones. Comments re SEC

Perceived as non-existent only restrictive Tries to monitor; sends a lot of letters / queries

Comments re RJSC

Processing time depends on the whims of people involved Slow & won’t do anything without money. The most corrupt body in the country today; every paper going in has to be helped out

Comments re BOI

Effectiveness depends on the Chairman; remittance of certain fees is a big problem even though it's allowed without approval for say upto 6%

Has changed for better considerably this year and has become more foreign investor-friendly - probably related to who is heading it

Good concept in theory but doesn't have any power; ex. we needed land once but BOI couldn't help. Representation from concerned departments would have helped.

Major hurdle to any kind of development; you can’t open a bank A/C, VISA open L/Cs without BOI permission/registration

Comments re Bangladesh Bank

Has become more disciplined over time, Financial Sector Reform has played a key role in bringing change.

faces interference from Ministry of Finance, BB at times gives arbitrary decisions, creates delays when clarifications are sought, CIB report clearance takes 15 days instead of 24 hrs

calibre of people down the ranks is sub-standard Comments on Submission of Personal Guarantees for Bank Loans Other than large multinationals like BOC and Lever, all other companies have, at one time or another, faced director assessment prior to bank loans. Those with significant clout refuse to give guarantees after their reputation has been established. For companies, downsides of this pre-requisite are:


Unfair on the directors who are on the Board for their expertise Deters exit Contradicts limited liability concept

The last point is probably the strongest - unless one has limited liability, enterprise development will be extremely difficult. Banks, on the other hand, defended their position by saying that this measure is needed to protect their exposure since recourse against companies generally is not effective. D. Disclosure & Transparency Audit Committee & Internal Audit Audit committees are not widespread amongst public listed companies (found in only 3 companies interviewed) and do not exist at all in private companies. Nominee and remuneration committees are also non-existent in the companies interviewed. The check-and-balance mechanism in 33% of the organizations is in the form of internal audit in light of the general lack of confidence on external auditor capabilities. Banks have a much more stringent risk management procedure in place – audits are performed at three levels by external audit, Bangladesh Bank, and internal audit teams. The reaction to establishing a supervising agency was predominantly (95%) negative on the part of the business community. One CEO put the reason behind this feeling most succinctly when he commented, “We don't want another regulatory body because you still won't be able to get rid of the ones already existing. Too many agencies will only cause further trouble.” Other rationales included difficulties involved in implementing this concept, creation of additional sources of corruption, and duplication of resources since we already have ICAB and SEC with expert panels. The only comment supporting the idea specified that this will be beneficial only if this agency belongs to the private sector. Reaction to holding regular dialogue on reporting & disclosure issues amongst government agencies for supervising corporate reporting The reaction to holding regular dialogues was again predominantly negative on the part of the businesses. Reasons cited are as follows:

• This will mean another procedure and additional burden - these agencies should be cleaned up first as they are corrupt themselves

• This should be done through chambers • Outside people should not be involved; if shareholders are not satisfied, they can come back to

next year's AGM The only interviewee supporting this idea mentioned that this should be extended to all government institutions as they often have contradictory policies; for instance BTTB and NBR may have different lists on which equipments qualify as capital machinery. Views on Voluntary Disclosure of Company-related Information General opinion among CEOs is pro voluntary disclosure with 57% favouring additional disclosure than what is required. A bank MD has even gone to the extent of providing his salary figure in a separate line in the bank’s annual report. A general look at the corporate annual reports of the country shows that multinational entities typically have more voluntary information than local houses. Specific noteworthy comments received from interviewees against additional disclosure were:

Existing disclosures are sufficient if auditors are correct in their work. It’s already too much and at times harassing.

Further disclosure will only help competitors.


This will provide the taxation authority with additional scope for harassment. Preparation of Different Accounts Using Different Accounting Standards This emerged to be an area of concern only for multinational companies who have to prepare two different sets – separately following BAS and IAS – and hence leading to duplication of efforts. Feedback on whether this is a critical issue was mixed and therefore difficult to determine. Perception re External Auditors The CG survey found that audit quality is a source of major discontent amongst most firms; 62% of organizations expressed dissatisfaction with external audits. Firms cited a range of problems including: inexperience of the auditors, a lack of professionalism and objectivity, and a mismatch between the fees they are charging and the actual value they are adding. It was a widely held view among stakeholders that rigorous auditing practices would improve corporate governance in large measure almost immediately. Group Company Issues 64% of the public listed companies belong to other concerns through common shareholding. Comments in this context emphasized that (a) currently, there is no incentive to creating a holding company and (b) company law should be improved to incorporate the merger and group concept. Existing situation involves added work in maintaining separate records for each of the entities. Issuance of Guarantees Guarantees are mostly extended by companies on behalf of employees to banks for loans, etc. These guarantees are secured by the employees’ terminal benefits so do not pose significant exposures. Two of the companies interviewed mentioned issuing guarantees against group companies only after appropriate analysis. Maintenance of Registers Only 4 of the companies interviewed maintain their records manually. All others are electronic with manual back-ups. Calculation of ¾ Vote at Extraordinary Resolutions At the CEO level, whether this calculation is based on shareholding or no. of members present is not clear. Many have not faced EGMs yet. E. Responsibilities of the Board All the companies selected reportedly hold regular board meetings (once every quarter) with boards comprised of all executive directors obviously meeting more frequently. In an overwhelming majority (i.e. 73%) of the non-bank listed companies, the board is heavily dominated by sponsor shareholders who generally belong to a single family – the father as the Chairman and the son as the MD is the usual norm. The boards are usually actively involved in management - in 50% of the companies, there is more than one executive director in the board. Only one of the MDs interviewed is not a voting board member. One noteworthy trend is that even in companies where the MD is a sponsor shareholder, he is well educated with good western qualifications - reflecting an increased level of sophistication, awareness, and knowledge of sound business practices for a second generation of business leaders. Most of the day-to-day operational functions are delegated by the board to management – the only powers retained by the board are extraordinary decisions of write-offs, dividends, auditor selection, new business/investment activities, etc. Majority of the companies interviewed have neither alternate directors nor provisions for them. Although the law provides for alternate directors in the case of the absence of a director from Bangladesh, the survey found that only companies with foreign directors (for whom it is difficult to travel to board meetings) have alternate director provisions.


Suggestions on how board performance can be improved ranged from increasing the frequency of board meetings and holding training sessions, to imposing punitive penalties for violation of laws and implementation of a well-defined selection process for board members (especially for nominee directors sent by the government). Specifically, recommendations were:

Minority shareholders should be more participative, institutional shareholders should be alert in sending right people.

Most board members don’t know what to do: chambers can facilitate exchange of ideas amongst board members.

Non-executive directors should be involved more so they know more about the company. Shareholders should be made aware about board quality then performance would be

automatically reflected in share prices. Regulatory bodies should make sure that at least 50% board seats go to public so that broader

interests are protected. Recommendations relating to boards of banks included:

20% of board should be professionals; specific criteria on educational background & business experience should be established. Including depositors in bank boards is not the answer.

Other South Asian countries have a ‘fit and capability” test for recruiting bank MDs and board members, similar tests should be implemented here.

Restrain the board from unduly interfering into operational details. Opinion was mixed on the necessity of directorship ceilings - with those favouring a ceiling (36%) recommending a number within the range of 5 – 10. People who advocated against a ceiling cited reasons like “companies should themselves judge whether they want a person on the board” and “boards of subsidiary companies are often symbolic so there shouldn’t be any limits”. General Comments Comments received from respondents regarding the overall business climate, over and beyond the questions asked, were as follows:

A lot more issues need to be looked at first before CG; the supervising agencies need to be fixed otherwise it’ll a moving target.

Required is a change in culture and mindset; government should take on defaulters so that they are no longer respected in society

Regulatory bodies should take a tough stance against public listed companies to bring back public confidence. They should send the right signal through exemplary punishment. Honest good work should be positively reinforced and dishonesty punished - that should be the basic principle of business. For instance, Saifur Rahman's initiatives to convert black money puts honest people, who have paid their taxes so far, at a disadvantage.

Implement what we have on paper; total lack of coordination amongst agencies is frustrating. Role of external & internal auditors is important; CG doesn’t have to be solely affected by loss-

making performance, dividend limitations & stock prices.


Appendix G. List of Relevant Laws and Regulations in Bangladesh Accountants • Chartered Accountants Ordinance, 1961 (Ordinance No.X of 1961) • Bangladesh Chartered Accountants Order, 1973 (P.O.42No.2 of 1973) • Cost and Management Accountants Ordinance, 1977 (Ordinance No.LIII of 1977) • SEC Order No. SEC/CFD-71/2001/Admin/08 dated 28 March 2001 • SEC Order No. SEC/CFD-71/2001/Admin/02/05 dated 3 January 2002 • Bangladesh Bank circular on auditors Banks and Financial Institutions • Bangladesh Bank Order, 1972 (P.O. No.127 of 1972) • Bangladesh Banks (Nationalisation) Order, 1972 (P.O. No.26 of 1972)

as amended by Bangladesh Banks (Nationalisation) (Amendment) Ordinance, 1977 (Ordinance No.28 of 1977)

• Bank Company Act, 1991 (Act No.XIV of 1991), as amended in 1991, 1993, 1995, 1997, 1999 and 2001 43

• Financial Institutions Act, 1993 (Act No.XXVII of 1993) 44 • Financial Institutions Regulations Rules 1994 • Foreign Exchange Regulation Act, 1947 (Act No.VIII of 1947) • Money Laundering Prevention Act 2002 (Act No.VII of 2002) • Negotiable Instruments Act, 1881 (Act No.XXVI of 1881)

Negotiable Instruments (Amendment) Act, 1994 (Act No.XIX of 1994) Bankruptcy • Bankruptcy Act, 1997 (Act No.X of 1997) • Bankruptcy Rules, 1997 Company • Companies (Foreign Interests) Act, 1918 (Act No.XX of 1918) • Undesirable Companies (Second) Ordinance, 1958 (Ordinance No.XLIX of 1958) • Companies Act, 1994 (Act No.XVIII of 1994)45 Debt Recovery Court • Artha Rin Adalat Ain [Money Loan Court Act], 1990 (Act No.IV of 1990) • Artha Rin Adalat Bidhan [Money Loan Court Rules], 1990

42 "P.O." means President's Order, which are legislation promulgated before the Constitution of Bangladesh came into force. 43 Unofficial translations in English of the official Bengali versions of the Bank Company Act 1991 and amendments made in 1993 and 1995 (but not those made in 1997, 1999 and 2001): http://www.sai.uni-heidelberg.de/bdlaw/1991-a14.htm/. 44 Unofficial translation in English of the official Bengali version: http://www.sai.uni-heidelberg.de/bdlaw/1993-a27.htm/ 45 http://www.vakilno1.com/saarclaw/bangladesh/companies_act.htm


Insurance • Insurance Act, 1938 (Act No.IV of 1938)

as amended by Insurance (Amendment) Act, 1990 (Act No.XXVI of 1990) and Insurance (Amendment) Act, 1993 (Act No.XII of 1993)

• Insurance Rules 1958 (as amended by SRO No. 201-Law/2002 dated 22 July 2002) • Insurance Corporations Act, 1973 (Act No.IV of 1973)

as amended by Insurance Corporations (Amendment) Ordinance, 1984 (Ordinance No.LI of 1984) and Insurance Corporations (Amendment) Act, 1990 (Act No.XXIX of 1990)

Securities 46 • Securities Act, 1920 (Act No.X of 1920) • Securities and Exchange Ordinance, 1969 (Ordinance No.XVII of 1969) • Securities and Exchange Ordinance (Amendment) Act 2000 [Amendment of Ordinance No.XVII of

1969] • Securities and Exchange Commission Act, 1993 (Act No.XV of 1993) • Securities and Exchange Commission (Amendment) Act) 2000 [Amendment of Act No.XV of 1993] • Securities and Exchange Rules 1987 dated 28 Sep 1987 (SRO 237-L/87) • Securities and Exchange (Amendment) Rules 1987 dated 15 Dec 1999 (Notification

No.SEC/SMED/98-551/1560) • Securities and Exchange (Amendment) Rules 1987 dated 4 Jan 2000 (Notification

No.SEC/LSD/SER-1987/149) • Securities and Exchange Commission (Merchant Banker and Portfolio Manager) Regulations dated

24 Apr 1996 (SRO 59-Law/96) • Eligibility of Merchant Banker and Portfolio Manager (Notification) dated 24 Apr 1996 (Notification

No.SEC/Section-7/Law/94-4/115) • Capital Sufficiency of Merchant Banker and Portfolio Manager dated 24 Apr 1996 (Notification

No.SEC/Section-7/Law/94-4/1140) • Securities and Exchange Commission (Stock-Dealer, Stock-Broker and Authorised Representatives)

Rules 2000 • Guidelines on Foreign Placement or Allotment of Securities dated 11 Feb 1995 (Notification

No.SEC/Section-7/95-23) • Guidelines on Initial Public Offering to Local Investors dated 8 Feb 1995 (Notification

No.SEC/Section-7/95-22) • Guidelines for Raising of Capital by Greenfield Public Companies dated 13 Jun 1995 (Notification

No.SEC/Section-7/95-28) • Credit Rating Companies Rules, 1996 dated 24 Jun 1996 (Notification No.SEC/Section-7/117) as

amended by vide Notification No. SEC/SRMID/2001-1018/Admin-03/02 dated 27 September 2001 • Securities and Exchange Commission (Mutual Fund) Rules 2001 • Public Issue Rules, 1998 dated 3 Jan 1999 (Notification No.SEC/Sec.7/P/R-98/140) • Rights Issue Rules, 1998 dated 27 Jul 1998 (Notification No.SEC/Section-7/RIR-98/137) • Depository Act 1999 (Act No.6 of 1999) • Depositories Regulations, 1999 • Margin Rules, 1999 dated 28 Apr 1999 (Notification No.SEC/Section-5/98-542/141)

46 Copies of some of the laws and regulations in the SEC Bangladesh website, http://www.secbd.org, contain some differences from the official versions.


• Members’ Margin Regulations 2000 • Listing Regulations of the Dhaka Stock Exchange, dated 18 Feb 1997 (Notification No.SEC/Member-

II) • Settlement of Stock Exchange Transaction Regulations, 1998 dated 24 May 1998 (Notification

No.DSE-343/97/910), as amended from time to time • DSE Protection Fund Regulations, 1999 dated 7 Dec 1999 • SEC (Acquisition of Substantial Shares, Merger & Take-over) Rules 2002 • Automated Trading Regulations 1999 • Investors’ Protection Fund Regulations 1999 • SEC (Market Maker) Rules 2000 • SEC (Capital Issue of Public Limited Company) Rules 2001 • SEC (OTC) Rules 2001 • SEC Notification No. SEC/CMRRCD/2001-14/Admin/03/06 dated August 01, 2002 • SEC order of 8 October 2002 (on Lock-in on Foreign Sponsors/Placement Shares and mandatory

investing through Portfolio Accounts)


Appendix H. Forms to be Submitted to the RJSC and Other Bodies Section 15: Certified copy of the order confirming the alteration of Memorandum within 90 days to the RJSC. The alteration is of no effect till registration with the RJSC and if not don’t within the time limit at the expiration of that period the alteration becomes null and void. Section 36 & 190: Copy of annual list of shareholders and summary of share capital within 21 days to the RJSC. If a company is in default of this it is liable to be fined not exceeding two hundred taka for every day. Section 44: Notice to RJSC for rectification of register of members within 15 days. Section 53: Notice for change in the structure of share capital to the RJSC within 15 days. Section 54: Notice for consolidation of shares or stock to the RJSC within 15 days. Fine: not exceeding two hundred taka. Section 56: Notice for increase in share capital to the RJSC within 15 days. Fine: not exceeding two hundred taka. Section 71(5): Notice for court order on variation of shareholder rights within 15 days. Fine: not exceeding two hundred taka. Section 88: Return of copies of special or extraordinary resolution to the RJSC within 15 days. Fine: not exceeding one hundred taka. Section 92(1): Consent of directors to act as such. Cannot act as director till he has filed such a consent with the RJSC. Section 93(2): A person cannot act as a director unless he has filed to the RJSC a consent to act as such within 30 days of his appointment. Section 115(2): Return of change in directorship within 14 days of such change to the RJSC. Section 138: Copy of prospectus signed by the directors on or before publication to the RJSC. Fine: not exceeding five thousand taka. Section 150: filing of verified declaration or statement in lieu of prospectus before commencement of any borrowing powers to the RJSC. Fine: not exceeding one thousand taka. Section 151(1)(a): where an allotment of shares is made company must within 60 days file a return of allotments to the RJSC. Fine: not exceeding one thousand taka. Section 159 and 160: Particulars of mortgage or charge with the instrument thereof or a verified copy to the RJSC within 21 days. Void if not registered. Section 161: filing of particulars in case of series of debentures being created within 21 days to the RJSC. Section 167(1): A company has the obligation to file with the RJSC for registration of every mortgage or charge created by the company and of the issues of debentures of a series to the RJSC.


Section 169: Notice for appointment of receiver within 15 days to the RJSC. Section 170: Abstract of receipt and payments during receiver’s time and notice of ceasement to act as receiver to be filed annually to the RJSC. Fine: not exceeding five hundred taka. Section 172: Intimation for satisfaction of mortgage or charges within 21 days to the RJSC. Section 190: Within 30 days of the annual general meeting three copies of audited and authenticated balance sheet and profit and loss accounts to the RJSC. Fine: not exceeding one hundred taka for every day’s delay. Section 210(2): Notice of appointment to the auditor within 30 days of such appointment to the RJSC. Section 228 & 229: Certified copy of the Court’s order sanctioning the compromise agreement between creditors and company within 14 days to the RJSC. Section 231: Filing of prospectus or statement in lieu of prospectus on conversion of the status of any company within 30 days to the RJSC. Section 233(5): Notice about court order on minority shareholders right within 14 days to the RJSC. Fine: not exceeding one thousand taka. Section 252: Copy of winding up order made by the Court within 30 days to the RJSC. Section 258(3): Statement of affairs to the official liquidator or the Court within 21 days. Fine: not exceeding five hundred taka for every day. Section 277(2): Report of the Court’s order for the dissolution of company to be filed at the RJSC within 15 days of such dissolution. Fine: The official liquidator liable to a fine not exceeding one hundred taka. Section 290: Declaration of solvency by directors to the RJSC on voluntary winding up for registration before board meeting. Section 296(3) & 305(3): Copy of accounts of winding up and return of general meeting of the company within one week of the meeting to be filed with the RJSC. Section 333: Notice of liquidator about criminal offence of directors to the RJSC. Government and Court. Section 379: Particulars of foreign companies to be filed with the RJSC for registration.


Appendix I. Current ICAB Adoption Status of IAS

Effective date by IASC IAS Present Title original version revised version

ICAB Adoption Status

01 Presentation of Financial Statements

01 January 1975 01 July 1998 Adopted original version as BAS 1

02 Inventories 01 January 1976 01 January 1995 Adopted latest version as BAS 2

07 Cash Flow Statements 01 January 1979 01 January 1994 Adopted original version 08 Net Profit or Loss for the Period,

Fundamental Errors and Changes in accounting Policies

01 January 1979 01 January 1995 Adopted original version

10 Events After the Balance Sheet Date


11 Construction Contracts 01 January 1980 01 January 1995 Adopted latest version as BAS 11 12 Income Taxes 01 January 1981 01 January 1998 Adopted original version 14 Segment Reporting 01 January 1983 01 January 1998 Not Adopted 15 Information Reflecting the

Effects of Changing Prices 01 January 1983 01 January 1995 Not Adopted

16 Property, Plant and Equipment 01 January 1983 01 January 1995 Adopted original version 17 Leases 01 January 1984 01 January 1999 Not Adopted 18 Revenue 01 January 1984 01 January 1995 Adopted latest version as BAS 18 19 Employee Benefit 01 January 1985 01 January 1999 Not Adopted 20 Accounting for Government

Grants & Disclosure of Government Assistance

01 January 1984 01 January 1984 Adopted latest version as BAS 20

21 The Effects of Changes in Foreign Exchange Rates


22 Business Combinations 01 January 1985 01 January 1995 Not Adopted 23 Borrowing Costs 01 January 1986 01 January 1995 Adopted original version 24 Related Party Disclosures 01 January 1986 01 January 1995 Not Adopted 26 Accounting and Reporting by

Retirement Benefit Plans 01 January 1988 01 January 1995 Not Adopted

27 Consolidated Financial Statements and Accounting for Investments in subsidiaries


28 Accounting for Investments in Associates

01 January 1990 01 January 1995 Not Adopted

29 Financial Reporting in Hyperinflationary Economics


30 Disclosures in the Financial Statements of Banks and Similar Financial Institutions


31 Financial Reporting of Interests in Joint Venture


32 Financial Instruments: Disclosures and Presentation

01 January 1996 Not revised Not Adopted

33 Earnings per Share 01 January 1998 Not revised Adopted latest version as BAS 33 34 Interim Financial Reporting 01 January 1999 Not revised Adopted latest version as BAS 34 35 Discontinuing Operations 01 January 1999 Not revised Not Adopted 36 Impairment of Assets 01 July 1999 Not revised Not Adopted 37 Provisions, Contingent

Liabilities and Contingent 01 July 1999 Not revised Not Adopted

Adoption status as of October 31, 2002 (Source: ICAB National Awards 2001 for Best Published Accounts and Reports)


Appendix J. Summaries of Literature Reviewed There has been some work done the area of corporate governance by the World Bank and ADB in Bangladesh, but overall there is a lack of material on corporate governance issues in Bangladesh. Some discussion regarding specific aspects of corporate governance has been undertaken by organizations like Centre for Policy Dialogue (CPD), Institute of Chartered Accountants (ICAB), and the Institute of Bank Management (BIBM). The brief summaries of the major articles and studies relating to CG are presented in this appendix. The summaries explain the authors’ major points that relate to corporate governance. The original articles and reports are in English, unless otherwise indicated. Other resources used in the study are listed in the Resources Appendix. Summaries in this Appendix World Bank. Bangladesh: Financial Accountability for Good Governance, 2002 Centre for Policy Dialogue. Corporate Responsibility Practices In Bangladesh: Results from a Benchmark Study, July 16, 2002 Mahmood, Prof. Wahiduddin. Bank Reform Committee Report (in Bangla), Government of Bangladesh, December 1999 Saha, Dr. Sujit and Md. Saidur Rahman. Implementation of International Accounting Standard (IAS) in Banks and Financial Institutions - A Step Towards Sound Governance System, Paper presented at the Management Forum - 2002, on "Institutional Governance: Failure in Building Infrastructure for Socio-Economic Growth" Organized by AMDB on July 25 - 26, 2002 World Bank. Taming Leviathan: Reforming Governance in Bangladesh An Institutional Review, March 2002 Asian Development Bank. Capacity Building of the Securities and Exchange Commission and Selected Capital Market Institutions, TAR:BAN 33226, November 2000 Sayeed, Yawer. Bangladesh: Strategic Issues and Potential Response Initiatives in the Finance Sector: Banking Reform and Development (BRD), Asian Development Bank and AIMS of Bangladesh Limited, July 22, 2002 Sayeed, Yawer. Bangladesh: Strategic Issues and Potential Response Initiatives in the Finance Sector: Integrated Financial Development (IFD), Asian Development Bank and AIMS of Bangladesh Limited, July 22, 2002 Chowdhury, Anwaruddin. Moving to International Standards, Presented at “Bangladesh Moving to International Accounting Standards, Regulation And Corporate Governance In Financial Services Opportunities and Challenges for Financial Managers and regulators in Bangladesh” March 20-21, 2001 Mahmud, Parveen. CPE Seminar on Microfinance – Governance and Reporting, Institute of Chartered Accountants of Bangladesh, November 6, 2001 Ghosh, Santi Narayan. Development of Accounting and Auditing Standards in Bangladesh IAS 18: Revenue Recognition, Institute of Chartered Accountants of Bangladesh Ahmad, Jamal Uddin and M.A. Baree. Corporate Governance for Transparency and Accountability, The Bangladesh Accountant, Vol.29; No. 2, April-June 2000


Islam, Khan Tariqul. Annual Financial Statements of Banking Companies – Are Those Serving the Purpose?, The Bangladesh Accountant, Vol.29; No. 2, April-June 2000 Rahman, Md. Abdur and Mohammad Badrul Muttakin. Profitability of Private Sector General Insurance Companies in Bangladesh, The Bangladesh Accountant, Vol.29; No. 2, April-June 2000 Bangladesh: Financial Accountability for Good Governance World Bank, 2002 This report primarily discusses the current state of public sector financial accountability and makes recommendations for reform and improvement. It deals in depth with the problems of the Comptroller and Auditor General’s Office (CAG), internal audit, public accounts, parliamentary oversight, and public enterprises. It also contains a section on private sector accountants and auditors, which is of primary concern to corporate governance. The report finds a number of failings with the structure of the accounting profession in Bangladesh. First, the supply of accountants is low due to lack of adequate training facilities and lack of sufficient financial support for trainees. ICAB has concentrated on increasing the quality of training and strengthening requirements, but the self-regulation of members of both professional institutes (ICAB and ICMAB) has been ineffective. There are three major recommendations for improvement of private sector accounting:

• Professional institutes (ICAB and ICMAB) should to prepare strategic plans to expand the output of professional accountants and auditors without sacrificing quality.

• The establishment of a sub-professional accounting qualification • ICMAB should introduce a code of ethics, and both professional institutes should enforce their

codes strictly. In general, the report concludes that the most significant failing in financial accountability in Bangladesh is between national standards and national practices. “Laws and regulations exits, but are not enforced. At present there are few visible sanctions for wrongdoing.” Recommendations focus on creating a cohesive voice for reform by mobilizing support from beneficiaries of reform, including citizen groups, civil society, the business community, the donor community, and reform-minded government officials. However, as a starting point, the report recommends greater transparency of the public sector through public dissemination of data, reports, and information. This recommendation could just as easily apply to the corporate sector, where public disclosure is one of the cornerstones of good corporate governance. Corporate Responsibility Practices In Bangladesh: Results from a Benchmark Study Centre for Policy Dialogue, July 16, 2002 The Centre for Policy Dialogue (CPD) carried out a survey of 151 stakeholder groups regarding corporate responsibility practices in Bangladesh. The stakeholder groups surveyed were civil society groups, companies, and employees. Corporate Governance was only one aspect of corporate responsibility included in the survey. The general findings of the survey were:

• Corporate responsibility practices in multinational companies are better compared to locally owned companies.


• Corporate responsibility practices in larger companies are better compared to smaller companies. • There are variations in corporate responsibility practices between different sectors.

The report shows that 66% of the civil society stakeholders are dissatisfied with corporate responsibility practices and 82% are dissatisfied with the level of consultation and interaction with the civil society over corporate responsibility practices. There are significant disparities in perception between different stakeholders. For instance, 71% of the companies surveyed perceive that there is no violation of health and safety standards, while only 16.9% workers perceives so. There is clearly dissatisfaction regarding corporate responsibility among the workers. The analysis of survey results concludes that improving corporate responsibility practices should provide fiscal benefits to companies and enable them to attract more foreign investment. A number of practical suggestions for improving corporate responsibility are discussed. Bank Reform Committee Report (in Bangla) GOB, Dhaka, December 1999 Prof. Wahiduddin Mahmood Chapter V: Private Banks The Banking Reform Committee Report (1999) observed that there is lack of good corporate governance practices in the private banks in spite of their appointing comparatively more efficient executives and using modern technology. In overall terms, the financial status of private banks is quite unstable, similar to the nationalized banks. Twenty-nine percent of private bank loans were classified. Political considerations were prevalent in the business decisions of the banks. There was also a lack of transparency, accountability and fairness in the private banks. Many directors were found to be misappropriating bank funds for their own advantage and neglecting the interest of depositors. It was found that at least 152 directors took an amount of Taka 13.5 billion, which was 20% higher than their investment in those banks. In addition to taking out loans in their own names, the directors took loans in the name of false institution and were also taking loans in disregard to the rules and regulations of the regulatory bodies. Many directors were found to be associated with the irregularities in the private banks in the recent years. At least 36 directors were reported to have been associated with irregularities such as disregarding the Bank Company Act and circulars of the Bangladesh Bank. Many directors took monetary and other benefits apart from being associated with irregular loans. Instances of disciplinary actions against private bank directors are rare even though Bangladesh Bank has the authority to remove such directors. At the time of the report, only ten directors had been ordered to be removed. However, no penal action has ever been taken against any offender. It is noteworthy that statutory and prudential regulations for good corporate governance have been circulated in the private banks. However, widespread misappropriation by the directors in taking loans and other illegal benefits from the bank is still prevalent. In considering the application for bank licenses, it was not the qualifications and efficiency of the enterprise, but political affiliation that received attention. The recommendations for good banking practices are enclosed in annex 5.1 of the report. In accordance to the Bank Company Law, Bangladesh Bank is bestowed with the authority of supervising the banking business. But it is the government, which takes the final decision on this matter by virtue of administrative decisions. This very process is not in favour of politically neutral decision-making.


The report points out that there is a paradox between imposing regulations on private corporations and allowing the private sector to operate freely. It is evident that imposing restrictions on banking activities hinders the freedom of corporate decision-making. Enhancement of the exercising authority of the Bangladesh Bank may also lead to a more complex bureaucracy for private banks. On the other hand, corruption and violation of the regulations cripple the total banking sector. It can be envisaged that restrictions on private banks can be substantially withdrawn in the future once the directors operating in the private sector can nurture a culture of good banking practices. Implementation of International Accounting Standard (IAS) in Banks and Financial Institutions - A Step Towards Sound Governance System Dr. Sujit Saha, Professor, and Md. Saidur Rahman, Assistant Professor, BIBM Presented at the Management Forum - 2002, on "Institutional Governance: Failure in Building Infrastructure for Socio-Economic Growth" Organized by AMDB on July 25 - 26, 2002 This report discusses the financial disclosure practices of banks and financial institutions before adoption of IAS-30 and the disclosure requirements now that IAS-30 has been adopted. Prior to the adoption of IAS-30, the Bank Companies Act, 1991 (Annexure 1) governed financial disclosures of banks and financial institutions. Compared to international standards, the requirements were lax; for example, provisions for loan losses (specifically for bad/doubtful debt and generally for unclassified loans) were not required. If a loan loss provision was made, it was not counted against profit and loss. In addition, the reporting of capital adequacy was insufficient. The report includes further detail about reporting requirements before the adoption of IAS-30. After encouragement from the World Bank, IMF, and other international donor agencies, the Bangladesh Bank directed banks and financial institutions to comply with the requirements of IAS-30 through BRPD Circular No. 3/2000 dated March 18, 2000. The regulations were effective beginning December 31, 2000. IAS-30 introduced a number of improvements in disclosure, which are detailed in the report, but will only be briefly summarized here. There are three major, new disclosure requirements in the Profit and Loss Account. First, categories of income and expenses must be disclosed separately. For instance, interest income, investment income, and dividend income must be shown. Second, a specific loss provision for individually classified bad and doubtful debts and a general provision for potential, but not specifically classified, loans must be identified in the Profit and Loss Account. The notes should provide details on the movement in provision for losses throughout the year. Third, BRPD Circular No. 14 (June 2001) requires that unrealised losses on securities investments be shown in an investment loss provision account. However, unrealised gains may not be shown in the financial statements. With regard to Balance Sheet reporting, assets (loans, advances, and investments) must be shown by category. Categories should include: type of asset, maturity, geographic location (domestic or international), borrower, and classification (substandard, doubtful, etc.). IAS-30 also requires disclosure of secured and unsecured liabilities and the type of security provided. Under the new requirements, banks must prepare a cash flow statement, which was previously not required. Banks and financial institutions will also have to prepare a statement showing changes in Equity. Finally, in addition to the financial statements required, detailed notes to the financial statements will be necessary.


Compliance with IAS-30 is a key step in improving the reputation of banks and financial institutions, both domestically and internationally. The new requirements will begin to reveal the true state of affairs to stakeholders and hopefully motivate management to make improvements. The author believes that “the positive results would come out only when the quality disclosure would take place instead of simple compliance with the IAS-prescribed formats.” To achieve this level of compliance, the author recommends that the Bangladesh Bank issue instructive circulars and develop a training module for bank personnel. Taming Leviathan: Reforming Governance in Bangladesh An Institutional Review, World Bank, March 2002 This large document mainly deals with public accountability and governance, not corporate governance. However, given that a significant number of corporations are State-Owned Enterprises (SOEs), its findings have some relevance here. The Review analyses the underlying causes of Bangladesh’s poor governance, the consequential weak performance of public institutions, and reasons for the government’s slowness to reform. The Review argues that Bangladesh’s development has been slow because too little attention has been given to social and political obstacles in the design of reforms to strengthen the rule of law, reduce corruption and arbitrary decision making and improve service delivery - which are the government’s avowed objectives. To achieve better performance from SOEs and in the privatisation process, these same factors must be taken into account. To succeed, reform must benefit all the stakeholders whose cooperation is needed. Because reformers have generally adopted a technocratic approach, and largely ignored the way incentives play out, the record of institution building is mixed – with few real successes and many setbacks to learn from effective incentives linked to real accountability are the key to better public sector performance. Capacity Building of the Securities and Exchange Commission and Selected Capital Market Institutions Asian Development Bank (TAR:BAN 33226) November 2000 This document is a project document for a new technical assistance project being funded under the auspices of the Capital Market Development Program Loan of ADB. A related technical assistance project (Loan 1580-BAN), which started in 1997 and was ongoing at the time of the report, focused on surveillance procedures for the SEC and other reform measures. In 1999, the GOB requested further assistance from the ADB to strengthen the Securities and Exchange Commission (SEC), this document details the objectives, scope, and budget of the technical assistance program (TA). The TA will focus on the SEC, the stock exchanges (CSE and DSE), and capital market participants. It will improve the SEC’s capacity to effectively regulate the markets and to audit listed companies. The TA will help CSE and DSE become more efficient in their function as a central securities depository. Finally, the TA will provide training for capital market participants. The focus will be on corporate governance, financial reporting, and compliance with international accounting and auditing standards. Some of the outputs detailed in the scope of the TA include:

• Proposed amendments to existing laws to improve corporate disclosure, corporate governance, and the protection of shareholders

• A corporate governance manual


• A shareholder rights manual • A syllabus for CG training • Guidelines for governance audits • Corporate governance training sessions for listed companies • Accounting and auditing training for personnel of listed companies • SEC staff training on procedures for financial statement reporting and IAS/ISA compliance

The SEC is the executing agency for this TA. A consulting firm will implement the TA and will be overseen by a steering committee. The TA was scheduled to start in February 2001 and was to be completed by April 2002. Bangladesh: Strategic Issues and Potential Response Initiatives in the Finance Sector: Banking Reform and Development (BRD) Yawer Sayeed, AIMS of Bangladesh Limited for the Asian Development Bank, July 22, 2002 In this working draft report prepared for the Asian Development Bank, Mr. Sayeed describes the current banking environment and establishes a road map for future initiatives in banking reform and development. Major failures in the banking sector identified by the report are: (i) the level of non-performing assets; (ii) operating practices in state-owned commercial banks; (iii) ineffective oversight by the Bangladesh Bank; and (iv) the legal and judicial framework for default loan recovery. Overall, the report questions the health of most banks in Bangladesh. The author states, “while there are sound banks, the banking sector as a whole is technically insolvent.” The primary symptom of the problem is a very high percentage of classified loans as a percentage of total outstanding loans. In 2001, classified loans comprised 31.3% of total outstanding bank deposits and 8.7% of GDP. A number of operational failings are at the root of this situation. Practices of particular concern are policy lending to loss-making state-owned enterprises, political patronage and directed lending, insider lending in private local banks, unproductive assets, and a pervasive culture of default by borrowers. The Bangladesh Bank, whose mandate is the oversight of the banks, does not fulfil its duties in this respect. “The Bangladesh Bank (BB) has questionable financial standing, its prudential regulations are lax and enforcement quite ineffective.” Primary obstacles to improvement of the BB are the organizational structure, excessive union activity, and politicised appointments to the BB board and top senior management positions. Some upcoming policy measures may improve the situation. Amendments to the legislation governing the BB will increase its autonomy from the Ministry of Finance. Second, the government plans to remove treasury functions from the BB, leaving it with more resources to fulfil its regulatory and oversight functions. The BB is also concentrating on monitoring non-performing loans, advising bank management on loan recovery, and controlling insider lending. The final major problem identified is the lack of a legal and judicial framework for default loan recovery. Use of Money Loan Court or Bankruptcy Court by banks pursuing loan defaulters does not yield satisfactory results, particularly with respect to executing judgments against defaulters. Recent directives by the BB regarding rescheduling instalment loans also have the effect of condoning delays in loan repayment. In short, the author suggests that reform of the banking sector must start with improved loan recovery practices and stronger regulatory oversight. Simultaneously, banks can be relieved of their non-performing loans by pooling them into a separate organization overseen by a private asset management company. In addition, fast-track privatisation of the SOEs and SCBs is recommended. The final


recommendations for a future program to improve the financial sector include detailed goals, performance targets, monitoring mechanisms, and assumptions and risks. In addition, the author makes suggestions for government policy initiatives and areas in which technical assistance will be required. Bangladesh: Strategic Issues and Potential Response Initiatives in the Finance Sector: Integrated Financial Development (IFD) Yawer Sayeed, AIMS of Bangladesh Limited for the Asian Development Bank, July 22, 2002 Prepared for the Asian Development Bank, this report identifies ways in which the capital market can be expanded to provide more options to enterprises and to decrease the economy’s vulnerability to economic shocks. The report includes a discussion of the current capital market environment, explaining the function of and problems with the Investment Corporation of Bangladesh (ICB), Bangladesh Shilpa Rin Sangstha, Jiban Bima Corporation, and Sadharan Biman Corporation. Since the current capital market is essentially equity oriented, the report primarily catalogues the impediments to the development of capital market instruments. The capital market outside the equity market in Bangladesh is very limited primarily because state-owned institutions are dominant. In addition, legal and practical obstacles make it difficult for private participants to compete with state-sponsored offerings. Current policies favor state-owned financial institutions. For instance, the state-owned financial institutions operate in the capital market under different rules than private players; for instance, the ICB mutual funds do not publish their net asset value or submit performance reports, which is required of private mutual funds. Currently, the only area in which non-bank financial institutions have been active is in leased assets, but they could expand into asset securitisation if the current Stamp Duty is reduced. The largest impediment to the development of a fixed income securities market is the high yield structure on government savings schemes; in comparison to the savings schemes, any private sector fixed income offering would not be competitive. The government recently reduced the rate paid on the savings schemes, which will likely encourage future corporate debt securities issuances. The Capital Market Development Program, funded by the ADB, worked to strengthen market regulation and supervision to development capital market infrastructure. The author maintains that the program is perceived by market participants as being regulatory-focused and has not had a direct effect on the market. Therefore, a future capital development program should focus on capacity-building in the private sector and removing impediments to new capital market products. Specific goals and recommendations for a future capital market development program are discussed. Moving to International Standards Anwaruddin Chowdhury, President ICAB Presented at: Bangladesh Moving to International Accounting Standards, Regulation And Corporate Governance In Financial Services, March 20-21, 2001, Dhaka. Hosted by The IFC, FMO, and Standard Chartered Bank Plc. This report reviews Bangladesh’s progress towards harmonization of financial reporting and auditing with international standards, as well as provides recommendations for future steps. The author sees accounting harmonization as a necessary step for Bangladesh to remain competitive in the face of globalisation and to attract capital into the economy. The author explains some of the challenges involved in implementing and monitoring IAS and ISA in Bangladesh. Some of the primary limitations to compliance are: a lack of monitoring by regulatory agencies, the low level of compensation for auditors, and differences between financial and tax reporting where the ICAB adopted IAS requirements are at odds with the legal


requirements in the Companies Act or the tax law. Furthermore, there is a lack of consistency between the standards required and enforced by the relevant regulatory agencies (SEC, Bangladesh Bank, etc.) and the standards adopted by profession organizations like ICAB. IAS and ISA adopted by the ICAB may be made legally enforceable through the relevant laws (Companies Act 1994, Securities Exchange Rules 1987, Bank Company Act 1991, etc.) and/or professionally enforceable through the application of Chartered Accountants Bye-laws 1973. In spite of the challenges, some positive steps have been taken. ICAB voted in 2001 to amend its Bye-laws so that compliance with adopted IAS and ISA is “professionally enforceable” for its members. In addition, effective April 1, 2000 Bangladesh Bank required that the financial statements of banking companies comply with IAS-30, which spells out rules on non-performing loans. Both steps provide avenues to enforce compliance with IAS and ISA once they have been adopted for Bangladesh. The author makes a number of recommendations for further harmonization of accounting policies. Those of interest include:

• The Companies Act should be amended to require public companies comply with IAS and ISA as adopted by ICAB. In 1997, the SEC amended the Securities and Exchange Rules 1987 so that all listed companies must comply with the IAS that have been adopted by ICAB. However, a further amendment in 2000 changed the rules to bypass the ICAB adoption of IAS.

• The SEC and ICAB should have a forum for regular interaction to work towards proper implementation and monitoring of the adoption of IAS by companies.

• The SEC needs additional staff qualified to monitor companies at a level consistent with international standards.

The report includes a survey of the financial reports of 36 listed companies and four foreign companies for compliance with IAS. The results show that, although there has been progress in ensuring harmonization of financial accounts in Bangladesh, there is still a significant degree of non-compliance with GAAP. Inventory cost basis, depreciation, accounting for leases, and earnings per share calculations were all areas in which the survey found financial statements did not comply with IAS and GAAP. An appendix to the report provides a useful table of the IAS and their ICAB adoption status. At the time of the report, 31 IAS had been adopted by IASC for practice. The ICAB had adopted 21 IAS in their original versions and six more were approved by the Technical and Research Committee of ICAB, but not yet adopted by ICAB. (IASC often revises the standards after they have been issued, hence the appellation “original versions.”) ICAB is reviewing the revised versions of the adopted standards. With regards to auditing standards, the IAPC has issued more than 40 ISA, of which ICAB has adopted 22 in their original versions. CPE Seminar on Microfinance – Governance and Reporting Parveen Mahmud, FCA, ICAB, November 6, 2001 The article explains the regulatory structure governing microfinance institutions (MFIs) and microfinance NGOs in Bangladesh. (In this summary, MFIs will refer to both microfinance institutions and microfinance NGOs.) The Palli Karma-Sahayak (PKSF) is an agency set up by the Government of Bangladesh (GOB) to oversee MFIs and to provide subsidized loans to such organizations. The PKSF has policy and standards guidelines, which should be followed by MFIs. The guidelines relating to governance and financial accountability include:

• Standards for microfinance accounting


• Policy for loan classification and debt management reserve: Similar to banks and financial institutions, MFI must classify their loans and account for loan loss provisions.

• Financial ratio analysis: Analysis of financial ratios covering portfolio quality, operating efficiency, and rates of return allow managers to identify strengths and weaknesses.

• Guidelines for Management Audit • Guidelines for Internal Audit: The PKSF internal audit cell carries out management and

financial audits of MFIs each year. • Terms of Reference for an external auditor auditing PKSF • Terms of Reference for an external auditor of PKSF auditing MFIs: When an external audit of

PKSF takes place, the external auditor also audits the MFIs under PKSF’s purview. • Terms of Reference for an external auditor auditing MFIs appointed by the MFI

If an MFI deviates from the guidelines set by PKSF, the audit report should explain the nature of each deviation and management’s reasons for not complying. PKSF’s guidelines are not official accounting standards and therefore only serve as a source of assistance to an analyst looking at the accounts of an MFI. Furthermore, the article outlines the PKSF’s principles of good governance that discuss the composition and function of the MFIs boards of directors. Development of Accounting and Auditing Standards in Bangladesh, IAS 18: Revenue Recognition Prof. Santi Narayan Ghosh, Institute of Chartered Accountants of Bangladesh The report explains various theoretical views on the definition of revenue, the measurement of revenue, the recognition of revenue and the timing of revenues. Revenue must be recognized in the period in which the major economic activity leading to revenue creation takes place. Furthermore, the exchange value of revenue must be measurable, the value of revenue be verified by a market transaction, and revenue should be recognized concurrently with the related expenses. In addition, the business’ value-adding activity should be substantially complete when revenue is recognized. There are various methods of matching the timing of revenue with value-adding activity. Depending on the type of product and the terms of sale, the identification of substantial completion can vary; revenue can be recognized at the time of production, completion, sale, cash collection, or some combination of those points in time. The theoretical summary of revenue recognition provides the background for the specific application of IAS 18. The author further details the accounting treatment of revenue under IAS 18, providing specific examples of how various transactions would be treated under IAS 18. Identification of transactions under IAS 18 and revenue measurement is explained. The article details IAS treatment of some specific revenue activities, including real estate sales, sale of services, franchise fees, interest, royalties, and dividends. Finally, the article mentions the disclosure requirements for IAS 18: an enterprise complying with IAS 18 must disclose the accounting policies used for revenue recognition and the method used to determine the stage of completion. Furthermore, an enterprise must provide the categories of revenue arising from the various activities of the enterprise. The author states that Bangladeshi companies do not provide such disclosures. Corporate Governance for Transparency and Accountability The Bangladesh Accountant, April-June 2000, Vol.29; No. 2 Jamal Uddin Ahmad, FCA and M.A. Baree, FCA


The authors summarize the principles and standards of corporate governance as agreed and put forth by OECD, Cadbury Committee (UK), and other international committees. The problems of implementing international corporate governance norms in Bangladesh are then explored. Finally, the authors make some recommendations for reform of corporate governance in Bangladesh. The article identifies eight characteristics of the private sector in Bangladesh as the primary obstacles to good corporate governance in Bangladesh. They are: (1) boards and management tend to avoid disclosure; (2) closely-held family ownership leads to limited transparency and accountability; (3) bank finance is the primary source of financing; (4) a lack of independent directors and skilled audit committee members; (5) a weak regulatory framework and inefficient bureaucracy; (6) low audit fees for external auditors and a dearth of qualified internal auditors; (7) the absence of sufficient institutional investors; and (8) a lack of active minority shareholder groups. The article recommends three substantive actions be taken to improve corporate governance in Bangladesh. First, a “high powered committee” including members from government, regulatory agencies, companies, and ICAB should write a code for CG in Bangladesh. Second, amendments to existing laws should be adopted to enforce CG norms. Third, academic and professional institutions should include CG principles in their syllabi. In addition, the authors encourage institutional investors to exercise their influence and discourage nominee directors from the GOB and financial institutions. Annual Financial Statements of Banking Companies – Are Those Serving the Purpose? The Bangladesh Accountant, April-June 2000, Vol.29; No. 2 Khan Tariqul Islam, FCA In this article from The Bangladesh Accountant, the author explains the various elements of a bank’s financial statements, the importance of accurate financial statements, and the difficulties in implementing international accounting standards in the banking sector. Annual financial statements for banks include a balance sheet, profit and loss account, cash flow statement, and notes to the financial statements. The article explains the major elements of each financial statement. Of particular interest are the discussions regarding loan loss provisions and shareholders’ equity. A review of the guidelines for loan classification and provision, as established by Bangladesh Bank’s Circulars, is provided and the importance of accurate loan reporting is emphasized. The author states, “without true and fair reflection of loans the entire balance sheet of a bank can be misleading for its users and any banking company can be bankrupt overnight if its loans are not truly and fairly reflected in the balance sheet.” With respect to Shareholders’ Equity, the article points out that the present form of bank balance sheets make it difficult to identify and understand the amount of shareholders’ equity. The article underscores the importance of making bank financial statements properly reflect the true and fair financial position of the institution. The quality of information regarding banks is the cornerstone of the economy. If internal or external actors in the economy lack confidence in the banks, the whole financial system may collapse or transactions with international banks or companies may be limited. In fact, the author believes that the lack of international-level accounting and auditing standards is a major factor in the low level of foreign investment in the country. The major obstacle to improving the quality of bank financial statements, as identified by the article, is legal inconsistency between the Bank Company Act and the BAS. The implementation of BAS-30, which is equivalent to IAS-30 and governs the treatment of loans, would bring banks closer to international standards. However, BAS-30 is, in many cases, in conflict with the Bank Company Act, 1991. Other instances of legal inconsistencies are also mentioned in the article.


Profitability of Private Sector General Insurance Companies in Bangladesh The Bangladesh Accountant, April-June 2000, Vol.29; No. 2 Md Abdur Rahman and Mohammad Badrul Muttakin The article summarizes the results of a survey analysing the profitability of four private sector general insurance companies over the last five years. The results of the survey showed that for most types of insurance, the private sector insurers earned a profit. The bulk of their profits came from marine insurance, with fire insurance being next most profitable. All the surveyed companies showed high Earnings Per Share and Return on Shareholders’ Equity results. The objective of the survey was to demonstrate the possibilities for profitable private sector insurance.


Appendix K. Financial Institutions in Bangladesh State-owned commercial banks

1. Agrani Bank (AB) 2. Janata Bank (JB) 3. Rupali Bank Limited (RBL) 4. Sonali Bank (SB)

Specialised and development banks (SDBs)

1. Ansar-VDP Unnayan Bank Limited (AVUBL) 2. Bangladesh Krishi Bank (BKB) 3. Bangladesh Samabaya Bank Limited (BSBL) 4. Bangladesh Shilpa Bank (BSB) 5. Bangladesh Shilpa Rin Sangstha (BSRS) 6. BASIC Bank Limited (BBL) 7. Grameen Bank (GB) 8. House Building Finance Corporation (HBFC) 9. Investment Corporation of Bangladesh (ICB) 10. Karmasangsthan Bank Limited (KBL) 11. Rajshahi Krishi Unnayan Bank Limited (RAKUB)

Private commercial banks (PCBs)

1. Arab Bangladesh Bank Limited (ABBL) 2. Bangladesh Commerce Bank Limited (BCBL) 3. Bank Asia Limited (BAL) 4. Brac Bank Limited (BBL) 5. Dhaka Bank Limited (DBL) 6. Dutch Bangla Bank Limited (DBBL) 7. Eastern Bank Limited (EBL) 8. Exim Bank Limited (EBL) 9. First Security Bank Limited (FSBL) 10. International Finance Investment and Commerce Bank Limited (IFICBL) 11. Jamuna Bank Limited (JBL) 12. Mercantile Bank Limited (MBL) 13. Mutual Trust Bank Limited (MTBL) 14. National Bank Limited (NBL) 15. NCC Bank Limited (NCCBL) 16. One Bank Limited (OBL) 17. Premier Bank Limited (PBL) 18. Prime Bank Limited (PBL) 19. Pubali Bank Limited (PBL) 20. Shahjalal Bank Limited (SBL) 21. Southeast Bank Limited (SBL) 22. Standard Bank Limited (SBL) 23. The City Bank Limited (TCBL) 24. The Trust Bank Limited (TTBL) 25. United Commercial Bank Limited (UCBL) 26. Uttara Bank Limited (UBL)


Foreign commercial banks 1. American Express Bank 2. Citibank NA 3. Credit Agricole Indosuez 4. Habib Bank Limited 5. National Bank of Pakistan 6. Shamil Bank of Bahrain EC (ex Faisal Bank) 7. Standard Chartered Bank 8. State Bank of India 9. The Hong Kong and Shanghai Banking Corporation Limited 10. Woori Bank Limited (ex Hanil/Hanvit Bank)

General Insurance Companies

1. Agrani Insurance Company Limited 2. Bangladesh Cooperative Insurance Limited 3. Bangladesh General Insurance Company Limited 4. Bangladesh National Insurance Company Limited 5. Central Insurance Limited 6. City General Insurance Limited 7. Continental Insurance Company Limited 8. Crystal Insurance Limited 9. Eastern Insurance Limited 10. Eastland Insurance Limited 11. Express Insurance Limited 12. Federal Insurance Limited 13. Global Insurance Limited 14. Green Delta Insurance Company Limited 15. Islami Commercial Insurance Company Limited 16. Islami Insurance Limited 17. Janata Insurance Limited 18. Karnaphuli Insurance Limited 19. Lloyds Insurance Limited 20. Meghna Insurance Limited 21. Mercantile Insurance Limited 22. Nitol Insurance Limited 23. Northern General Insurance Company Limited 24. Paramount Insurance Company Limited 25. People’s Insurance Limited 26. Phoenix Insurance Limited 27. Pioneer Insurance Limited 28. Pragati Insurance Limited 29. Prime Insurance Company Limited 30. Purabi General Limited 31. Reliance Insurance Limited 32. Republic Insurance Limited 33. Rupali Insurance Limited 34. Sadharan Bima Corporation 35. South Asia Insurance Limited 36. Sunflower Insurance Limited 37. United Insurance Limited


Life Insurance Companies 1. American Life Insurance Company Limited 2. Baira Life Insurance Limited 3. Delta Life Insurance Limited 4. FarEast Islami Life Insurance Company Limited 5. Homeland Life Insurance Company Limited 6. Jiban Bima Corporation 7. Meghna Life Insurance Limited 8. National Life Insurance Limited 9. Padma Life Insurance Company Limited 10. Progressive Life Insurance Company Limited 11. Provati Life Insurance Company Limited 12. Rupali Life Insurance Company Limited 13. Sandhani Life Insurance Limited 14. Sunlife Life Insurance Company Limited

Non Bank Financial Institutions

1. Bangladesh Finance & Investment Limited (BFIL) 2. Bangladesh Industrial Finance Company Limited (BIFIL) 3. Bay Leasing & Investment Limited (BLIL) 4. Delta Brac Housing Finance Company Limited (DBHFCL) 5. Fareast Finance & Investment Limited (FFIL) 6. Fidelity Assets and Securities Company Limited (FASCL) 7. First Lease International Limited (FLIL) 8. GSP Finance Company (Bangladesh) Limited (GSPFCL) 9. Industrial & Infrastructure Development Finance Company Limited (IIDFCL) 10. Industrial Development Leasing Company (IDLC) of Bangladesh Limited 11. Industrial Promotion Development Company (IPDC) of Bangladesh Limited 12. Infrastructure Development Company Limited (IDCOL) 13. International Leasing & Financial Services Limited (ILFSL) 14. Islamic Finance & Investment Limited (IFIL) 15. Midas Financing Limited (MFL) 16. National Housing Finance & Investment Limited (NHFIL) 17. Oman Bangladesh Leasing & Finance Limited (OBLFC) 18. Peoples Leasing & Financial Services Limited (PLFSL) 19. Phoenix Leasing Company Limited (PLC) 20. Premier Leasing International Limited (PLIL) 21. Prime Finance & Investment Limited (PFIL) 22. Saudi Bangladesh Industrial & Agricultural Investment Company (SABINCO) Limited 23. Self Employment Limited (SEL) 24. The UAE-Bangladesh Investment Company Limited (UBINCO) 25. Union Capital Limited (UCL) 26. United Leasing Company Limited (ULC) 27. Uttara Finance & Investment Limited (UFIL) 28. Vanik Bangladesh Limited (VBL)


Appendix L. Resources Ahmad, Jamal Uddin and M.A. Baree. Corporate Governance for Transparency and Accountability, The Bangladesh Accountant, Vol.29; No. 2, April-June 2000 Ahmad, Mushtaq. Doing Business in Bangladesh, S.F.Ahmed & Co. August 1999. Originally published by Ernst & Young International, Inc, Singapore, June 1996. AIMS of Bangladesh. Bangladesh: Strategic Issues and Potential Response Initiatives in the Economic Sector: Enterprise Reform and Privatization (ERP). Asian Development Bank. Capacity Building of the Securities and Exchange Commission and Selected Capital Market Institutions, TAR:BAN 33226, November 2000 Bangladesh: Strategic Issues and Potential Response Initiatives in the Economic Sector: Enterprise Reform and Privatization (ERP), Working Draft for Discussion, Asian Development Bank. Centre for Policy Dialogue. Corporate Responsibility Practices In Bangladesh: Results from a Benchmark Study, July 16, 2002 Chowdhury, Anwaruddin. Moving to International Standards, Presented at “Bangladesh Moving to International Accounting Standards, Regulation And Corporate Governance In Financial Services Opportunities and Challenges for Financial Managers and regulators in Bangladesh” March 20-21, 2001 Commonwealth Association for Corporate Governance. Principles for Corporate Governance in the Commonwealth, November 1999. www.cbc.to Ghosh, Santi Narayan. Development of Accounting and Auditing Standards in Bangladesh IAS 18: Revenue Recognition, Institute of Chartered Accountants of Bangladesh IDCOL Newsletter, August 24, 2001 Imam, Shahed. The Cost and Management (Journal of the ICMAB), September-October 1999. International Accounting Standards Committee. International Accounting Standards 2001, 2001. Islam, Khan Tariqul. Annual Financial Statements of Banking Companies – Are Those Serving the Purpose?, The Bangladesh Accountant, Vol.29; No. 2, April-June 2000 Lal, Dr. T. and Ahmed Fakhrul Alam. Need for a Specialised Export Financing Institution in Bangladesh, The Bangladesh Accountant, Vol.29; No. 2, April-June 2000 Mahmood, Prof. Wahiduddin. Bank Reform Committee Report (in Bangla), Government of Bangladesh, December 1999 Mahmud, Parveen. CPE Seminar on Microfinance – Governance and Reporting, Institute of Chartered Accountants of Bangladesh, November 6, 2001


Meghna Condensed Milk Industries Limited. Prospectus, June 28, 2001 Organisation for Economic Co-operation and Development. OECD Principles of Corporate Governance. 1999. Available from http://www.oecd.org Organisation for Economic Co-operation and Development. Corporate Governance in Asia: A Comparative Perspective, 2001. Rahman, Md. Abdur and Mohammad Badrul Muttakin. Profitability of Private Sector General Insurance Companies in Bangladesh, The Bangladesh Accountant, Vol.29; No. 2, April-June 2000 Saha, Dr. Sujit and Md. Saidur Rahman. Implementation of International Accounting Standard (IAS) in Banks and Financial Institutions - A Step Towards Sound Governance System, Paper presented at the Management Forum - 2002, on "Institutional Governance: Failure in Building Infrastructure for Socio-Economic Growth" Organized by AMDB on July 25 - 26, 2002 Sayeed, Yawer. Bangladesh: Strategic Issues and Potential Response Initiatives in the Finance Sector: Banking Reform and Development (BRD), Asian Development Bank and AIMS of Bangladesh Limited, July 22, 2002 Sayeed, Yawer. Bangladesh: Strategic Issues and Potential Response Initiatives in the Finance Sector: Integrated Financial Development (IFD), Asian Development Bank and AIMS of Bangladesh Limited, July 22, 2002 Temple, Frederick T. Country Director, World Bank, Dhaka Speech at a seminar titled “Financing Private Sector Infrastructure Projects” on August 24, 2002 Transparency International Bangladesh, Office of the Comptroller and Auditor General (CAG), Executive Summary and Working Paper, September 2002 Transparency International Bangladesh, Standing Committee on Public Accounts, Executive Summary and Working Paper, September 2002 World Bank. Bangladesh: Financial Accountability for Good Governance, 2002 World Bank. Taming Leviathan: Reforming Governance in Bangladesh An Institutional Review, March 2002


Appendix M. Report on January 7, 2003 Seminar Report on Seminar: “Strengthening Corporate Governance” January 7, 2003 All invitees were provided the Executive Summary of the December 30, 2002 Draft for Discussion report “A Diagnostic Study of the Existing Corporate Governance Scenario in Bangladesh.” All those invited as special/chief guests or discussants were provided the full version of the report. (Please see the attached schedule.) All points attributed to speakers are paraphrased from notes and the seminar transcript, unless they are provided in quotes. A full transcript has also been prepared. Session 1: Farooq Sobhan inaugurated the session. Mr. Sobhan explained the basic objectives of the project and the methods used in the research. He highlighted the survey of companies as well as interviews with key stakeholders in the corporate governance arena. The seminar is part of the ongoing process of receiving feedback from stakeholders. Particular thanks were given to DFID for their support of the project. In addition, a warm welcome and thanks were extended to all the participants, but particularly the Chief Guest, Mr. Moudud Ahmed (MP, Minister of Law, Justice and Parliamentary Affairs), and Special Guest, Dr. Fakhruddin Ahmed (Governor, Bangladesh Bank). After introductory remarks by Farooq Sobhan (President, Bangladesh Enterprise Institute), Wendy Werner presented a summary of the report’s findings. The floor was then opened to comments from participants. Mohammed Abdul Hannan Zoarder, SEC47

Through indirect regulation of listed insurance, bank, and non-bank financial institutions, therefore, SEC’s scope and jurisdiction is broader than just the listed companies.

Mr. Zoarder had a number of points to refute the characterisation of the SEC in the report. o SEC has to put rules in English and Bangla newspapers before implementation to allow

an opportunity for comments, so it is not correct that the SEC does not allow opportunity for comments.

o The SEC tries to “do something on the basis of individual events.” o Those with grievances against SEC rules or rulings can go to court. The court has not

ruled against SEC, therefore one cannot say that the SEC acts outside its legal authority. On the point of fraud and inaccurate information in IPOs, Mr. Zoarder said the SEC cannot

examine all documents for an IPO. It is the responsibility of the auditors to ensure full disclosure. With regard to bankruptcy, the U.S. has Ch. 11 and Ch. 7 bankruptcy. Ch. 11 bankruptcy allows

for reorganization. Bangladesh needs a similar Ch. 11 reorganization law. The importance of an audit was also emphasized, Mr. Zoarder said “good accountants are doing

bad audits.” Mohammed Aziz Khan (Managing Director, Summit Group)

Bangladesh does not yet have a critical mass of businesses to implement good Corporate Governance (CG).

A key problem (also mentioned in the presentation and report) is the personal guarantees required of directors. It is difficult to ensure that all directors have good credit.

47 Securities and Exchange Commission


o This requirement is in opposition to the limited liability concept and it is a very important problem.

A.K. Chowdhury (FCA, Hoda Vasi Chowdhury & Co.)

Mr. Chowdhury pointed out that the DSE, insurance, and mutual fund sectors were not mentioned in the Executive Summary and that these are also key institutions/sectors. (Editor’s note: DSE, insurance, and mutual fund sectors are discussed in the full report. Mr. Chowdhury had only received the Executive Summary.)

He also believes that there is a strong need for emphasizing audit committees in companies. Board of Investment (BOI) also plays a key role in attracting investment. Before good CG, we need good public governance.

M.A. Malik (former Secretary) There is a need for a post-privatization programme for State-owned Enterprises (SOEs) and a need to look specifically at CG at privatised SOEs. Sultan-uz Zaman Khan (former Chairman, SEC)

There is a need to improve general governance and adherence to the rule of law in addition or before looking at CG.

Insurance funds can play an important role in CG, particularly the Chief Controller of Insurance. BOI and Bangladesh Export Processing Zone Authority (BEPZA) are also important to attracting

foreign direct investment (FDI). He asked the writers to substantiate the claim that “SEC impinges on business decisions regarding

distribution of profits.” There is a need to close and/or privatise more SOEs.

Special Guest, Dr. Fakhruddin Ahmed (Governor, Bangladesh Bank) was then asked to make his comments. Dr. Fakhruddin Ahmed (Governor, Bangladesh Bank) In order to improve CG, we have to break it down into pieces and operationalize it. We need good governance as well, but can start on the pieces of CG first. If the pieces of CG are identified, we can begin to do something on each one of those pieces. The BEI study is a start and it provides a menu of the current problems. With regard to directors and management, outsiders should understand the role of directors and management. Bangladesh Bank (BB) has issued a circular on the role and responsibilities of boards in nationalised banks. We [BB] are also thinking about requirements for directors for private banks. Another organisation that could play a part is Bangladesh Institute of Bank Managers (BIBM). What is their role? An amendment to the Bank Control Act is also being considered to allow for directors representing depositors to be appointed by BB. This could be the beginning of real independent directors. BB has recently been working to strengthen regulations. We recently increased the capital adequacy of banks. Loan approval limits are now 50% of a bank’s capital. There are also new limits on total exposure. With regard to audits, financial statements should require more disclosures. There is also a need to improve audit standards. BB has now required banks to comply with IAS-30 and BB itself will be complying with IAS and will be audited according to ISA.

All BB regulations should now be available on our website.


The issue of impediments to the capital markets is an important one. Banks should not be 97% of the financial sector.

Bank rates should also increase to move closer to the national savings certificate rates. BB is working on a primary auction market.

The one thing that will truly determine the improvement in CG is the quality of boardroom discussions, which no one can regulate. How will we know if the directors behave as they should? Perhaps training for directors (as mentioned by Farooq Sobhan) is a good solution.

A question was posed by the SEC representative. Mr. Zoarder: You have limited the size of the bank boards to 9 to 11 directors. Dr. Ahmed: Yes, we have circulated a proposal on limitation of the size of boards for everyone’s views. It’s not yet been officially released. We are also considering a “fit and proper” test for directors similar to the “fit and proper” test for CEOs that we already issued. The Law Minister was then given the floor. Moudud Ahmed (MP, Minister of Law, Justice and Parliamentary Affairs) The BEI study provides a base for improving CG in Bangladesh. Our primary problem is a lack of professionalism, meaning a lack of efficiency and also a lack of good governance. So far, the country has not been able to develop a corporate culture, but we are a new country and were previously not independent.

Two important laws that have not been mentioned that encourage foreign investors are the intellectual property rights and the Arbitration Act.

We have recently decided, just last night, that the government will have to be devolved and BB will be completely independent.

The Registrar of Joint Stock Companies (RJSC) is in a dismal condition. One can’t get documents that should be available. It can take 6 months or more to get documents and some documents are just not there. Certified copies also take time. The RJSC needs to be modernized and computerized. They also do some things that are just not in the law. For instance, the RJSC requires a no objection certificate to change a registered office, but this appears nowhere in the law.

There is also a high default rate because borrowers don’t use money for the reasons the money was provided.

Banks also are half-hearted in their filing in the Money Loan Court. They file at the last minute so that they can tell their boards they have done so. Once the suit is filed, they do not pursue the case.

Execution of Money Loan Court decisions is also a problem; execution usually takes several years. We will recast the law on loan recovery to deal with this problem.

Extensive training of judges regarding arbitration and mediation procedures that could take place outside the court.

The current Bankruptcy Act is inadequate. There has been no case in the Supreme Court yet, so the courts have a lack of understanding regarding the law. There is a need for education regarding the proper use of the Bankruptcy Act.

Implementation recommendations for this project should include training to increase awareness of CG. Also, we should recognize good CG, perhaps through national awards and the establishment of a national standard.

Session 2: The Role of the Directors and Shareholders Prof. Abu Ahmed (Dept. of Economics, University of Dhaka)


I have some relevant experience to share here as I have been on boards of directors as the lone outsider. Mostly management and the board have been family owned. In the case of one board that was family-dominated, they didn’t even want to hold board meetings and AGMs did not take place on time. Finally, I quit the board because I didn’t feel I was representing shareholders adequately.

There should be a regulation by the SEC that the number of board meetings and the attendance at board meetings should be reported.

Usually on boards non-executive directors are dominated by executive directors In banking companies, I think there should be proportional board representation to the

contributors of capital. Prof. Ahmed is Chair of the board for a development financial institution (gov’t). He finds generally that the board does not have time to even read the agenda before the meeting and executive directors and management control what is put on the agenda. So the directors do not have much real input to the board meeting. Furthermore, when, as Chair, he asks for borrowers to provide more information (i.e. tax information), they question why the information is being requested and do not like to provide the information. On shareholders, AGMs don’t last more than 3-4 hours, with good food and therefore are not long enough to spend time on the substantive issues. Shareholders in Bangladesh are not educated to analyse financial statements. Disclosures are an area in which things could be improved for shareholders. First, salaries and allowances of CEOs should be a required disclosure. Second, one can notice many differences in Annual Reports due to voluntary disclosure. For instance, some companies disclose the individual shareholdings by each director and show the changes over time. This is a piece of information a shareholder can understand and it should be a required disclosure.

Z category companies: One third of the companies on the DSE are categorized as Z category. They start declaring 2-3% dividends in order to graduate from the Z category even though there is no change in operations.

With regard to the SEC requirement for institutional shareholders to have a board seat, he is in favor of the requirement.

The report asserts there are few incentives to going public. He agreed; the current tax advantage (5%) is not enough to provide an incentive to go public. The tax advantage should be at least 10%

Syed Manzoor Elahi (Chair, Apex Group; President, Bangladesh Association of Banks; Vice President, Bangladesh Association of Public Listed Companies)

Private companies see no reasons for disclosure or to go public. When a company has a big project, it then goes to the public because financing only with debt is too expensive. So the assertion of the report that there are few reasons to become a public company is correct.

With regard to the Companies Act, the Companies Act should clearly define the rights and responsibilities of shareholders.

Boards of directors with too many directors are very difficult to run. I would limit the number of directors to 10. A good way to limit the number of directors is to require that all directors hold qualification shares of 5-10% of the company.

With regard to family holdings, the thinking of shareholders here is that larger family holdings (at least 60%) is better. If the family’s shareholding is diluted shareholders complain because they feel the family managers-owners are no longer interested in the company.

Therefore, it is difficult to implement many CG governance principles in Bangladesh when the board is dominated by family and that’s exactly what the shareholders want.


On shareholders and the AGM: Most activist shareholders are professional hecklers that try to extort money prior to the AGM in exchange for their silence at the AGM. Even with stronger SEC rules, this AGM mafia continue to blackmail companies.

Rights and responsibilities of shareholders and directors should be in the Companies Act. Companies Act should also not conflict with Articles of Association. It is the task of the RJSC to point out violations of the Companies Act that appear in Articles of Association. For instance, the Companies Act does not allow the renting out of company property (?), but many Articles of Association allow it.

Independent directors are a “double-edged sword” and their inclusion should be left up to the sponsors.

The floor was opened to discussion and questions. Sultan-uz Zaman Khan (former Chairman, SEC) suggested merging the offices of the SEC and RJSC. Haroonur Rashid (former Chairman, SEC)

A merger of the SEC and RJSC may not solve the problem if they are not provided with proper pay, equipment, logistics, etc.

The rights and responsibilities of directors and shareholders are adequately addressed in the laws, but are not enforced properly.

It is also difficult and expensive to utilise minority shareholder protections under Section 233. Mohammed Abdul Hannan Zoarder (SEC)

The SEC cannot monitor all board meetings and minutes; that would be micro-managing companies. There is no circular yet on individual board shareholdings.

The SEC is understaffed and the benefits are inadequate. In Pakistan, the SEC and RJSC have been merged and extra compensation is offered to SEC officers.

There are incentives to going public: 1. A public company gains respect and esteem. 2. They can raise more money and can grow bigger. 3. A publicly listed company receives a 10% tax rebate.

The SEC has required videotapes of AGMs but has not yet reviewed them all. Videos will be used to make a case before a court, but they have not yet gathered sufficient evidence to prosecute anyone yet.

On the issue of CG principles being voluntary or required: The SEC has tried to encourage voluntary compliance with good CG principles. We sent the OECD guidelines on CG to the chamber bodies, but the chambers don’t do anything to encourage them. Further, 95% of the requirements for global CG are in the law, but they are not enforced.

Farooq Sobhan posed the question of why IPOs in Bangladesh are declining. Mr. Zoarder replied that other countries have also seen a decline in IPOs. He cited examples of Pakistan and Thailand which have had one and zero IPOs, respectively.

Yawer Sayeed (CEO, AIMS of Bangladesh Ltd. and BEI CG Team) In response to Mr. Zoarder of the SEC, Mr. Sayeed highlighted that the diagnostic study revealed the state of corporate governance in the country through the impressions of entrepreneurs as well as regulators. The study highlights that there is considerable scope for improvement in the regulatory agencies. It recognizes that the SEC has a difficult situation to manage and that the pay scale and capacity at the SEC is in need of improvement. The exercise here is not to pass the buck or blame other groups or agencies, but to begin to work together to improve the situation. Session 3: Banks and Financial Institutions


Dr. Debapriya Bhattacharya (Executive Director, Centre for Policy Dialogue)

The financial sector section of the report does not cover the full financial sector. It doesn’t look at non-banking financial institutions and micro-credit. The focus of the report should be qualified.

As for the organization of the report, the sub-headings should identify the areas of major problems.

Other areas that should be mentioned in the report include: (i) corporate management and incentive failures/moral hazard problems, (ii) banking wing of the Ministry of Finance, (iii) more on the indigenous committees and reports that have been prepared on banking (Money and Banking Reform 1985, Mahmud’s Commission 1991)

In the capital markets section, there should be a discussion of governance issues with the DSE/CSE and computerization. For instance, the central depository system didn’t work for the stock exchange.

The survey is not completely reflected in the paper. The data from the survey should be provided in a tabular form.

The judiciary is not discussed in the financial sector. Banks often face questions of which court to take a case to, the Money Loan Court or Bankruptcy Court. The Supreme Court also identifies defaulters.

M.A. Malik (former Secretary) The importance of CG is not confined to the commercial banking sector. The CG situation at Bangladesh Bank should also be included. We need to see if the risk is being managed properly at Bangladesh Bank. I would suggest you take a look at the Basel Committee guidelines on banking supervision. Sultan-uz Zaman Khan (former Chairman, SEC) I agree the report should include more discussion of the DSE/CSE. The performance of the capital markets could also be expanded. There were a number of SEC reports after the 1996 situation that could be helpful. Habibullah Bahar (Economic Advisor, Bangladesh Bank) There is some inaccuracy in the report regarding the composition of the BB Board of Directors; there are currently 9 members. Dr. Debapriya Bhattacharya (Executive Director, Centre for Policy Dialogue)

There is a problem of the BB board. Right now there’s an MD (medical doctor) on the board, which should not be allowed.

NCBs are also not under the purview of the BB, which is a major shortcoming. Session 4: Auditing and Accounting M.A. Baree (former president, Institute of Chartered Accountants of Bangladesh)

I’ve just returned from India and the group will be glad to hear that a Bangladeshi company received an award for the quality of its accounts.

Adoption of accounting standards is not enough by itself. In Bangladesh, companies do not want to spend money and time to have proper accounts prepared. Even if adopt all International Accounting Standards (IAS), companies will select the worst auditor.

The basic problem is very low audit fees. The SEC does not have sufficient technical knowledge to check accounts.


I propose that all listed companies should have an audit committee of the board of directors, which must include directors with financial knowledge. The audit committee should select the auditors.

I believe that having non-executive directors without family connections is important. Director training is also a good idea.

A major problem in Bangladesh is that group companies don’t have to be consolidated. We do not have a fiscal incentive to consolidate. Most places have a provision in the tax law that allows a company with greater than 51% of a holding in a subsidiary to apply any loss from that subsidiary to the overall accounts of the group (and therefore reduce taxes). We do not have this in our tax law.

Comments were taken from the floor. A.K. Chowdhury (FCA, Hoda Vasi Chowdhury & Co.)

Accounting standards and auditing standards are often mixed up. Accounting standards apply to the internal workings of preparing accountings. There are no regulations on who will prepare accounts.

No one in the SEC properly evaluate the accounts prepared by companies. ICAB only has 700 members and they have very little money, the contributions from members

are very low. Hafizuddin Khan (former CAG) Mr. Khan made extensive comments regarding the preparation and treatment of public accounts and the CAG. The full remarks will be taken from the transcript. The floor was opened to questions. Wendy Werner (BEI) Ms. Werner asked Mr. Baree about his opinion regarding the role of ICAB in informing shareholders about the role and value of an auditor and about what further steps should be taken to encourage or enforce consolidation. M.A. Baree

ICAB has many limitations in raising awareness among shareholders. The SEC or stock exchanges should make shareholders more aware.

On consolidation, the Companies Act should allow/require consolidation when a company has 51% of the equity of another enterprise.

Haroonur Rashid (former Chairman, SEC)

ICAB maintains that audit quality is not maintained because fees are too low. However, the fees should be controlled by the self-regulating organisation (SRO). If all members agree not to quote rates below a standard, the level of rates will be maintained.

In his experience, ICAB punishments are too light. ICAB should work harder at enforcing quality requirements.

Mr. Zoarder also defending the capabilities of the officers at the SEC saying they all had MBAs or MAs in Accounting. Mr. Baree pointed out that an MBA is a professional degree but a Chartered Accountant is a technical qualification. The SEC needs this type of technical expertise. Session 5: Regulatory and Legal Environment


Dr. M. Zahir (Senior Advocate, Supreme Court) The legal environment for CG is poor. The particular problem is implementation. There should be further training for judges on corporate and securities law. The SEC is trying, but sometimes there is some overkill. SEC comes up with lots of regulations,

every Friday they are introduced and I don’t know who has the time to read them all. There is also a lack of knowledge of the law and its requirements on the part of managers. Accountants and auditors should act as watchdogs, not bloodhounds, but also should not give up

after sniffing the air just once. Auditors must clearly point out the problems so others can solve them. In 1993, Justice Donovan in a Canadian case said “yes, yes he may be a watchdog, but it is no good if after one howl, he retires to the barn and goes to sleep.”

Liability of auditors: If auditors are not up to the mark, what remedy do shareholders have? There is nothing in the law protecting shareholders, there is only some case law. In the U.S. for instance, there must be direct causation of financial liability from the auditor’s statements or actions.

With regard to application of Section 233, a case can only go forward with 10% of the shares, which is quite a lot in the case of a large company. It is also difficult to prove directors are at fault. In response to questions, Dr. Zahir pointed out that the 10% requirement could be sensitive to the size of a company – i.e. large companies could only require 5% of the stock, or similar.

The High Court does not have direct jurisdiction over SEC cases. Ms. Sheela Rahman (Advocate and BEI CG team)

There is a significant lack of prompt information regarding rules, regulations and laws with regard to companies and securities. This creates difficulties for companies trying to comply with the laws as well as for professionals trying to advise companies whether to go for listing or stay a listed company.

One result of the report was that there is a lack of awareness regarding the rights of shareholders. This is true in many instances of law so what we would like to do is to raise awareness before going on to law reform.

The question of shareholder rights also brings up the 10% floor for minority protection. There has been recommendations regarding lowering the floor for minority shareholder action; this would open a floodgate of actions.

There is a significant need for additional training in the areas of commercial law, securities law and the role of specialized courts.

Dr. Zahir On the issue of the 10% floor for minority shareholding, a formula could be used that relates the percentage requirement to the size of the company. After some further discussion with Dr. Zahir, the meeting was adjourned by Farooq Sobhan, with thanks particularly to the participants and the discussants. Particular thanks are extended to Mr. Mohammed Abdul Hannan Zoarder of the SEC and Mr. A.K. Chowdhury of Hoda Vasi Chowdhury & Co. who provided written comments to the draft report. In all possible cases, the written comments were incorporated into this final report.


List of participants in the Seminar on Strengthening Corporate Governance held on

7 January 2003 at BEI Sl No Name Organization 1. Ms. Wendy Werner BEI 2. Mr. Haroonur Rashid Former Chairman, SEC 3. Mr.K. Mahmood Sattar Managing Director & CEO Eastern Bank Ltd 4. Mr. Zia U. Ahmed SEDF, 10 Gulshan Ave 5. Mr. Anil Sinha SEDF, 10 Gulshan Ave 6. Mr. Anton de Wilde SEDF 7. Mr. Aminul Islam Former Ambassador 8. Mr. Mostafa Faruque Mohammed Sr. Research Fellow, BEI 9. Mr. Sultan-uz Zaman Khan Ex-Chairman, SEC 10. Mr. M.A. Malik Former Secretary 11. Mr. M. Afsarul Qader Former Ambassador 12. Mr. Frank Matsaert DFID, British High Comm 13. Mr. Monzurul Haque ORG-MARG-QUEST 14. Mr. Yawer Sayeed AIMS of Bangladesh Ltd 15. Mr. A.K. Chowdhury HODA VASI Chowdhury & Co. 16. Mr. Wali-ul-Maroof Matin Chittagong Stock Exchange 17. Mr. AKM Ziauddin P.B.TL 18. Mr. Mohammad Tipu Sultan P.B.TL 19. Mr. Abu Ahmed Dhaka University 20. Mr. Mohammed Abdul Hannan Zoarder SEC 21. Mr. Zahid Hossain Sr. Research Fellow, BEI 22. Mr. Mohammed Aziz Khan Summit Group 23. Mr. M. Shafiullah Sr. Research Fellow, BEI 24. Iqbal U Ahmed A.B. Bank Ltd, Head Office 25. Mr. SM Abdul Mannan Member, BEI Board of Governors 26. Mr. Mollah Shahidul Haque Consultant DCCI 27. Syed Mazur Elahi Chairman, Apex Group; Vice President,

Bangladesh Association of Public Listed Companies 28. Mr. Habibullah Bahar Bangladesh Bank 29. Mr. Debapriya Bhattacharya Executive Director, CPD 30. Mr. M.A. Bari Institute of Chartered Accountants of

Bangladesh 31. Ms. Sheela R. Rahman Bar-at-Law, Rokunuddin Mahmud

and Associates 32. Dr. M. Zahir Sr. Advocate, Supreme Court 33. Mr. Hafizuddin Khan Former CAG 34. Mr. Altaf Hossain Sarkar Member, BEI Board of Governors 35. Mr. Farooq Sobhan President, BEI


Programme for National Seminar on

“Strengthening Corporate Governance in Bangladesh”

January 7, 2003 Bangladesh Enterprise Institute

House 20, Road 5, Gulshan-1, Dhaka Session 1: 9:30 am to 11:00 am

Introductory Remarks: Farooq Sobhan President, Bangladesh Enterprise Institute Presentation of the Draft Report “Diagnostic Study of the Existing Corporate Scenario in Bangladesh” BEI Corporate Governance Team Special Guest: Dr. Fakhruddin Ahmed Governor, Bangladesh Bank Chief Guest: Moudud Ahmed, MP Minister of Law, Justice and Parliamentary Affairs

Tea Break: 11:00 am to 11:30 am

Session 2: 11:30 am to 1:00 pm

The Role of the Directors and Shareholders Discussants: Prof. Abu Ahmed, Dhaka University Syed Manzoor Elahi, Apex Group

Lunch: 1:00 pm to 2:00 pm

Hosted by Bangladesh Enterprise Institute

Session 3: 2:00 pm to 3:00 pm

The Role of Banks and Financial Institutions Discussants: Allah Malik Kazemi, Deputy Governor, Bangladesh Bank Mahmud Sattar, MD, Eastern Bank Dr. Debapriya Bhattacharya, Executive Director, CPD

Session 4: 3:00 pm to 4:00 pm

Auditing and Accounting Standards Discussants: MA Baree, President, ICAB M Hafiz Uddin Khan, Chairman, Public Expenditure Review Commission

Tea Break:


4:00 pm to 4:15 pm Session 5: 4:15 pm to 5:15 pm

The Regulatory and Legal Environment Discussants: Manir Uddin Ahmad, Chairman, SEC Dr. Muhammad Zahir, Senior Advocate, Supreme Court

Closing Session: 5:15 pm to 6:00pm

Chief Guest: Amir Khosru Mahmud Chowdhury, MP Commerce Minister Closing Remarks: Farooq Sobhan President, Bangladesh Enterprise Institute


Getting There — Pretty Rapidly

The State of Corporate Governance in India

Omkar Goswami48 Chief Economist Confederation of Indian Industry New Delhi, India It would be accurate to say that ‘corporate governance’ was a relatively unknown phrase throughout most of Asia until the Thai baht spun out of control in July 1997, and started the financial crisis throughout the region. No doubt there were occasional international seminars on the subject where a handful of activists made powerful, often emotional, cases for greater corporate transparency, disclosure and protection of minority rights; and some enlightened managers and policy-makers had read the Cadbury Committee Report and believed in the desirability of having better boards with more independent directors. However, in the main, corporate governance was generally unheard of, and considered an alien occidental fad that was ill suited to Asian values and time-tested ways of doing business. Superficially, South-East and East Asian corporations, banks, stock markets and governments seemed to have every reason to be unconcerned about corporate governance. From the mid-1980s right up to 1996, the region as a whole had consistently clocked extremely impressive growth rates — among the highest in the world. The countries followed prudent fiscal policies. Indeed, most of them notched budget surpluses, and none that were crippled by the Asian contagion racked up deficits like the ones seen in Latin America, Turkey, India, or even some of the western European nations. Most enjoyed a booming export trade. These countries had high savings as well as investment rates, and relatively good infrastructure. Banks as well as foreign and domestic investors bent over backwards to offer all manner of debt and equity. Sure, many of the conglomerates were heavily leveraged with short term dollar denominated debt, and were riddled with complex cross-holdings. But, there were projects to be had, profits to be made, and so long as the boom continued, debts would be paid. Stock markets were booming like never before, giving equity investors handsome capital gains. The system worked like a well oiled machine. There was absolutely no felt need to impose concepts like better accounting practices, greater disclosure, and independent board oversight. The crisis of 1997-98 changed all that. This was no classical Latin American debt crisis. Here were fiscally responsible, healthy, rapidly growing, export driven economies that went into crippling financial crisis. Slowly, companies, banks, governments as well as international multilateral institutions began to understand that severe structural flaws in the realms of microeconomics could trigger region-wide macroeconomic financial collapse. There was a gradual realisation that the devil lay in the institutional details — the nitty-gritty of transactions between companies, banks, financial institutions and capital markets; of the design of corporate laws; of bankruptcy procedures and practices; of the structure of ownership and crony capitalism; of stock market practices; of poor boards of directors with scant fiduciary responsibilities; of disclosures and transparency; and of inadequate accounting and auditing

48 For comments and queries, please E-Mail [email protected]. No part of this article may be quoted or reproduced without permission of the author or the Confederation of Indian Industry.


standards. Suddenly, ‘corporate governance’ was dusted out of academic and activist closets and given centre stage. The corporate governance movement began in most of Asia in 1998 and continued at varying paces right up to 2001. By the middle of 2001, however, most of Asia was getting back to a concerted growth phase, and the psyche of investors had swung from fear to greed. Not unsurprisingly, there were incipient signs that while every country was faithfully mouthing the mantras, the spirit of corporate governance was being prepared for a quiet burial in most. Thankfully, then came Enron, followed by World Com, QWest, Global Crossing and the rest of their ilk. And, in the words of Nell Minnow, a corporate governance activist in the US, “What couldn’t be got for decades is now being achieved in days.” All tea leaves suggest that corporate governance is here to stay — at least for a fair while. Strangely, in this Asian scheme of things, India has been an unpublicised outlier. First, unlike South-East and East Asia, the corporate governance movement did not occur due to a national or region-wide macroeconomic and financial collapse.49 Indeed, the Asian crisis barely touched India. As we shall see later in this paper, the need for having international standards of corporate governance and better financial and non-financial disclosures became prominent well before the Thai baht began to nosedive in June 1997. Second, again unlike all other Asian countries, the initial formalised drive for having higher standards of corporate governance and disclosure came from an all-India industry and business association — and not the stock markets, regulators, investor associations or government.50 Third, at the risk of pre-empting a conclusion, it will be fair to say that listed companies in India follow the most stringent guidelines for corporate governance throughout Asia, which rank among some of the best in the world. This is not to claim that India can’t do better corporate governance; but that it is definitely in the vanguard — and that the pace of India’s corporate governance reforms far outstrip that of other economic reforms. This article attempts to interlink some business history and economic theory with considerable empirical evidence to delineate the story of corporate governance in India — how the country stands today, and what could be the future direction. Section 1 gives a brief historical overview, if only to understand the structure of corporate India and why corporate governance meant so little until the late 1990s. Section 2 describes the existing structure of corporate India, and its legal and regulatory agencies. It gives details of

49 Governance issues came to the fore due to a spate of corporate scandals that occurred during the first flush of economic liberalisation. The first was a major securities scam that was uncovered in April 1992, which involved a large number of banks, and resulted in the stock market nose-diving for the first time since the advent of reforms in 1991. The second was a sudden growth of cases where multinational companies, aided by an obscure provision in Companies Act, 1956, started consolidating their ownership by issuing preferential equity allotments to their controlling group at steep discounts to their market price. The third scandal involved disappearing companies of 1993-94. Between July 1993 and September 1994, the stock index shot up by 120%. During this boom, hundreds of obscure companies made public issues at large share premia, buttressed by sales pitch of obscure investment banks and misleading prospectuses. The management of most of these companies siphoned off the funds, and a vast number of small investors were saddled with illiquid stocks of dud companies. This shattered investor confidence, and resulted in the virtual destruction of the primary market for the next six years. These three episodes led to the prominence of corporate governance within the financial press, banks and financial institutions, mutual funds, shareholders, the more enlightened business associations, the regulatory agencies and the government. 50 In December 1995, the Confederation of Indian Industry (CII) set up a high-powered committee under the chairmanship of Rahul Bajaj to prepare a comprehensive voluntary code of corporate governance for the listed companies. The author was a member of the committee. After several committee meetings and hearings, the final draft report was prepared by April 1997, whose almost unedited version was released in April 1998 as a booklet, Desirable Corporate Governance: A Code. Until the end of 2000, the CII code was the only guideline for corporate governance in India. Since 2001, it has been supplemented by Clause 41 of the Listing Agreement of all stock exchanges — where most of the requirements derive from the initial CII code.


the number of companies, the percentage that is listed, the size of stock exchanges and so on, plus the corpus of corporate laws and agencies that monitor these laws and regulations. Section 3 looks at the legal and procedural linchpins of good corporate governance. These are divided into two categories — those that deal with debt-holders and others with equity-holders. Thus, the section examines bankruptcy restructuring, liquidation and loan recovery on the one hand, and the market for takeovers and corporate control on the other. Section 4 examines corporate financial disclosures, and how these match up with the best international practices. Section 5 describes recent corporate governance initiatives, and how have these have positively affected governance, disclosure, fairness and transparency. In doing so, it analyses the new roles and duties of the Board of Directors, including the Audit Committee. It also takes a peep at the corporate governance initiatives that can be expected in the near future. Section 6 discusses corporate governance of state-owned enterprises (SOEs), which account for a significant share of secondary and services sector GDP. Section 7 concludes the article. 1. Historical Overview In some ways, India was unlike other de-colonised nations of Asia and Africa. At the time of independence in 1947, India was one of the poorest nations in the world with a per capita income of less than $30. Yet, manufacturing accounted for almost a fifth of the country’s national product, and half of that (10% of GDP) was produced by the modern factory sector, which included cotton textile mills, jute mills and collieries, iron and steel mills, nascent engineering units and foundries, cement, sugar and paper.51 From the last quarter of the 19th century, the organisational structure of the large- and medium-scale factories was along corporate lines through the vehicle of widely-held, joint-stock limited liability companies — most of which were floated in India and listed on local stock exchanges.52 The Bombay Stock Exchange (BSE) was formed in 1875 under the name of Native Share and Stockholders Association, and began trading three years before the Tokyo Stock Exchange. At the beginning of the 20th Century, India had four fully functioning stock exchanges in Bombay (now called Mumbai), Calcutta, Madras and Ahmedabad, with reasonably well-defined listing, trading and settlement rules. By independence, there were over 800 listed rupee companies, with many having sizeable floating stock. The dominant corporate organisation form was the so-called ‘managing agency’ system. It worked something like this. Every major corporate group had a closely held company or partnership called a managing agency. De facto, these functioned like holding companies. Managing agencies would float (or ‘promote’) companies, and their prestige, past performance and signature sufficed to ensure massive over-subscription of shares.53 Given excess demand, most of these companies could split shareholdings into small enough allotments to ensure that nobody — barring the managing agency — had sufficiently large stocks to ensure their presence in the board of directors. Dispersed ownership, thus, facilitated managing agencies to retain corporate control with relatively low equity ownership — a trend that continued right up to the mid-1980s and early 1990s. From the corporate governance point of view, therefore, the

51 For detailed expositions on the growth of Indian industry since the early 20th. century, see Bagchi (1972), Ray (1979) and Morris (1983). For national income estimates during the period 1900-47, see Sivasubramonian (1965, 1977) and Heston (1983). 52 Carr-Tagore and Company, the first joint-stock limited liability company in India was incorporated as early as 1848; and one of the ‘promoters’ of this company was an Indian — Dwarkanath Tagore. For details of this company, see Kling (1976). 53 Those who promoted companies were called ‘promoters’ — a term that exists in ordinary and legal lexicon until this day. Promoters invariably managed the companies they floated.


tendency for management in India to enjoy control rights that significantly exceed ownership or residual cash flow rights goes back to the early years of the 20th century. 54 On the positive side, however, because much of corporate growth in pre-independent India was financed through equity, India’s urban investors developed a fairly sophisticated equity culture by the time of independence. Furthermore, banks ware surprisingly well developed for a country as poor as India. Most of the major banks that exist in India today were operating before independence. Until the late 1960s, these were privately owned, typically advanced working capital against the collateral of inventories (as distinct from long- and medium-term loans secured against plant and machinery), maintained fairly prudential lending norms, and were backed up by reasonably sound recovery processes. Given that the company was a key organisational form of industrial development, it is not surprising that colonial India put in place a substantive body of corporate law. For instance, the present Companies Act, 1956 — which, with periodic amendments, substantially governs the legal and regulatory aspects of public and private limited companies — derives from the Indian Companies Acts of 1866, 1882 and 1913. Similarly, most of today’s legal jurisdiction for corporate matters and disputes pre-date independence. The Indian Trusts Act was passed in 1882 to regulate the functioning of all public and private trust funds. Legislation aimed at prudent regulation of banks began with the Reserve Bank of India Act, 1934 and was extended by the Banking Regulation Act, 1949. To re-cap, India in 1947 had a sizeable corporate sector accounting for some 10% of GDP; it had reasonably functioning stock markets and a fairly well developed (if not extensive) banking system; it had a substantial body of corporate and banking laws; and it had developed a nascent but vibrant equity culture among a section of the urban populace. In hindsight, therefore, India was probably the de-colonised country that was best equipped to use the corporate vehicle to trigger rapid industrial and service sector growth, and simultaneously practice good corporate governance that could have maximised long term corporate value while protecting stakeholder rights. But it didn’t. To understand why and how India squandered its early advantages, it is necessary to examine the post-independent regulatory regime. The first barrier to investments came with the Industries (Development and Regulation) Act, 1951 (IDRA), continued for four decades before being dismantled in June 1991. The IDRA required all existing and proposed industrial units to obtain licences from the central government. This all-pervasive licensing regime quickly fostered entry barriers through pre-emption of industrial licences which, in turn, allowed for widespread rent seeking. Entrepreneurial families and business houses that had built their fortune in textile, coal, iron and steel and jute now used licences to secure monopolistic and oligopolistic privileges in new industries such as aluminium, paper, cement and engineering. Over the years, licensing became increasingly stringent and was accompanied by multiple procedures that required clearances from a large number of uncoordinated ministries. For instance, a typical private sector manufacturing company in between the late-1970s and the mid-1980s needed government permission to establish a new plant,

54 Occasionally, this strategy had its dangers. In some industries, Indian merchants who were long term corporate vendors or purchasers also happened to be stockholders. Given the rudimentary nature of technology and low barriers to entry, some of these traders began to accumulate shares in the secondary market and then demand seats on the boards. This happened in a significant way in the jute and coal industry even during the colonial era. Goswami (1985, 1988, 1990) chronicles the market for takeovers in the jute industry and collieries during 1920-1950. Even so, it would be fair to say that low equity ownership coupled with complex cross-holdings allowed most promoters to control listed companies with relatively low ownership.


manufacture a new article, expand capacity, change location, import capital goods and do many other things that fell under the rubric of normal corporate activity.55 A more serious barrier to entry occurred in 1956, when the Industrial Policy Resolution (IPR) adopted the maxim of ‘a socialist pattern of society’ and prescribed that the public sector would occupy ‘the commanding heights’ of the economy. Schedule A of the IPR listed 17 industries whose future development would be “the exclusive responsibility of the State” and 12 Schedule B industries where “the State will increasingly establish new undertakings”.56 In one stroke, India succeeded in creating another barrier to private investment. With it, the government also created a legislative and executive milieu to build a massive, all-pervasive state-owned industrial and services sector which, over time, created its own dysfunctionalities, inefficiencies, cost disadvantages and governance problems. These are discussed in Section 6. The late-1960s and early-1970s witnessed a more intensified trend to limit private investment and foster inefficient manufacturing scales. The Monopolies and Restrictive Trade Practices Act, 1969 (popularly known as MRTP) linked industrial licensing with an asset-based classification of monopoly.57 With the passing of MRTP, private sector businesses whose assets exceeded a paltry amount varying from Rs.10 million to Rs.1 billion had to apply for additional licences to increase capacities. More often than not, such applications were rejected. MRTP was followed by widespread nationalisation, which began in 1969 with the insurance companies and banks and, in 1970 encompassed petroleum companies and collieries. Among other things, nationalisation made employment preservation a political objective. The 1970s and early 1980s saw the second wave of nationalisation, with the government taking over financially distressed private sector textile mills and engineering companies — thus converting private bankruptcy to high cost public debt. In addition, the government made a fetish out of ‘small is beautiful’. This occurred in two ways. First, successive governments sponsored the setting up of mini-plants. For instance, the 1980s saw a mushrooming of technologically non-viable mini-steel, mini-cement and mini-paper units whose profitability hinged upon heavy tax concessions, high initial leveraging, subsidised long term finance, high tariffs and import quotas and the munificence of government orders. Second, governments actively encouraged small-scale industries. While this is not necessarily a bad thing — small and medium enterprises are often more efficient and flexible compared to larger firms — the small-scale sector was fostered through artificial means such as tax concessions and product reservations. Even today, there are over 800 product lines reserved for the small scale sector, of which more than 600 aren’t even manufactured in India! These distortions could not have existed as long as they did in an outward-oriented, open economy. In the final analysis, they were eventually supported by a regime of high tariffs and import quotas. Despite preferential tariffs for Britain and the Empire countries, there were no major barriers to trade during the colonial era. Consequently, the major industries that existed prior to independence — cotton textiles and yarn, jute, tea and coal — were internationally competitive, and two of them (jute and tea) were driven by exports. Things began to change from the mid-1960s, intensifying with the import substituting regime of the 1970s and early 1980s. Import substitution made it incumbent upon a company to demonstrate to

55 Today, it seems odd — almost funny — to recall that India had something called a Carry On Business (CoB) licence, which was needed to expand capacity and output by even 5% under normal course of business. 56 The genesis, growth and problems of India’s state owned enterprises is discussed by Mohan and Aggarwal (1990) and Bhandari and Goswami (2000). 57 Interestingly, MRTP did not apply to state owned enterprises — on a wishful assumption that public monopolies were not inimical to either the nation’s or the consumer’s interest.


bureaucrats the ‘essentiality’ of any import, and the doctrine of ‘indigenous availability’ ensured the purchase of Indian inputs even at higher price-lower quality configurations. Import substitution was sustained by quantitative restrictions and high tariffs. Quotas came in the form of various types of import licences. Among them were Actual Users (Industrial) Licenses, Actual Users (Non-industrial) Licenses, Capital Goods Licenses, Customs Clearance Permits, Supplementary Licenses, Import Replenishment Licenses, Special Import Licenses, Additional Licenses, canalisation of imports and Open General Licenses. Over the years industrial tariffs continued to be raised until the peak rate exceeded 300%. By 1985, the mean tariff rate for intermediate goods was 146% (standard deviation 56%); and for capital goods it was 107% (standard deviation 48%).58 To be sure, some of the policies helped setting up industrial capacities, especially in iron and steel, engineering, cement, pharmaceuticals, chemicals, fertilisers and petrochemicals. But these also created highly protected markets, fostered an uncompetitive regime and promoted large scale rent-seeking through a nexus between companies and bureaucrats and politicians. Adding fuel to fire was the corporate and personal income tax structure. At its peak, the corporate tax rate was as high as 55%, and the maximum marginal personal income tax rate was an astronomical 98.75%. Such rates created widespread incentives for cheating which took many forms — undeclared cash perquisites, private expenses footed on company account, complicated emolument structures and complex cross-holdings of shares to confound calculations regarding dividend and wealth tax. The message was simple and profoundly negative. What mattered was how to expropriate larger slices of a small pie, and do so in ways that escaped the tax net. There were absolutely no incentives to grow the pie, create wealth and share it among stakeholders in transparent and equitable ways. Curiously, the instrument that the government used to foster widespread industrial growth — subsidised long term loans as ‘development finance’ for creating fixed assets — militated against good corporate governance. In many ways, the story is similar to that of South Korea and requires some elaboration. After independence, the Government of India set up three all-India development finance institutions (DFIs). These were the Industrial Finance Corporation of India (IFCI), the Industrial Development Bank of India (IDBI) and the Industrial Credit and Investment Corporation of India (ICICI). In addition, state governments set up their State Financial Corporations. From their inception up to the early 1990s, the raison d’être of these public sector DFIs was to foster industrialisation by advancing subsidised, low priced, long term loans for setting up plant and machinery. Arguably, there may be nothing wrong with a fiscally surplus government using subsidised long term funds to create competitive industrial capacities. South Korea’s huge industrial base is a testimony to such a policy. However, when careful project appraisal is abandoned for loan pushing — DFIs were judged on the amount of loans sanctioned and disbursed, and not by their asset quality — and when this occurs in a tightly controlled, rigidly licensed, highly protected, import substituting milieu, it invariably results in crony capitalism, rent seeking, setting up of inefficient capacities, and corporate misgovernance with public funds. In more ways than one, this is what occurred in India in the 1970s and 1980s. There are two strands to the DFI-induced corporate misgovernance story. The first has to do with excess leveraging, and the second with the role of DFIs as shareholders. By the early 1980s, many term loans for industrial projects were sanctioned with a long term debt-to-equity ratio that exceeded 2.5:1, and a total 58 At that point of time, China’s mean tariff rates were 79% for intermediates and 63% for capital goods. See Kelkar, Kumar and Nangia (1990).


debt-to-equity ratio that went over 4:1. This kind of gearing allowed the promoters to start projects with a relatively low equity base, and an even lower promoters’ contribution. During the industrial expansion of the 1970s and 1980s, average share ownership of the controlling groups was less than 15% of total equity. Thus, promoters could commission a Rs.500 million project with only Rs.100 million of equity, of which a mere Rs.15 million came from their pockets — and yet retain full management control. To understand the extent of leveraging, one needs to take a look at corporate data for the financial year ended 31 March 1991 — just before the beginning of economic reforms. In that year, 528 listed manufacturing and non-banking services companies posted sales in excess of Rs.500 million. Some 65% of their total capital employed of Rs.1,145 billion (or $64 billion at the prevailing exchange rate) was accounted for by borrowed funds. Almost 20% of borrowings were supplied by the three all-India DFIs. The mean gearing (ratio of total borrowing to net worth) was 1.25, the median was 1.44 and a third of the sample were leveraged in excess of 2.50.59 The stage was thus set for enacting the moral hazard of limited liability. Given subsidised loan funds and various tax incentives to set up industries, most promoters recovered their relatively meagre equity within a year or two of operation, if not earlier. Thereafter, in good states, DFIs could count on the loans being repaid. In bad states, debt took a hit while equity had already recouped its outlay. The nexus between business groups and politicians ensured that debts would be invariably rescheduled even after successive defaults, all in the name of ‘rehabilitating’ financially ‘sick’ industrial companies. Played out in the backdrop of inefficient implementation of bankruptcy laws, this created widespread corporate misgovernance, and contributed to systematic diversion of taxpayer financed, government subsidised DFI funds for other ventures. The other aspect of poor governance had much to do with the shareholding of government owned financial institutions. Even today, 11 years after the advent of economic liberalisation, a substantial proportion of the equity of India’s private sector companies is held by the DFIs, the nationalised insurance companies, and the government owned mutual fund, the Unit Trust of India, or UTI. Consider, for instance, a sample of 144 listed private sector companies which, as of June 2002, accounted for almost a fifth of India’s market capitalisation. For these companies, the median shareholding of government-owned DFIs, banks and mutual funds stood at 17%; while the median borrowing from government owned banks and financial institutions was 58% of total borrowing. Thus, even in this day and age, government indirectly supplies not only over half the debt of private sector companies accounting for 20% of market cap, but also owns close to a fifth of their equity. There is a small body of corporate governance literature which argues — without sufficiently conclusive evidence — that concentrating debt and equity in the hands of banks facilitates better corporate governance of the borrowing companies. It is believed that such bundling automatically increases the quality of monitoring which, in turn, reduces the agency costs associated with debt as well as dispersed equity holdings. Unfortunately, this literature has staked its empirical claim partly based on German companies in the 1980s, and largely on Japanese and Korean companies in the 1970s and 1980s. As we now know, Japan and Korea were engulfed in a banking crisis in 1998 with massive amounts of non-performing loans — and Japan still struggles with the problem. Equally, most conglomerates both countries can hardly be described as paradigms of good corporate governance. Therefore, the empirical basis for staking the benefits of banks and DFIs holding large chunks of equity as well as debt is quite questionable. Indeed, the Indian data suggest quite the opposite. In theory, the three all-India DFIs could have played the role of corporate governance watchdogs in the 1970s and 1980s. But they didn’t. The DFIs insisted 59 Unless stated otherwise, data are computed from Prowess.


on nominating their directors on corporate boards. Given their shareholdings, nobody could argue with that. However, at best, most of these nominee directors were incompetent; at worst, they were tacitly induced to support the incumbent management irrespective of performance. Soon, promoters knew that they had the unstated support of anything between a fifth and a third of the voting stock. Not surprisingly, their control rights vastly exceeded their cash flow rights Such significant errors of omission cannot be fully explained by the nexus between industrialists, bureaucrats and politicians. Much of it has to do state ownership of these DFIs — where nobody was rewarded for profit-making or punished for adverse wealth and income consequences of inaction. On the equity side, the failure had to do with distorted incentives of government ownership and management of the DFIs, and the state–business nexus that induced nominee directors to invariably vote with the promoters. On the debt side, it had much to do with inadequate income recognition and provisioning norms, as well as poor processes for bankruptcy and debt recovery.60 Thus, by the time India embarked on economic liberalisation, the waters had got very muddied. On the one hand, the country had an equity base which was substantially greater than most developing countries; laws that regulated companies and protected the rights of shareholders; and a large and active industrial sector ranging from complex petrochemicals to simple manufacturing. On the other, a combination of licensing, protection, quotas, high gearing and poor board-level accountability had created an environment that didn’t punish poor corporate governance. How have reforms changed this picture? Before going into this, it is useful to give a snapshot of the corporate sector in India. 2. Structure of Corporate India India’s corporate sector consists of closely held (private limited) as well as publicly held (public limited) companies. Among the latter are those listed in one or more stock exchanges. Table 1 gives the data for 1997-2000. 61

Table 1: Basic statistics of India’s corporate sector, 1997-2000

1997 Share 1998 Share 1999 Share 2000 Share

Number of companies

Closely held (Private limited) 386,841 86% 415,954 86%440,997 86% 487,111 86%

Widely held (Public limited including listed) 64,109 14% 68,546 14% 71,064 14% 76,029 14%

60 Right up to the late 1980s, banks and DFIs were allowed to book interest income on an accrual basis irrespective of actual payment, and rare was the case when a loan asset was properly written down. Thus, most accounts were never non-performing. Not surprisingly, all banks and FIs made ‘profits’. India took 1993-96 to gradually introduce proper income recognition, asset classification and provisioning according to the Basle standards. When it did, the profits of most banks and financial institutions nosedived, and the government had to spend in excess of $5 billion to recapitalise impaired banks. Bankruptcy is discussed in section 4. For non-performing loan assets and problems in the banking system, see CII, Report on Non-Performing Assets in the Indian Financial System: An Agenda for Change (December 1999). 61 There is no category called listed company in The Companies Act, 1956. That is defined in the Securities Contract (Regulation) Act, 1956 and the Securities and Exchange Board of India Act, 1992. Unfortunately, the Department of Company Affairs has not been able to compile the data for 2001 — which says something about its ability to monitor the hundreds of thousands of companies under its regulatory purview.


All companies 450,950 100% 484,500 100%512,061 100% 563,140 100%

Paid-up capital (Rs. Billion)

Closely held (Private limited) 588 32% 718 34% 790 34% 1,013 33%

Widely held (Public limited including listed) 1,257 68% 1,409 66% 1,503 66% 2,063 67%

All companies 1,845 100% 2,127 100% 2,293 100% 3,076 100%

Government companies

Number of companies 1,220 0.30% 1,223 0.30% 1,240 0.24% 1,256 0.22%

Paid-up capital (Rs. billion) 797 43% 824 39% 890 39% 982 32%

Source: Ministry of Law and Justice, Department of Company Affairs, Government of India

As expected, the number of closely held companies vastly outnumber the publicly held ones, and constitute the bulk of small-scale enterprises. However, public limited companies, including the listed ones, account for almost two-thirds of the book-value of equity. The other point worth noting from Table 1 is the sheer size of the government corporate sector: while it accounts for a mere 0.22% of the number of companies, it speaks for 34% of corporate India’s paid-up capital. A silver lining of economic liberalisation is the gradual reduction of the relative size of the state-owned sector. As the table shows, its share in total paid-up capital has fallen from 43% as on 31 March 1997 to 32% on 31 March 2000.

Today, there are well over 13,500 listed companies in India. While there are 23 registered stock exchanges in India, many are moribund — and exist only because the law insists that any listed company must at least register with the stock exchange that is located nearest to the company’s registered address.62 Only two stock exchanges matter in terms of size, efficiency and liquidity. These are the Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE), which came into being in the late 1980s. Any company worth its reputation in corporate India is listed in either BSE or NSE, or both.

Despite a long bear market phase, the market capitalisation of companies listed on the BSE at the end of September 2002 stood at Rs.6.3 trillion, or US $130 billion at prevailing exchange rates. In other words, at the trough of the bear hug, the market cap of India’s listed companies accounts for almost 23% of the country’s GDP.63 At current levels, India’s market cap ranks seventh in Asia-Pacific league table.

A remarkable feature of listed Indian companies is the relatively large weight of SOEs in overall market capitalisation. For example, the BSE lists only 75 SOEs, which translates to less than 1% of the listed companies on the exchange. Yet, despite the hammering received because of the present government’s lack of appetite for consistent disinvestments and privatisation, these stocks still account for almost 15% of market capitalisation. It reflects the fact that most listed SOEs are larger in size, sales and value than their private sector counterparts. This has serious policy implications for corporate governance, which are discussed in section 6.

Given India’s pre-eminence in information technology (IT), it is hardly surprising that IT stocks are at the top of the market capitalisation table. However, every conceivable major industry or service have their place in the sun among listed companies. Computer software, computer hardware, diversified companies, 62 In fact, many of these ‘regional’ stock exchanges see no active trade whatsoever, and survive only on the basis of the annual listing fees of the companies located in its region. 63 At its peak, market cap accounted for almost 60% of GDP.


crude oil, petroleum, natural gas, banks and DFIs, pharmaceuticals, telecom service providers, trading firms, commercial vehicles, cars, two- and three-wheelers, communication equipment, cement, steel, aluminium, cosmetics and toiletries, and electricity utilities, to name a few — all account for anything between 18% and 1% of total market cap.

How wide and deep are the two main stock markets? Not enough by the standards of most developed countries. The free float of any company should account for shares owned by individual investors, mutual funds, insurance companies and DFIs. In India, DFIs and, to a lesser extent, the state-owned insurance companies hardly trade their portfolio in the market. Hence, a more realistic concept of ‘freely tradeable shares’ should be limited to the holdings of individual investors and the mutual funds. This

share varies considerably across listed companies.

As Chart a shows, something like 30% of the shares of a ‘typical’ listed company can be theoretically treated as freely tradable. The average trading volume is far less. For liquid, pivotal stocks, no more than 20% of the freely tradable shares are actually traded on highly active days. Thus, while the market cap of Indian companies is impressive — given India’s per capita income of $510 — the actual trading market is quite thin even in active exchanges like the BSE and the NSE. That explains the relatively high volatility of share prices, especially narrow-based share indices such the BSE Sensitivity Index (or Sensex) or the NSE-50 (popularly called Nifty).

At this stage, it is useful to briefly describe the laws that govern corporations in India. If an entity is incorporated as a company — which accounts for the vast majority of corporate India — it is primarily governed by the provisions of the Companies Act, 1956. Based largely on its British counterpart, many sections of the Companies Act have been amended from time to time.64 Table 2 describes the more substantive parts of Act.

64 In fact, there have been so many disjointed amendments that the Act has now become unwieldy and, in many instances, unrepresentative of the times.

Chart A: Frequency distribution of freely tradeable shareholdings

14.2%

0.0%0.6%0.8%

2.8%3.8%

29.1%

24.0%

18.6%

6.0%

0.0%

0%

5%

10%

15%

20%

25%

30%

35%

0 10 20 30 40 50 60 70 80 90 100Shareholding class (%)

% o

f com

pani

es in

a c

lass

Me


Table 2: Abridged subject content of the Companies Act, 1956

Parts Description

Part I Preliminaries, including definitions, and administration of the Company Law Board (CLB), a quasi-judicial body that has the powers to hear cases dealing with provisions of the Act. The CLB’s decisions can be appealed to at the High Courts and, thereafter, the Supreme Court.

Part II Rules and procedures regarding the incorporation of a company — memorandum and articles of association, definition of a ‘member’ and the membership of companies, registration.

Part III Prospectus and allotment of ordinary and preference shares and debentures

Part IV Kinds of share capital (ordinary and preference), numbering and certificate of shares, transfer of shares and debentures and reduction in share capital.

Part V Registration of various types of charges

Part VI Management and administration of a company: registered office, register of shareholders and debenture-holders, annual returns, frequency and conduct of shareholders’ meetings and proceedings, managerial remuneration, the nature and payment of dividend, maintenance of accounts, statutory audit, the board of directors, disqualification of directors, meetings of the board, register of directors and their shareholdings, remuneration of directors, role of the Company Secretary, prevention of mismanagement and oppression of minority shareholders’ rights, provident funds, and the power of investigation by the government, including powers of the CLB.

Part VII Winding up, or liquidation of companies

Schedules The important ones: the minimum that needs to be given in the memorandum and articles of association, who constitute relatives, the form of the annual report including balance sheet and profit and loss account along with its schedules, and rates of permissible depreciation.

Three other pieces of legislation are also important from the point of view of corporate governance. These are:

• Securities Contracts (Regulation) Act, 1956. It covers all types of tradable government paper, shares, stocks, bonds, debentures and any other form of marketable securities issued by companies, including the “rights and interest in securities” — thus effectively allowing for options. The SCRA defines the parameters of conduct of stock exchanges as well as its powers.


• Securities and Exchange Board of India (SEBI) Act, 1992. It established the independent capital market regulatory authority, SEBI, with the objective to protect the interests of investors in securities and to promote and regulate the securities markets.

• Sick Industrial Companies (Special Provisions) Act, 1985. This Act, popularly known as SICA, lays down the framework for bankruptcy restructuring of financially distressed companies. SICA will be critiqued in section 4.

To conclude this section:

• India has a sizeable corporate sector registered as closely- or widely-held companies under the Companies Act.

• Although widely held firms speak for only 14% of the number of registered companies, these account for 67% of corporate India’s book value of paid-up capital.

• SOEs play a significant part among the widely held public limited companies. While government companies constitute only 0.22% of the number of companies, these account for 32% of paid-up capital.

• There are over 13,500 listed companies, of which the larger ones are listed on the Bombay Stock Exchange (BSE) and the National Stock Exchange (NSE). As of end-September 2002, market cap of the BSE stood at $130 billion, or 23% of India’s GDP.

• Private sector listed companies account for almost 85% of BSE’s market cap; the remaining 15% is made up of listed SOEs.

• Listed companies represent all possible commercial activity, covering every major branch of manufacturing and services.

• As in most stock exchanges, a large number of companies constitute a very small proportion of the market cap, while relatively few make up for the bulk. For instance, the top 10% of private sector companies (450 corporates) account for over 95% of private sector’s market cap.

• Freely tradable shares account for roughly 30% of the equity of listed companies. However, even on very active days, no more than 20% of this stock is traded — and even this estimate is on the high side. Thus, despite the size of corporate India’s market cap, trading volumes are quite thin.

3. Agency Costs and the Rights of Debt and Equity In corporate governance literature, the discussion of agency costs has mostly focused on efficiency. That’s not surprising given the disproportionate role which US corporations have played to empirically validate agency costs arguments. Following Jensen and Meckling (1976), and a series of Michael Jensen’s articles [Jensen (1986, 1988, 1989, 1993)], there has been a widespread view in the Anglo-Saxon world that the dominant aspect of poor corporate governance is erosion of corporate value due to dispersed shareholding and the separation of ownership from control.65

65 Well before Jensen, Adam Smith had highlighted the efficiency aspect of agency costs. Speaking of managers of joint-stock companies, Smith wrote, “The directors [managers] of such companies, however, being managers of other people’s money than their own, it cannot well be expected that they should watch over it with the same anxious vigilance with which the partners in a private co-partnery frequently watch over their own… Negligence


3.1 Agency Costs

The model is as follows. Modern US (and British) corporations are characterised by almost complete separation of ownership and control. Managers of vast corporations used to run their empires with little or no shareholding. Therefore, they had no incentive to align their managerial behaviour and decisions in line with those desired by the shareholders. Until the mid-1980s, this was facilitated by widely dispersed share ownership, and the absence of powerful pension and mutual funds which could have used their concentrated stockholdings to demand greater shareholder value. According to Jensen and his followers, this was the prime cause for erosion of corporate value, which triggered the spate of junk-bond financed takeovers and leveraged buyouts from the mid-1970s to the mid-1980s.

Jensen’s description fits US corporations of the 1970s and early 1980s like a glove. But here lies the rub. Intense competition after second oil price shock, technological discontinuities leading to the growth of new corporations and the demise or radical re-engineering of the older ones, the warning bells pealed by leveraged buy-outs during 1975-85, and the rapidly increasing power of large pension funds like CalPERS and TIAA-CREF in the USA have changed the Jensenian model of corporate America. More important, the Jensen description doesn’t seem to fit the story of corporate control in most parts of Asia.

There are three dominant themes that characterise corporate ownership and control in most parts of Asia. First, relative to their size, most Asian companies have low equity. This has been traditionally facilitated by highly geared, credit-driven growth. Second, given the low equity base, promoters have found it relatively cheap to own majority shares. This is true for many companies in Hong Kong, Indonesia, Malaysia, Philippines, Thailand and China. In many instances, the entrepreneur and his family own up to 75% of the equity, which thwarts all possibilities of equity-triggered takeovers. Third, as in the case of Korea and Japan, equity ownership is invariably camouflaged through complex corporate cross-holdings.

None of this conforms to the model of the modern US corporation — with its large equity base, dispersed shareholding and profound separation of ownership from management. However, that doesn’t reduce the importance of agency costs. Unlike Jensen’s model, the corporate governance structure of Asian companies these did not affect corporate efficiency as much as minority shareholder rights.

A promoter who controls management and directly or beneficially owns over 75% of a company’s equity is not expected to perform in a value-destroying manner like many US corporate managers and boards did up to the mid-1980s. However, he can do a large number of things that deprive minority shareholders of their de jure ownership rights, without adversely affecting pre- or post-tax profits. These involve fixing the election of board members, packing boards with crony directors, ensuring that key shareholder resolutions are vaguely worded and inadequately discussed at shareholders’ meetings, fobbing off minority shareholder complaints, issuing preferential equity allotments to the promoters and their allies at discounts, transferring shares through private bought-out deals at prices well below those prevailing in the secondary markets, and the like.

In most parts of Asia, such acts did not necessarily destroy corporate value, and until the Asian crash of 1997-98 most listed companies of South-east Asia enjoyed consistently good valuations. Much of that may be because of thin and inefficient capital markets, greedy investors, and corporate governance structures that placed no value on proper financial and non-financial disclosures. Thus, from the late 1980s right up to the crash, poorly governed Asian companies did very well for themselves. They earned large profits, bagged greater and greater debt, grew in scale and scope and, most important, managed to maintain high valuations. The tycoons were honoured citizens who were admired for creating national and profusion, therefore, must always prevail more or less in the management of the affairs of such a company.” Adam Smith, An Inquiry into The Nature and Causes of The Wealth of Nations, 31


wealth — not reviled as inefficient perquisite-grabbing managers and directors of the Jensenian corporations of the US in the mid-1980s.

It will take considerably more research before anyone can definitively apportion agency cost effects between efficiency and expropriation for the Asian corporations. However, the point to recognise is that poor corporate governance is not only about destroying shareholder value through managerial inefficiency arising out of the disjunction between share ownership and corporate control. Efficiently run firms that consistently outperform the market and earn returns that exceed the opportunity cost of capital can have poor corporate governance. And this can manifest itself in a steady expropriation of minority shareholder rights. Indeed, the attitude of minority shareholders in most parts of Asia has facilitated this process. For most part, they have not questioned corporate policies of their companies, and felt satisfied by their dividends and capital appreciation.66

Until the mid-1990s, India had the worst of both types of agency costs. Dysfunctional economic and trade policies combined with low equity ownership to allow companies to thrive in uncompetitive ways — which began to have their denouement when the economy started opening up to international competition. There was a major erosion of corporate value, measured in terms of economic value added (EVA), which is difference between the return on capital employed and the opportunity cost of capital. A CII study shows that, during the four-year period between 1995 and 1998, the top 363 listed Indian companies ranked by sales lost EVA to the tune of Rs.564 billion ($13 billion), which amounted to almost 6% of the aggregate value of sales.67

Added to this value destruction was the expropriation of minority shareholder rights. In part, this was facilitated by the nominee directors of banks, financial institutions and DFIs who invariably voted with management. But laws did their bit as well. Until nine years ago, there were provisions in the Companies Act which put restrictions on acquisition and transfer of shares.68

Thankfully, such provisions are things of the past and, as we shall see in this section, there is now a transparent legal framework for facilitating the market for equity-driven corporate control. Besides, the introduction of paperless trading through dematerialisation of shares has drastically reduced transactions costs and allowed minority shareholders to enter and exit at will. Moreover, the market has begun to severely punish under-performing companies as well as those that have disregarded minority shareholder interests. For instance, the CII study mentioned above shows that, in the last four years, markets have consistently punished poorly governed under-performers and rewarded the more transparent firms. 66 An example suffices to emphasise the difference in attitudes of small shareholders in the US and Great Britain and most parts of Asia. Until a couple of years ago, most individual Indian shareholders (who in the aggregate often hold more equity than mutual funds) were happy when their companies incessantly increased free reserves. It was considered a sign of good management and financial prudence — where the company put back a large chunk of its post-tax profits for future investments or for a rainy day. Such managerial behaviour will not be tolerated by shareholders in the US or Britain. 67 Omkar Goswami, M. Karthikeyan and G. Srivastava, ‘Are Indian Companies Losing Shareholder Value?’, CII Corporate Research Series, 1(1), 1999. It is, however, difficult to ascertain how much of this value destruction was due to poor corporate governance, and how much due to these companies’ inertia and historical inability to deal with increasing competition. 68 Section 108B stated that if the government was satisfied that any share transfer might result in a change in the board of directors, and if it considered this “prejudicial to the interest of the company or to the public interest”, it could prevent such a transfer. Section 108D allowed government to restrict share transfer if it could lead to a change in the controlling interest that might be prejudicial to the company or public interest. These provisions were tested in 1983, when Swraj Paul, a British citizen of Indian origin, launched a takeover bid for two major companies, Escorts and DCM. In both companies, the promoters controlled corporate affairs despite owning less than 5% of the equity. Paul might have succeeded in getting on to their boards, if not wresting control, had not the government used these provisions to prevent the share transfers.


Curiously, while the market for corporate control has greatly improved on the equity side with a well-defined takeover code, the debt side remains as bad as before. It is not a coincidence that countries with ineffective bankruptcy laws and procedures have widespread corporate misgovernance. Poor protection of creditors’ rights gives enormous — and ultimately value destroying — discretionary space to inefficient management. It allows companies to reallocate funds to highly risky investments (since management fears neither attachment nor bankruptcy); it needlessly raises the cost of credit; it debases the ex ante disciplining role of debt; and it eventually ruins the health of a country’s financial sector. Unfortunately, India has very poor bankruptcy reorganisation laws and procedures, and the liquidation procedures are worse still.

3.2 Bankruptcy restructuring

While a new Insolvency Bill has been awaiting Parliamentary assent for the last two years, bankruptcy reorganisation of large industrial companies still continues to be governed by Sick Industrial Companies (Special Provisions) Act, 1985 or SICA, and the process is directed and supervised by the Board for Financial and Industrial Reconstruction (BIFR). A quick look at the law and BIFR will demonstrate the flaws of poorly designed and inadequately implemented bankruptcy procedures.

There are five fundamental flaws with the SICA-BIFR process. These are:

a) Late detection. The law defines financial distress as erosion of net worth. This is much worse than bankruptcy — which is basically debt default. When a company loses so much as to erode its net worth, the probability of a successful turnaround becomes very low. Not surprisingly, between July 1987 and November 1998, only 11% of the 1954 cases that BIFR has considered ‘maintainable’ are no longer sick. A losing record of 89% reflects both late detection and time consuming procedures.

b) Cumbersome and time consuming procedures. Between 1987 and 1992 the mean delay in arriving at a decision in BIFR was 851 days. That was bad enough. It has worsened since then. Between January 1997 and March 1998, the mean delay for cases that were sanctioned restructuring schemes was almost double at 1664 days; while those that were recommended liquidation took 1,468 days. Such delays are caused by tedious quasi-judicial procedures where cases continue to go through multiple loops before a final decision is taken. In the process, the delays confer additional bargaining power to the management of the bankrupt company at the expense of secured and senior creditors.

c) Indefinite stay on all claims of creditors. From the time the company is registered and until the case is disposed, BIFR will not allow creditors to exercise any claims. All reasonable restructuring processes confer time-bound stays. This is based on the assumption that the value of the whole is greater than the sum of its parts, and that a company must get some breathing space to reorganise itself and offer a viable restructuring plan. In BIFR, however, delays exceed four years. That makes the legal stay a strategic device for the promoters of debtor firms. All they need to do is to get the case registered, and then secure protection from creditors’ claims for years on end.

d) Debtor in possession. Neither SICA nor BIFR recognises that incumbent management always has great informational advantage compared to outside creditors. Therefore, a procedure that allows existing management to control and run a bankrupt company during the period when it is being reorganised invariably results in secured creditors having to take big hits on their exposures at the expense of existing shareholders and management. Studies clearly show that secured creditors of


BIFR companies had to make large write-offs on their exposure, while management and shareholders did not.69

e) Violation of absolute priority rule. This says that in any bankruptcy restructuring or liquidation, senior creditors have to be settled in full before junior creditors are entertained at all. BIFR procedures violate this principal by often rewarding incumbent management and old shareholders (despite net worth being negative) at the expense of fully secured creditors.

It is not difficult to design a far better bankruptcy reorganisation system. The key features of an expeditious, market-driven and incentive compatible procedure must incorporate the following features.

• The definition of bankruptcy should be altered to debt default. That will detect financial distress much earlier than net worth erosion and, all else being equal, increase the probability of a successful turnaround.

• Up to a point, bankruptcy restructuring should be voluntary for the company. The onus must be on the company to convince its secured and senior creditors with a satisfactory rescheduling and cash flow plan. This should be outside bankruptcy court.

• Only if negotiations break down between the company and senior creditors should the case be taken to the bankruptcy court, which can give one extra time-bound chance to renegotiate. If that does not succeed, the court must appoint an independent administrator with the mandate to advertise for the sale of the company. During the advertising and sale period, the court should impose a strictly time bound stay on creditors’ claims on the company’s assets. In the meanwhile, an independent financial professional can determine the liquidation value of the company. That will serve as the confidential reserve price.

• The sealed bid offers must be submitted within the given time period. During this period, subject to a confidentiality bond, all prospective bidders should be permitted to conduct due diligence. Existing promoter(s) can also bid.

• The bids should be in two parts: (a) the post-restructuring profit and loss account, balance sheet and cash flow projections, and (b) the financial bid, which can be in cash or in recognised securities.

• Secured and senior creditors should vote within their class on (a). Those bids that secure the assent of 75% of secured and senior credit should be short-listed. The best financial bid of the shortlist is the winning bid.

• If the winning bid happens to be less than the liquidation value, then the company should go for liquidation. If it is greater than the liquidation value but less than the secured debt, then the proceeds should be pro-rated across secured creditors (including wage dues), with unsecured creditors getting nothing. If the bid is high enough to meet the outstanding of unsecured creditors, then all claimants get their dues. And if it was higher still, then old equity obtains the residual value.

In this scheme of things, the bankruptcy court will act like a facilitator. All cases are designed to get cleared within a specified time period, and in a market-driven manner. Such a time-bound scheme was enunciated in the Companies Amendment Bill, 2000, and placed in Parliament for consultative committee debate and legislation. Unfortunately, two years have passed without the bill being enacted as law. 69 See, for instance, the Committee on Industrial Sickness and Corporate Restructuring (Goswami Committee, July 1993), Anant, Datta Chaudhuri, Gangopadhyay and Goswami (1994), Anant and Goswami (1995) and Goswami (1996).


3.3 Bankruptcy liquidation or winding up

If bankruptcy restructuring under BIFR is tedious, liquidation under the Companies Act is virtually impossible. Table 3 gives data as of 1992-93 for 1,859 companies which were under winding up in courts. Not much has changed up to now.

Table 3: Delays in Winding Up in Courts

0-10 yrs

10-20 yrs

20-30 yrs

30-40 yrs

40-50 yrs

>50 yrs

774 (41%)

506 (27%)

346 (19%)

186 (10%)

44 (2%)

3 (1%)

Note: ( ) indicates % of total. Source: Ajeet N. Mathur, ‘Industrial restructuring and the National Renewal Fund’, ADB, 1993. These delays reflect two factors of the law and legal administration: • Lack of appreciation that it is of prime importance to preserve the value of the assets of a company

that is being wound up – which is best achieved by ensuring that these assets are quickly re-allocated to productive use by more efficient entrepreneurs;

• Failure to realise that the parties worst affected by delays in winding up are employees and secured creditors.

An attempt to reform the laws governing liquidation was made in 1996-97 by the Working Group on the Companies Act. The group recognised international best practices in corporate bankruptcy: sell assets as quickly as possible; adjudicate and distribute later. It recommended an entirely new and time-bound approach to winding up, whose key features are:

• Encouraging voluntary winding-up, which is generally a more cost and time efficient manner of liquidation.

• Distinctly separating the two aspects of liquidation: (i) first, asset sale and (ii) then, distribution of the proceeds.

• Clarity in winding-up order — which should coherently describe the steps that have to be taken along with time frames for each action.

• Clear enunciation of the manner in which the Act would catalyze rapid, transparent, market-determined sale of assets.

• Well-defined and non-subjective norms to ascertain whether a company’s assets should be sold in totality as a going concern, or in parts as individual asset sale.

• Permitting professionals such as chartered accountants, lawyers or company secretaries to be empanelled by the High Court as Company Liquidators.

Indeed, these recommendations found their place in the Companies Amendment Bill, 2000, popularly referred to as the ‘Insolvency Bill’. But, as mentioned earlier, the bill still awaits legislative sanction.

By law, creditors have prior claims over shareholders. When their contractual obligations are not adhered to, creditors can do one of three things — demand bankruptcy reorganisation under SICA/BIFR, or file for winding up of the company, or apply for receivership. As discussed, BIFR leaves much to be desired,


and filing for winding up is losing proposition. Therefore, these are hardly credible threats. The speed with which creditors can obtain a receivership decree varies according to High Courts. It is quite efficient in Mumbai, extremely inefficient (bordering on impossible) in Kolkata, and somewhere in between in other High Courts.

Since 1993, banks and DFIs have recourse to a third alternative — that of filing for recovery of dues at the Debt Recovery Tribunals (DRTs). These quasi-judicial bodies were set up in response to inordinate delays in the basic judicial system. However, the last six years have shown that the DRTs are riddled with their own problems. For one, many of them have not yet been set up because of either administrative delays in finding an appropriate presiding officer, or because injunctions have been filed against the appointment of such officers. For another, the DRTs have also got clogged up, and they have no infrastructural support to decongest their traffic.

In June 2002, frustrated by delays in the legislative process, the government promulgated an ordinance that permits banks and DFIs to go through an abbreviated, summary procedure to attach assets and foreclose on loans of debt defaulters who are classified as non-performing assets (NPAs). It is too early to comment on how this ordinance will play out. At the time of writing, industrial lobbies — especially those close to huge debt-defaulting promoters — have already decried this ‘NPA ordinance’ as draconian. And moves are afoot to dilute the provisions so as to render them ineffective. Given Indian industry’s innate ability to use the levers of power to delay bankruptcy reforms, it seems unlikely that this ordinance will be effectively executed by banks and DFIs.

On balance, therefore, creditors have very little protection in reality. A consequence is extreme risk aversion, especially in a milieu where public sector bank managers have to stop pushing loans and focus on their bottom-line. As a result, banks are in a peculiar situation. On the one hand, they are flush with depositors’ funds. On the other, they avoid lending to anyone other than blue chip companies. The remainder they invest in treasury bills — which are risk free, don’t impair capital adequacy and, most important, require no effort at project appraisal. This pervasive debasing of debt is choking off funds to small and medium enterprises which, unless rectified by better implementation of creditors’ rights, will have serious negative implications for the future structure and sustainability of industrial growth. 3.4 Market for equity-driven takeovers Thankfully, the equity side of the market for corporate control has been reformed in substantive ways. Credit for this goes entirely to the capital market regulatory body, the Securities and Exchange Board of India or SEBI, which came into being under the Securities and Exchange Board of India (SEBI) Act, 1992.70 Until February 1997, companies could structure quietly negotiated takeover deals, which more often than not, left minority shareholders in the lurch. This changed with the SEBI (Substantial Acquisition of Shares and Takeovers) Regulation, 1997, which is popularly known as the Takeover Code. The major provisions are: 70 The Board consists of a chairman and five other members, two of whom are from the central government and one from the central bank, the Reserve Bank of India (RBI). Among other things, SEBI is empowered to (i) regulate stock exchanges and any other securities markets, (ii) register and regulate brokers and sub-brokers, share transfer agents, bankers and registrars to an issue, underwriters, domestic and foreign portfolio managers, investors in securities, independent financial advisers, trustees of trust deeds, mutual funds and venture capital funds, credit rating agencies, depositories and custodians of securities, and self-regulatory securities market organisations, (iii) prohibit fraudulent and unfair trading practices, including insider trading; (iv) regulate public offers for the takeover of companies; and obtain information from all securities market institutions and intermediaries and conduct inspections, inquiries and audits.


• Disclosure. Any person or body corporate whose shareholding crosses the 5% threshold has to publicly disclose this to the relevant stock exchange and to SEBI.

• Trigger. SEBI initially specified a 15% trigger. If an acquirer’s shareholding crossed 15%, he (person or body corporate) has to make an open offer for at least an extra 20% of the shares. In other words, if the acquirer crosses the 15% threshold, he must purchase at least 35%. Given the structure of share ownership in corporate India, SEBI believes — and rightly so — that 35% generally suffices to give controlling interest.

• Minimum offer price. Any such public offer must carry a minimum price which is the average of the market price for the last six months.

• Creeping acquisition. Existing management is allowed to consolidate its holdings through the secondary market so long as such acquisition does not annually exceed 5% of the shares. This creeping acquisition provision is aimed to allow management to gradually consolidate its ownership without detriment to minority shareholders.

• Escrow. To ensure that the takeover bids are serious, there has to be an escrow account to which the acquirer has to deposit 25% of the value of his total bid. He loses this in the event of his winning the bid but reneging on timely payment.

The SEBI regulation has had two beneficial effects. First, it has created a transparent market for takeovers. Second, by legislating in favour of open offers, it has ensured that minority shareholders will have the right to obtain a market driven price in any takeover. Moreover, while friendly takeovers are still the norm, hostile takeovers have begun. And the SEBI Takeover Code has been already tested in at least half-a-dozen hostile bids, and has come out more robust than before. 4. Financial Disclosures This section deals with financial disclosures mandated by law, as well as their strengths and weaknesses. All companies have to submit their statutorily audited annual accounts first to the Audit Committee of the Board of Directors for discussion and approval. The Audit Committee then recommends the results to the full Board for assent. Thereafter, the annual accounts are sent to all shareholders, and their adoption is sought in the annual shareholders’ meeting. After this, copies of the accounts are lodged with the Registrar of Companies. Listed companies have three other requirements. First, the annual accounts have to be submitted to every stock exchange where the companies are listed. Second, they have to prepare abridged un-audited financial summaries for every quarter. Third, in addition to all the disclosure requirements mandated under the Companies Act for public limited companies, listed firms have to submit a detailed cash flow statement. As far as incorporated companies go, the quality of financial disclosure in the annual accounts is determined by three agencies: (i) The Department of Company Affairs, which administers the Companies Act, (ii) SEBI, which mandates special disclosure requirements for listed companies, and (iii) the Institute of Chartered Accountants of India (ICAI) — the body which lays down the parameters of Indian accounting standards. The most substantive financial disclosures of companies are to be found in their annual reports — particularly the balance sheet, profit and loss account and their relevant schedules. All these have to give the data for the current and the previous financial year. The gist of such disclosures is discussed below.

4.1 Balance Sheet


SOURCES OF FUNDS Capital: This gives the share capital of the company, backed up by a schedule that gives details of the number of equity shares authorised, issued and paid-up. Taken together, these are sufficiently transparent. Reserves and surplus. The summarised version is supported by a detailed schedule that classifies the reserves under various heads. The mandated items are (i) capital reserve, (ii) share premium reserve, (iii) debenture redemption reserve (iv) investment allowance reserve, (v) general reserves less the debit balance in the profit and loss account, and (vi) the surplus, i.e. balance in profit and loss account after providing for dividends, bonus or reserves. Again, this is up to international standards. Secured loans. The accompanying schedule gives full line-by-line disclosure of debentures. The data on loans and advances from term lending institutions and banks is also quite detailed, and includes the description and extent of charge on each loan, with separate disclosure on foreign currency loans. These, too, are exhaustive by international norms.

Unsecured loans. All heads of unsecured loans have to be listed.

APPLICATION OF FUNDS

Fixed assets. Although the listing of fixed assets in the schedule is quite exhaustive, it suffers from two types of problems. First, gross block is valued at historical cost. A more realistic approach will be to value all the elements at either market prices or replacement cost. Second, the depreciation schedules used in annual accounts have no bearing with that which is permitted for computing the corporate income tax liability. This is a historical anomaly which has been rectified in 2001-02, by mandating the accounting deferred tax liability and/or assets in the balance sheet and its provisioning in the profit and loss account.

Investments. These are split between long and short term, with the latter covering a period of a year or less. Investments in quoted securities have to be marked to market, while those in unquoted instruments are evaluated at cost. While the disclosures look tight on paper, this is the area of opaqueness, especially because companies still have the option of not consolidating their accounts. The best solution is to mandate consolidation according to US-GAAP or Internationally Accepted Accounting Standards (IAAS), and insist of full disclosure of all related party transactions. The latter has been made mandatory from 2001-02. At the time of writing, the ICAI is actively considering making consolidation compulsory. When that happens, these disclosures will become much more transparent.

Loans, advances and deposits. In the absence of consolidation, entries on this account can be opaque. However, since the terms of each such loan have to be stringently disclosed, these are more transparent than inter-corporate investments evaluated at cost.

Inventories are normally well captured, especially for medium and large scale manufacturing companies. Smaller companies tend to play around a bit with work-in-progress, but that is quite minor.

Sundry debtors can occasionally be used to artificially push up sales in the profit and loss account. It works as follows. Companies book extra sales in the last month or two before the end of the financial year, knowing that the revenue is not intended to be received by the year end. The top line on the profit and loss account gets inflated and, all else being equal, the bottom line as well. Fully anticipated unpaid dues get booked as receivable under sundry debtors. Sometimes this gets a bit more sinister. Output is siphoned out to a host of subsidiary or ‘front’ dealer companies through dummy sales. No payment is


intended to take place. The amount languishes receivable for a few years and is then written down — first as doubtful, and then as bad debt.

Cash and bank balances. Usually reflects the true picture. 4.2 Profit and loss account By and large, the disclosures required in the profit and loss account are quite exhaustive and up to international standards. The Companies Act requires detailed schedules for: • ‘Other income’, i.e. income other than what the company earned from its sale of goods and services. • Expenditure on raw materials and intermediate goods. • Wages and employee costs. • ‘Other expenses’, which includes consumables, energy charges, repairs and maintenance, rents, rates

and local taxes, advertising and selling costs, R&D expenses, travelling expenses, directors’ fees and commissions, and other heads.

• Inventories, including work-in-progress and finished goods. • Interest, which includes interest on fixed term loans and debentures and on other loans, less interest

received. There are two areas for fiddling the books. The first relates to manufacturing expenses, which can be inflated up to a point. Beyond that it requires collusion with the government’s sales tax and excise duty officials. The second has to do with selling, distribution, administration and other expenses. However, the scope for mis-reporting on these two heads is far less than for investments on the balance sheet. And, by and large, most of the records in the profit and loss account tend to reflect the true and fair picture of a company. 4.3 Cash flow statement Listed companies have to submit a three-part cash flow statement consisting of cash flows from (i) operating activities, (ii) investing activities, and (iii) financing activities. This statement is quite detailed and any reasonably well equipped financial analyst should be able to arrive at a company’s free cash flows for a given year. 4.4 New accounting initiatives In 2001-02, the ICAI announced four major initiatives that have played a significant role in aligning Indian financial disclosures with international best practices. These are: • Segment reporting. All multi-product or multi-industry or multi-segment companies have to give a

detailed audited report of annual segmental incomes. A segment is defined as a distinct area of business which accounts for at least 10% of revenue. These involve: (i) segmental revenues, (ii) segmental operation costs, (iii) segmental operational profits, and (iv) segmental allocation of capital. Today, the segment report is very much in line — indeed, goes beyond — with best practices; and any financial analyst should be able to read that report to ascertain which division of the company is gaining shareholder value (earning a return in excess of the opportunity cost of capital) and which isn’t.

• Related party transactions. The ICAI has mandated exhaustive disclosure on any materially significant related party transaction. Again, if followed in letter and spirit, the accounting standard for disclosing related party transactions is in line with the best in the world.


• Accounting for deferred taxation. As mentioned earlier, 2001-02 saw the introduction of internationally defined procedures to account for deferred tax liabilities and assets. Until 2001-02, law allowed two sets of audited accounts to be prepared — one for the shareholders, and another for income tax purposes. The difference lay in differential deprecation provisions and in specific income and indirect tax incentives. For instance, the accounts presented to shareholders generally used lower depreciation rules and, thus, created higher net profits and, hence, dividends; while those prepared for the tax authorities used higher fiscally permissible depreciation provisions and all the relevant tax shields to legally reduce the pre-tax profit and, therefore, the tax liability. Today, the aggregate value of the timing difference between the two has to be reported in the balance sheet (as deferred tax liability or asset) and annually provisioned for in the profit and loss account. Over time, accounting for deferred taxation will help harmonise the two accounts — and give the same picture to the shareholders as well as the tax authorities.

• Consolidation of accounts. As of now, it is recommended by ICAI, but not made compulsory. However, if a reporting company chooses to consolidate its accounts, it must do so only according to internationally acceptable accounting standards.

4.5 Credit rating

Since the early 1990s, the law prescribes that companies have to be rated by approved credit rating agencies before issuing any commercial paper, bonds and debentures. At present there are five rating agencies, of which four — CRISIL, CARE, ICRA and Duff and Phelps — are well established. Each of these agencies have a set of ratings from very safe to poorer than junk bond status. The rating has to be made public, and must be accompanied by the rating agencies’ perceptions of risk factors that can affect payment of interest and repayment of the principal. Company management also exercises its right to comment on these risk factors.

In the past there was a tendency to do ‘rating shopping’ — namely, to approach more than one rating agency, and then publish the one which is most beneficial to the company. As early as 1998, the Confederation of Indian Industry (CII) commented on this practice, and recommended that:

If any company goes to more than one credit rating agency, then it must divulge in the prospectus and issue document the rating of all the agencies that did such an exercise. It is not enough to blandly state the ratings. These must be given in a tabular format that shows where the company stands relative to higher and lower ranking. It makes considerable difference to an investor to know whether the rating agency or agencies placed the company in the top slots, or in the middle, or in the bottom. [CII, Desirable Corporate Governance: A Code, April 1998, Recommendation 15, pp.9-10]

Today, CII’s recommendation has been adopted by SEBI. All ratings have to be fully disclosed.

4.6 Insider trading

Clause (g) of sub-section (2) of section 11 of the SEBI Act, 1992, clearly states that one of the functions of the capital market regulator is “prohibiting insider trading in securities”. The law also defines insider trading quite explicitly:

Insider trading takes place when insiders or other persons who, by virtue of their position in office or otherwise, have access to unpublished price sensitive information relating to the affairs of a company and deal in the securities of such company or cause the trading of securities while


in possession of such information or communicate such information to others who use it in connection with the purchase or sale of securities.

Moreover, the annual report of every listed company has to statutorily list its guidelines that ban insider trading.

However, as in most countries, the problem with insider trading lies in implementation. The example of SEC shows that, even with sophisticated detection devices, it is very difficult to pin-point insider trades. In the US, less than 1% of the trades that are initially identified as potential cases of insider trading are actually investigated; lesser still are charged and convicted. In India there are three sets of problems. The first, despite the BSE and NSE having full-fledged screen based trading, it is still difficult to flag a trade as a possible case of insider trading. Second, given the number of brokers and middle-men who operate in the market, it is possible for a person who has insider information to create enough fire-walls between himself and the traders — which militates against identifying the real insiders. Third, and most important, SEBI does not have judicial powers like courts. It can conduct an investigation, prepare a report and even suggest a penalty; but it cannot inflict that penalty. The act of implementing the punishment vests upon courts. Given the judicial delays in India, such penalties don’t account for much. Despite SEBI’s handicap, it has initiated several cases of insider trading.

4.7 Financial disclosures of banks and DFIs

Although Indian banks and DFIs disclose more than their counterparts in East and South-east Asia and, indeed, Switzerland, these fall short of what is desirable. In particular, neither banks nor DFIs need to disclose the structure and extent of their asset-liability mismatch — something that says a great deal about their future financial health. Moreover, while they follow the Basle standards for recognition of non-performing assets, this does not take into account some of the institutional realities of India. To give an example, a case that is referred to BIFR should not be expected to be resolved in anything less than four years. Therefore, prudential accounting should treat that loan as bad, and write it off the books — to be added back as profits if and when something is recovered. Similarly, any case going for winding-up under court should be written off. More often than not, such practices are followed 71in the breach.

In this context, ICICI Bank has taken a lead. Driven by the objective of becoming India’s first truly universal bank, ICICI decided to tap the US capital market via an American Depository Security Receipt that was launched in late September 1999. To access the US market, ICICI voluntarily re-cast its accounts for the year ended 31 March 1999 in terms of US-GAAP. The exercise eroded ICICI’s bottom-line by a third. But it has also created investor confidence — arising from the comfort that a large DFI in the process of becoming a universal bank is not afraid of using the toughest accounting standards. Not surprisingly, ICICI’s domestic IPO (concluded on 13 September 1999) was over-subscribed by 80%. On 28 March 2000, ICICI Bank, then a subsidiary of ICICI, also got listed on the NYSE and thus conformed to all SEC disclosure standards.

While the Companies Act specifies punishments for non-compliance of financial disclosures, these are extremely light and, in most instances, the penalties are disproportionately less than the extent of the infringement. Moreover, huge judicial delays further diminish the minimal deterrence that such penalties are supposed to inflict. At the time of writing, the Department of Company Affairs has appointed a committee to recommend more realistically deterring penalties. Hopefully, the recommendations of the committee will be quickly enshrined in the rule book.

71 From April 2002, ICICI has merged into ICICI Bank, and the entity is an NYSE-listed company, following all disclosure standards mandated by the SEC and the NYSE.


If anything, stock markets are doing their own enforcement. Increasingly, companies are enjoying market premium for best-in-class corporate disclosures, which has increased the demand for hiring the services of internationally respected and independent audit firms. The search of international capital at competitive rates has resulted in an increasing use of international auditing firms. And, the experience of the last few years suggests that the better companies are voluntarily following the maxim: “When in doubt, disclose”.

To be sure, India can do even better in its financial disclosures. However, it is important to emphasise that Indian accounting and financial disclosure standards today are significantly better than those that prevail throughout most of Asia (excepting perhaps Singapore), Latin America, and continental Europe. This point needs emphasising and advertising much more vigorously.

5. Recent Corporate Governance Initiatives

There have been two major corporate governance initiative launched in India since the mid-1990s. The first has been by the Confederation of Indian Industry (CII), which is India’s largest industry and business association. The second is by the SEBI.

5.1 The CII Code

More than a year before the onset of the Asian crisis, CII set up a committee to examine corporate governance issues, and recommend a voluntary code of best practices. The committee was driven by the conviction that good corporate governance was essential for Indian companies to access domestic as well as global capital at competitive rates. The first draft of the code was prepared by April 1997, and the final document (Desirable Corporate Governance: A Code), was publicly released in April 1998. The code focuses on listed companies. Given below are excerpts that highlight the rationale of the exercise, and summarise the key recommendations.

First, there is no unique structure of corporate governance … Thus, one cannot design a code of corporate governance for Indian companies by mechanically importing one form or another. Second, Indian companies, banks and financial institutions (FIs) can no longer afford to ignore better corporate practices. As India gets integrated in the world market, Indian as well as international investors will demand greater disclosure, more transparent explanation for major decisions and better shareholder value. Third, corporate governance goes far beyond company law.

The objective of good corporate governance [is] maximising long-term shareholder value. Since shareholders are residual claimants, this objective follows from a premise that, in well performing capital and financial markets, whatever maximises shareholder value must necessarily maximise corporate prosperity, and best satisfy the claims of creditors, employees, shareholders and the State.

Board of Directors

“The key to good corporate governance is a well functioning, informed board of directors. The board should have a core group of excellent, professionally acclaimed non-executive directors.”

“The full board should meet a minimum of six times a year, preferably at an interval of two months.”

“Any listed company with a turnover of Rs.1 billion and above should have professionally competent, independent, non-executive directors, who should constitute at least 30% of the board if the Chairman of the company is a non-executive director, or at least 50% of the board if the Chairman and Managing Director is the same person.”


“No single person should hold directorships in more than 10 listed companies.”

“To secure better effort from non-executive directors, companies should:

Pay a commission over and above the sitting fees for the use of the professional inputs.

Consider offering stock options, so as to relate rewards to performance.”

“While re-appointing members of the board, companies should give the attendance record of the concerned directors. If a director has not been present for 50% or more meetings, then this should be explicitly stated in the resolution that is put to vote. As a general practice, one should not re-appoint any director who has not had the time to attend even one half of the meetings.”

“Key information that must be reported to, and placed before, the board must contain:

Annual operating plans and budgets, together with up-dated long term plans.

Capital budgets, manpower and overhead budgets.

Quarterly results for the company as a whole and its operating divisions or business segments.

Internal audit reports, including cases of theft and dishonesty of a material nature.

Show cause, demand and prosecution notices received from revenue authorities which are considered to be materially important. (Material nature if any exposure that exceeds 1 percent of the company's net worth).

Fatal or serious accidents, dangerous occurrences, and any effluent or pollution problems.

Default in payment of interest or non-payment of the principal on any public deposit, and/or to any secured creditor or financial institution.

Defaults such as non-payment of inter-corporate deposits by or to the company, or materially substantial non-payment for goods sold by the company.

Any issue which involves possible public or product liability claims of a substantial nature, including any judgement or order which may have either passed strictures on the conduct of the company, or taken an adverse view regarding another enterprise that can have negative implications for the company.

Details of any joint venture or collaboration agreement.

Transactions that involve substantial payment towards goodwill, brand equity, or intellectual property.

Recruitment and remuneration of senior officers just below the board level, including appointment or removal of the Chief Financial Officer and the Company Secretary.

Labour problems and their proposed solutions.

Quarterly details of foreign exchange exposure and the steps taken by management to limit the risks of adverse exchange rate movement, if material.”


Listed companies with either a turnover of over Rs.1 billion or a paid-up capital of Rs.200 million should set up Audit Committees within two years. Audit Committees should consist of at least three members, all drawn from a company's non-executive directors, who should have adequate knowledge of finance, accounts and basic elements of company law. Audit Committees should assist the board in fulfilling its functions relating to corporate accounting and reporting practices, financial and accounting controls, and financial statements and proposals that accompany the public issue of any security and thus provide effective supervision of the financial reporting process. They should periodically interact with the statutory auditors and the internal auditors to ascertain the quality and veracity of the company's accounts as well as the capability of the auditors themselves.

Desirable disclosure

“Listed companies should give data on: high and low monthly averages of share prices in a major stock exchange where the company is listed; greater detail on business segments, up to 10% of turnover, giving share in sales revenue, review of operations, analysis of markets and future prospects. “

“Major Indian stock exchanges should gradually insist upon a corporate governance compliance certificate, signed by the CEO and the CFO.”

“If any company goes to more than one credit rating agency, then it must divulge in the prospectus and issue document the rating of all the agencies that did such an exercise. These must be given in a tabular format that shows where the company stands relative to higher and lower ranking.”

“Companies which are making foreign debt issues cannot have two sets of disclosure norms: an exhaustive one for the foreigners, and a relatively minuscule one for Indian investors.”

“Companies that default on fixed deposits should not be permitted to accept further deposits and make inter-corporate loans or investments or declare dividends until the default is made good.”

The CII code is voluntary. Between 1998 and 2000, CII induced over 20 companies to disclose much greater information in line with the code. Consequently, annual reports of such companies reflected much greater disclosure with better qualitative and quantitative information. Even before SEBI mandated a corporate governance code for financial year 2001 and thereafter, companies that voluntarily adhered to the CII code disclosed information on:

• The composition of the board: executive, non-executive and independent directors. An independent director is (i) not a formal executive and has no professional relationship with the company, (ii) not a large customer and/or vendor to the company, (iii) not a close relative of the promoter and/or any executive directors, (iv) not holding a significant stake, and (v) not a nominee of any large shareholder/creditor.

• The number of outside directorships held.

• Family relationship with other directors.

• Business relationship with the company, other than being a director.

• Loans and advances taken from the company.

• Remuneration — consisting of salaries and perquisites, sitting fees, commission and stock options, if any.


• Attendance of directors at board meetings, including those of special committees of the board. These have to be tabulated as number of meetings held versus those attended.

• Details about their monthly high and low share prices in various stock exchanges, and compare these with the market indices;

• Data on the distribution of shares across various types of shareholders and according to size classes;

• Classes of complaints received from shareholders regarding share transfers, and how these have been addressed;

• Economic value added (EVA), return on capital employed (ROCE) and return on net worth (RONW);

• Details on risk factors, especially foreign exchange and derivative risks;

• Details on contingent liabilities;

• Data on outstanding warrants and their effect on dilution of equity, when converted;

• Segment-wise information, wherever appropriate, in a chapter on management discussion and analysis.

For the financial year ended 31 March 1999, 23 large listed companies accounting for 19% of India’s market capitalization have fully or partly adopted the CII disclosure norms. For the year ended 31 March 2000, 36 companies joined the ranks. Indeed, companies such as Infosys or Dr. Reddy’s Laboratories systematically overshot such norms. A more subtle, effect of the CII initiative was to create a trend among larger listed companies to look positively towards corporate governance, instead of discounting it as ‘the flavour of the month’.

5.2 SEBI’s Initiative

The other major — and mandatory — corporate governance initiative was by SEBI. In early 1999, it set up a committee under Kumar Mangalam Birla. By late 2000, the SEBI board accepted and ratified key recommendation of this committee and informed all stock exchanges accordingly. SEBI’s key recommendations are mandatory. These apply to listed companies and are enforced at the level of stock exchanges through listing agreements. The main recommendations are:

• Independent directors are defined as those who, apart from receiving director’s remuneration, do not have any other material pecuniary relationship or transactions with the company, its promoters, its management or its subsidiaries, which in the judgement of the board may affect their independence of judgement.

• Not less than 50% of the board should comprise of non-executive directors. The number of independent directors would depend on the nature of the chairman of the board. In case a company has a non-executive chairman, at least one-third of board should comprise of independent directors and in case a company has an executive chairman, at least half of board should be independent.

• Every listed company must, according to their size and a three year time-table, set up a qualified and independent audit committee at its board level. The audit committee should have minimum three members, all being non executive directors, with the majority being independent, and with at least one director having financial and accounting knowledge; the chairman of the committee should be an


independent director, who should be present at Annual General Meeting to answer shareholder queries; the Company Secretary should act as the secretary to the committee. To begin with the audit committee should meet at least thrice a year. One meeting must be held before finalisation of annual accounts and one necessarily every six months. The audit committee should have powers to (i) investigate any activity within its terms of reference, (ii) seek information from any employee, (iii) obtain outside legal or other professional advice, and (iv) secure attendance of outsiders with relevant expertise, if necessary.

• Among other things, the audit committee should (i) oversee a company’s financial reporting process and quality of disclosure of financial information, (ii) recommend the appointment and removal of external auditor, (iii) review with management, external and internal auditors the adequacy of internal audit function and the annual financial statements before submission to the board, including financial risks and risk management policies.

• The board of directors should decide the remuneration of non-executive directors.

• The following disclosures should be made in the section on corporate governance of the annual report: (i) all elements of remuneration package of all the directors i.e. salary, benefits, bonuses, stock options, pension etc. (ii) details of fixed component and performance linked incentives, along with the performance criteria, (iii) service contracts, notice period, severance fees, and (iv) stock option details, and whether issued at a discount as well as the period over which accrued and over which exercisable.

• Board meetings should be held at least four times in a year, with a maximum time gap of four months between any two meetings.

• To ensure that directors give due importance and commitment to their fiduciary responsibilities, no director should be a member in more than 10 board-level committees or act as chairman of more than five committees across all companies in which he is a director.

• In every company’s annual report, there should be a detailed chapter on Management Discussion and Analysis. This should include discussion on industry structure and developments, opportunities and threats, segment-wise or product-wise performance, outlook, risks and concerns, internal control systems and their adequacy, relating financial performance with operational performance, and issues relating to human resource development.

• For appointment or re-appointment of a director, shareholders must be provided with the following information: (i) a brief resume of the director, (ii) nature of his expertise in specific functional areas, and (iii) companies in which he holds directorships.

• Information like quarterly results, presentation made by companies to analysts should be put on the company’s web-site and sent in such a form so as to enable the stock exchange on which the company is listed to put it on its own web-site.

• A board committee under the chairmanship of a non-executive director should be formed to specifically look into the redressing of shareholder complaints like transfer of shares, non-receipt of balance sheet, non-receipt of declared dividends etc.

• There should be a separate section on corporate governance in the annual reports of companies. Non-compliance of any mandatory recommendation with their reasons should be specifically highlighted.


This will enable the shareholders and the securities market to assess for themselves the standards of corporate governance followed by a company.

SEBI set a clear timetable for ushering in mandated corporate governance. The recommendations had to be followed at the time of listing for all companies that are listing for the first time. For already listed companies, the larger ones that fall under Group A of the BSE or in the S&P CNX 50 index (the Nifty), had to adhere to the guidelines no later than 31 March 2001. That covered more than 80% of market cap. For most of the rest, the guidelines came into effect by 31 March 2002. Today, listed companies accounting for over 95% of India’s market capitalisation have to follow SEBI’s corporate governance guidelines.

While most of SEBI’s recommendations follow from the CII code, there is no question that the regulator’s mandate has much more teeth. CII’s code is, by its very nature, voluntary. In contrast, the substantive aspects of the SEBI code are mandatory. And there is a need to put in place certain mandated aspects of corporate governance. 5.3 Even more recent initiatives After the collapse of Enron followed by the scandals of WorldCom, Global Crossing, QWest and others, India, like the US, has decided to tighten corporate governance standards in several areas. The Ministry of Finance, SEBI and Department of Company Affairs have set up several high-powered committees to recommend improvements in the follow areas: • Review of relationship between companies and auditors. This committee, which is expected to

submit its report in early November 2002, is examining the auditor-client relationship, the issue of auditor independence, rotation of audit firms or principal auditors, restrictions on non-audit work, audit versus non-audit fees and methods to strengthen Audit Committees of Boards.

• Accounting for stock options. Although there are stringent caps of the percentage of a company’s shares that could be earmarked for stock options, the US scandals have raised the issue of expensing of such options. A committee under the SEBI has been set up to review the issue and submit its recommendations by mid-November 2002.

• Additional corporate financial and non-financial disclosures. Set up to examine whether the existing corpus of mandated disclosures suffice, or whether there is need to tighten some standards as well as introduce some new disclosures. This committee is also expected to submit its report by the second half of November 2002.

• Penalties and fines for non-compliance and infringement. To recommend substantially greater fines and penalties, so that these are more in line with the size of the crime. The committee will submit its report by late November 2002.

Thus, by December 2002 or early 2003, India, most likely, will have several more disclosures and accounting standards that align the country even more in line with international best practices. There are, however, a couple of questions. The first relates to policing and punishment. SEBI envisages that all these corporate governance norms will be enforced through listing agreements between companies and the stock exchanges. A little reflection suggests that for companies with very little floating stock — which account for more than 85% of the listed companies — de-listing because of non-compliance is hardly a credible threat. SEBI can, of course, counter that by stating that it is first focusing on the big


fish, namely the Group A and S&P CNX 50 companies. Here, the reputation effect of de-listing can induce compliance and, hence, better corporate governance.

If SEBI’s policing mechanism are not considered credible enough, then the Department of Company Affairs’ (DCA’s) is worse still. For one, it deals with over 76,000 public limited companies, while SEBI’s mandate is limited to 13,500 listed corporates. For another, the DCA staffing is much poorer in quality compared to SEBI’s. More important, unlike the SEBI, the DCA is not an independent regulatory body. It is a department of government and, therefore, a servant of the whims and fashions of its ministers.

The second issue is more problematic, and it has to do with form versus substance. There is a fear that by legally mandating several aspects of corporate governance, SEBI might unintentionally encourage the practice of companies ticking checklists, instead of focusing on the spirit of good governance. The fear is not unfounded. Take, for instance, the case of Korea. After the crash of 1998, a part of the IMF bailout package was that a fourth of the board of every listed Korean company must consist of independent directors. They do, but the directors are hardly independent by any stretch of imagination. For most part, they are retired executives of the chaebols, friends of business groups and politicians that have supported the business in the past. And, in any event, they don’t do what was intended — namely, to speak for shareholders and ensure that management does what is necessary to maximise long term shareholder value.

This raises a question of how to trace the line that divides voluntary from mandatory. In an ideal world with efficient capital markets, such a question need not arise — because the markets would recognise which companies are well governed and which are not, and reward and punish accordingly. Unfortunately, ideal capital markets exist only in theory. The reality is quite different. Markets are often thin and shallow and operate on the basis of ebbs and flows of pivotal stocks; informational requirements are lax; and regulatory and policing devices leave much to be desired.

Thus, it could be argued is that the need of the hour is a relatively small corpus of legally mandated rules, buttressed by a much larger body of self-regulation and voluntary compliance. This will surely happen in India. When all listed companies as well as public limited companies are forced to follow increasingly stringent SEBI and DCA guidelines, the better ones will voluntarily raise the bar so as to be measured according to best international practices. That will occur because of the desire of the high performers to be separated from the chaff — and to emphasise this separation to attract international funds. 6. State Owned Enterprises Given the size of state owned enterprises (SOEs) among listed companies — which account for 15% of market capitalisation — it necessary to touch upon their governance structures. These are companies which can be best described by a phrase: “Agents without principals”. Shareholders (or principals) of private sector companies are direct beneficiaries of profitable performance. Therefore, in theory, they have an incentive to monitor management so that it maximises corporate value. In contrast, most government companies, especially the unlisted ones, do not have a substantial body of informed private shareholders whose income depends upon the performance of these companies.

If anything, the major shareholder of SOEs has distinctly different objectives. Commercial viability, profitability, quality, cost minimisation, optimal investment decisions and corporate value creation rarely figure among the concerns of a typical Member of Parliament or a minister. Next in the hierarchy of shareholders’ representatives comes the civil servants. By their very training, bureaucrats specialise in slavishly adhering to laid-down procedures, irrespective of their relevance. This training creates an


inconsistency between the organisational forms of governments and those of modern financial and industrial entities: governments and their agents are process oriented, whereas firms have to result oriented. The mismatch gets exacerbated by a civil servant’s aversion to risk taking. Thus, when a civil servant serves on the board of an SOE, he typically tows the ministry’s line, ensures that the SOE follows ‘proper’ procedures, and avoids any risky decision that may have harmful consequences for his ministry.

Given the non-commercial objectives of the principal, most chief executives of SOEs quickly adopt the line of least resistance, develop the ‘don’t rock the boat’ syndrome and avoid changes that may alienate any powerful element among the shifting and fuzzy coalition of interests. Thus, important organisational changes are not made, erring staff remain undisciplined, loss-making plants are neither downsized nor closed, wages are not linked to productivity, and redundant workers are not retrenched.

Above all this sits Article 12 of the Constitution of India, which defines ‘the State’ as “the Government and Parliament of India and the Government and Legislature of each of the States and all local or other authorities within the territory of India or under the control of the Government of India”. Since most SOEs have more than 50% government ownership, they fall under the ambit of ‘the State’. This has affected SOEs in several adverse ways.

• All SOEs are expected to achieve a wide variety of non-commercial objectives which are imposed by the ministries and the Parliament.

• One of the most difficult one to maintain is employment reservation. Every SOE must adhere to the affirmative action norms, and ensure that the share of employment under reserved categories (scheduled castes, scheduled tribes, other backward castes, physically handicapped persons, and ex-military or dependants of those killed in military or para-military action) is identical to the central government ministries. Employment reservation is monitored at five levels: by the administrative ministries, the Department of Public Enterprises under the Ministry of Industry, the Departments of Personnel and Training under the Ministry of Labour, the Parliamentary Committee on the Welfare of Scheduled Castes and Scheduled Tribes, and the National Commission for the Scheduled Castes and Scheduled Tribes. The chief executive of an SOE has to ensure that the reserved quota is maintained not just on incremental employment, but increasingly on the average – and deviations, particularly in the higher paid categories, invite immediate Parliamentary questions and show-cause notices.72

• The annual audit by the Comptroller and Accountant General (CAG) in addition to the audit by the statutory auditor. The area where CAG audits inflict the greatest ex ante damage is in purchases and tenders. SOE managers and board members invariably veer towards selecting the lowest bid, even when they know that the quality is poorer. Innumerable CAG allegations of financial impropriety adduced only on the basis of rejecting the lowest bid have taught SOE executives and directors that propriety dominates profitability.

• Constraints on appointment of senior management personnel, which can only be done through the Public Enterprise Selection Board (PESB) and, thereafter, clearance from the Department of Personnel, the Home Ministry, and, in many instances, by the Office of the Prime Minister. This has led to delays, non-appointment of CEOs and executive directors and excessive emphasis on seniority. In such a milieu, biding time dominates corporate accomplishment. A study sponsored by the Standing Committee on Public Enterprises (SCOPE) in 1992 found that only 64 companies of a

72 Presently, for all state agencies the minimal reservation quotas are 15% for Scheduled Castes, 7.5% for Scheduled Tribes, and 27% for Other Backward Classes – making it 49.5% of total employment. For the relatively lower paid, lower skill jobs, there is an additional quota of 3% for the physically disabled, and 14.5% to 24.5% for ex-military and dependants of those killed in military or para-military action. These quotas are particularly restrictive in selecting people for technically specialised jobs.


sample of 101 central SOEs had full-time chairmen or executive chairman-cum-managing directors; and the post of 30 chief executives and 66 executive directors were lying vacant [Kaw (1994), 360]. The study also found that only 13% of the chief executives and 5% of the functional directors remained in employment for the full five-year contract period; they reached the mandatory retirement age in an average of 18 months. Matters have not improved since.

• Since SOEs are parts of ‘the State’, they are subject to writ petitions to the Supreme Court under Articles 32, and High Courts under Article 226 of the Constitution.

• Again by virtue of being considered as servants of ‘the State’, managers as well as directors of SOEs are, in principle, subject to criminal investigation by the Chief Vigilance Commissioner and the Central Bureau of Investigation.

• State status limits managers from downsizing plants, retrenching or re-deploying employees.

• Finally, the directors of SOEs have little autonomy in finalising investment decisions.

What do SOE managers have to say about these restrictions? A survey published in January 1997 emphasises their frustrations in no uncertain terms, as seen in Table 4.

Table 4: Responses of Senior SOE Managers

Issues Percentage of respondents

Accountability Oppose Interference from political quarters 62 Oppose Interference from bureaucracy 75 Oppose multiple reporting 65 Oppose multiple accountability (Ministries, vigilance, Parliament)

82

Bureaucrat Directors Oppose increase in number of government officers as directors

82

Restructuring Favour financial restructuring 77 Favour business restructuring 74 Favour privatisation 71

Note: 114 senior executives from 83 SOEs responded to the questionnaire. Source: SCOPE, Opinion Survey of Public Sector Chief Executives: Executive Summary, January 1997.

In the final analysis, there can be no real solution to SOEs without systematic and transparent privatisation. This has been recognised by the present government and clearly enunciated in its policies. However, progress has been poor — partly because of resistance from entrenched, rent-seeking bureaucracy, and partly due to the lack of sufficient political will. In the meanwhile, even the better run SOEs are suffering on two counts. First, there has been a major fall in corporate value, measured in terms of EVA. For the four year period between 1995 and 1998, a sample of 109 SOEs in the aggregate lost EVA worth Rs.9.1 billion, which amounted to almost 9% of their capital employed.73 Second, there has been a far more important loss — that of skilled and trained managers leaving for the private sector.

73 Bhandari and Goswami (2000), Chapter 3.


Unless these companies get privatised, and managers realise that they will be rewarded for performance and risk-taking, this exodus will continue. And with it, the deterioration of SOEs will exacerbate.

7. Conclusion

It is fair to say that, in the last five years, India has made much more rapid strides in corporate governance than most, if not all, its Asian counterparts. It is also certain that the next few years will see an even greater flurry of activity. This will be driven by several factors.

First, and most important, is the force of competition. With the dismantling of licenses 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. Underutilised assets are being sold, capital is being utilised like never before, and companies are focusing on the top and bottom line with a hitherto unknown degree of intensity. Moreover, while there have been losers in liberalisation, competition has led to greater over all profits. Thus, the aggregate financial impact of competition has been positive — the more so for those who went through the pains of restructuring in the relatively early days of liberalisation. And there is every indication that while many companies will fall by the wayside, many more will earn greater profits than before.

Second, economic reforms of the last 11 years — however glacial the process of change — has definitely contributed to a great churning in corporate India. Nothing emphasises this more than two simple comparisons — the fall from grace of yesterday’s corporate giants, and the rise of the new kids on the block.

Consider the top 100 companies ranked according to market capitalisation as on 1 April 1991. How have these been treated by the market 11 years after liberalisation? Very poorly, as the following statistics indicate:

• The rank of the top 10 companies on 1 April 1991 fell by an average of 38 points as on 30 September 2002.

• The rank of the top 25 companies fell by an average of 67 points.

• The rank of the top 50 companies fell by an average of 88 points.

• For the top 100, the average fall in rank was 157 points.

In relative terms, therefore, yesterday’s giants have been dwarfed by the forces of change. What about the new kings of the bourse? When did these companies come into being? That data is even more revealing, and shows how economic liberalisation, competitiveness and dismantling of controls have reduced entry barriers and permitted new entrepreneurs to race to the top of the market capitalisation table.

• Four of the top 10 companies ranked by market cap as on 30 September 2002 either did not exist or were not listed on any stock exchange.

• Twenty-two of the top 50 companies were in identical circumstances.

The dominant characteristic of today’s top 50 companies is the preponderance of first generation enterprise or professionally run businesses. In 1991, 22 out of the top 50 companies were controlled by family groups that held their sway during the licence-control regime. By February 2002, the roles were


reversed: 35 were professionally managed, of which 14 were first generation businesses; only 4 out of the 50 were run by older business families. By and large, these are companies managed by relatively young, modern, outward-oriented professionals who place a great deal of value on corporate governance and transparency — if not for themselves, then as instruments for facilitating access to international and domestic capital. Therefore, they are more than willing to have professional boards and voluntarily follow disclosure standards that measure up to the best in the world.

Third, there has been a phenomenal growth in market capitalisation. This 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. Creating and distributing wealth have become more popular maxims than ever before — the more so when these tenets are validated by growing market cap.

Fourth, one cannot exaggerate the impact of well focused, well researched foreign portfolio investors. These investors have steadily raised their demands for better corporate governance, more transparency and greater disclosure. And given their clout in the secondary market — they account for over 25% of the average daily volume of trade — foreign portfolio investors have voted with their feet. Over the last two years, they have systematically increased their exposure in well governed firms at the expense of poorly run ones.

Fifth, the pressure on corporate governance will intensify with the entry of foreign pension funds. Indian equity offers attractive dollar-denominated rates of return on capital, which should make international pension funds begin to look at selected Indian stocks. These funds hold on to their investments much longer than mutual funds; and their managers will be looking even more closely at corporate governance before making their investments. Indeed, it is fair to predict that in the next five years, the biggest pension funds will invest in India, and some of them will put Indian companies on their corporate governance watch.

Sixth, India has a strong financial press, which gets stronger with the years. In the last five 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.

Seventh, despite serious lacunae in Indian bankruptcy provisions, neither banks nor DFIs have the appetite to support management irrespective of performance. Already, the more aggressive and market oriented DFIs have started converting some of their outstanding debt to equity, and have set up mergers 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.

Penultimately, Indian corporations have appreciated the fact that good corporate governance and internationally accepted standards of accounting and disclosure can help them to access the US capital markets. Until 1998, this premise exited only in theory. It changed with Infosys making its highly successful Nasdaq issue in March 1998. This was followed ICICI, Satyam Infoways, Satyam, ICICI Bank, Wipro, HDFC Bank, Dr. Reddy’s Laboratories and others (most of whom are listed on the NYSE). At this point, there at least ten companies gearing up to issue US depository receipts in 2003. 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. Second, it has demonstrated that good corporate governance and disclosures are not difficult to implement — and that 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.


Finally, within the next five years or so, 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 wrong to predict that, by the time Beijing hosts the 2008 Olympics, India might have the largest concentration of well governed companies in South and South-east Asia.


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Corporate Governance in Pakistan: Ownership, Control and the Law

By Ali Cheema Faisal Bari Osama Siddique74

Table of Contents Introduction 165

1. Industrial Policy and Corporate Finance in Pakistan: A Historical Overview 167

2. Pakistan’s Corporate Governance System 170

3. Capital Markets 180

4. SECP’s Recent CG Reform Effort 182

5. Financial Reporting and Disclosure 192

6. Financial Sector and Corporate Governance 200

7. Judicial System 206

8. Conclusions 207

9. Bibliography 209

List of Appendices

Appendix 1. Sample Description 211

Appendix 2. Relevant Excerpts from the SECP Annual Report 2002 216

Appendix 3. Case Study Evidence on Corporate Structures 219

Appendix 4. The Code of Corporate Governance 223

Appendix 5. The Legal Aspects of Corporate Governance in Pakistan 236

74 Faculty at the Lahore University of Management Sciences. We would like to thank Ms. Ghazia Aslam and Mr. Ali Zahid Rahim for providing valuable research assistance. We would like to thank Mr. Bilal Minto, Mirza Mehmood Ahmed and Ms. Wendy Werner for their comments on earlier drafts. Finally, we owe a very deep gratitude to Khadim Ali Shah Bukhari, ICAP and SECP Pakistan, in particular, Mr. Haroon, Sharif for their help with data.


Introduction Corporate governance (CG) reform has dominated policy agendas in both developed and developing countries during the nineties. Policy making interest in CG gained momentum in the wake of the East Asian financial crisis and as a result of scandalous revelations about corporate practices in leading U.S corporates like Enron. Governments, stock exchanges and business associations across the world are competing to produce CG guidelines. These reforms are thought to be of great significance for developing countries that are making a sustained effort to attract Foreign Direct Investment (FDI) and to mobilize greater savings through capital markets. In Pakistan, CG reforms initiated during the last few years, by the Securities and Exchange Commission of Pakistan (SECP), are argued to be an important component of the Government of Pakistan’s (GOP) growth revival strategy. The concern for growth revival in Pakistan is underscored by Table 1, which reveals the extent of the growth slowdown during the last decade.

Table 1. South Asian GDP per Capita Growth Rates Growth Rate of GDP per capita

Country Name 60's 70's 80's 90's Pakistan 4.29 2.11 3.82 1.47 India 1.52 0.75 3.70 3.73 Bangladesh 1.40 -0.52 1.98 3.15 Nepal 0.48 -0.32 1.49 2.25 Sri Lanka 2.15 2.63 2.84 3.98

Source: World Development Indicators, 2002.

Pakistan’s growth response stands in sharp contrast to the positive response of other South Asian economies that have adopted similar policies of structural adjustment and liberalization during the nineties. The relative slowdown in Pakistan’s growth during the nineties can be attributed to falling rates of capital accumulation and total factor productivity growth (Table 2).

Table 2. Comparison of Factors Contributing to Growth in South Asia75

Growth of Output per

worker

Physical Capital

Per worker

Education Per worker

Total Factor Productivity

Bangladesh 90's 2.08 0.88 0.16 1.03 1960-90 0.06 -0.07 0.31 -0.18 India 90's 3.40 1.45 0.33 1.61 1960-90 2.31 1.05 0.38 0.87 Pakistan 90's 1.39 0.61 1.75 -0.97 1960-90 2.45 1.48 0.79 0.17 Sri Lanka

75 The methodology for these estimates is given in Basudeb and Bari (2002).


90's 2.51 1.02 0.16 1.33 1960-90 2.32 1.19 0.28 0.84

Source: Basudeb and Bari (2000). There is a concern that low rates of capital accumulation reflect Pakistan’s inability to mobilize domestic savings (Table 3) and Foreign Direct Investment (Table 4).

Table 3. Gross Domestic Savings (Percentage of GDP)

Country 1980-90 1990-2000 Country 1980-90 1990-2000

South Asian Economies East Asian Economies Bangladesh 7.84 14.60 South

Korea 30.59 35.10

India 20.09 20.98 Thailand 26.46 35.16 Nepal 10.70 12.20 Singapore 41.78 48.68 Pakistan 8.31 12.08 Malaysia 33.09 40.63 Sri Lanka 12.78 16.08 Indonesia 31.60 32.29

Source: World Development Indicators (2002).

Table 4. Foreign Direct Investment Inflows (US $ million)

1980-85 1990 1995 1998 World 49,813 203,341 331,189 643,879 Developing Countries

12,634 31,345 105,511 165,936

Asia 5,043 18,948 67,386 84,880 SAARC 178

(3.5%) 458

(2.4%) 2,753

(4.08%) 3,433

(4.04%) Bangladesh -0.1

(0%) 3.0

(0.01%) 2.0

(0.002%) 317.0

(0.37%) India 62

(1.2%) 162

(0.85%) 1,964

(2.9%) 2,258

(2.7%) Pakistan 75

(1.5%) 244

(1.3%) 719

(1.07%) 497

(0.6%) Sri Lanka 42

(0.8%) 43

(0.2%) 53

(0.7%) 345

(0.4%) Source: UNCTAD, World Investment Report, various years, taken from Institute of Policy Studies Note: Parenthesis gives country FDI as a percentage of Asian FDI.

In order to address these growth-financing concerns the SECP has placed considerable emphasis on the reform of capital markets. The objective of capital market reform is to increase the depth and efficiency of capital markets with an aim to mobilize domestic savings and foreign portfolio investment. As pointed out earlier, an important component of this reform is the improvement in Pakistan’s Corporate Governance (CG) system. The measures proposed to fulfill these objectives include: minority shareholder representation in the board of directors; requiring directors to discharge their fiduciary responsibility in the larger interest of all stakeholders; and improved disclosure through better regulation of audit activity and through the adoption of international standards. SECP recognizes that growth creation in global


capitalism requires a corporate governance system that has the ability to efficiently raise external equity capital, to increase corporate competitiveness and to stimulate corporate growth. This chapter assesses the constraints imposed by Pakistan’s corporate governance structure, laws and regulatory institutions on the development of external investor financing. Section 1 provides a historical analysis of Pakistan’s corporate growth and corporate finance experience. Its main purpose is to illuminate the reasons for the underdevelopment of capital markets in Pakistan. Section 2 provides detailed empirical analysis of Pakistan’s structure of corporate ownership and control. We show that family based corporates represent an important potential source of corporate growth in Pakistan’s existing economic environment. However, we also argue that the control maximization objective of family based corporates may be inimical to the development of Pakistan’s capital markets. Section 3 argues that opaque information disclosure and other inefficiencies in Pakistan’s capital markets tend to make them unattractive avenues for both mobilization of funds and investment. Sections 4 and 5 detail the recent Corporate Governance reforms brought about by the SECP. We argue that while the reforms have brought Pakistan’s corporate law in line with international best practice, its implementation may be limited by the country’s structure of ownership and control. We also show that an underdeveloped corporate sector creates negative externalities, which reduce incentives for the improvement in the quality of the audit market. However, we acknowledge the SECP’s recent reforms have had a positive effect on the consolidation of a quality segment in the accounting profession. Sections 6 and 7 analyze the causes for inefficiencies in credit allocation and the rise of non-performing loans (NPLs) in Pakistan’s financial sector. We identify poor judicial enforcement and historical weaknesses in the structure of financial markets and their regulatory agencies as important causes for this phenomenon. We also argue that recent financial sector reforms have made financial institutions excessively risk averse in their practices, which will raise the cost of debt financing for Pakistani corporates. This suggests that there may be a need for capital market reforms. Section 8 concludes. 1. Industrial Policy and Corporate Finance in Pakistan: A Historical Overview The Pakistani State’s policy involvement with the corporate sector dates back to the fifties. The private sector was identified as the main agent for industrialization during the first two decades after partition. During the fifties, the state intervened through heavy protection and it provided the manufacturing sector with generous fiscal incentives, cheap imports of capital goods and subsidized credit. An overvalued exchange rate was used to reduce the domestic prices of jute and cotton, the two main sources of industrial raw material. Quantitative import restrictions created acute scarcities in the domestic market, which together with an overvalued exchange rate allowed windfall profits76 to be made by importers and import substituting industrialists. Generous state incentives combined with a large domestic market and cheap industrial raw material created the first wave of accumulation in Pakistani industry. Pakistan’s industrial policy during the sixties witnessed a number of important departures, although it kept intact quantitative barriers and tariffs on imports of manufacturing goods. The state introduced the export bonus scheme, which “was in effect a multiple exchange rate system favouring manufacturing exports” (Noman 1992). Government policy continued to insure the availability of subsidized raw material as well as the availability of subsidized credit and cheap foreign exchange. In addition, the government instituted policies that kept the price of machinery close to the international level and maintained an overvalued exchange rate for agricultural exports. 76 Papaneck’s (1967) estimates suggest that many import-substituting industrialists made over a hundred percent profit during this phase of Pakistan’s industrialization.


The state also created ‘policy transfers’ through the financial sector. It did this by providing foreign exchange and domestic currency loans on favourable terms to Pakistan’s corporate sector. The rate of interest charged on these loans was 30% of the scarcity value of capital (Amjad 1982). This considerably influenced the profitability and financial position of Pakistan’s industrialists. Easy access to these subsidies was provided by disbursing foreign exchange loans and grants provided by multilateral agencies through state-run financial institutions namely, the Pakistan Industrial Credit and Investment Corporation (PICIC) and the Industrial Development Bank of Pakistan (IDBP). These schemes covered over 65% of investment financing during the sixties. Amjad’s (1982) estimates clearly show that access to subsidized foreign exchange loans explains, in large part, the differences in corporate growth in Pakistan during the sixties. The main beneficiaries of the state’s financing policy were Pakistan’s monopoly houses. Amjad (1982) defines monopoly houses as being characterized by family ownership under a centralized decision making authority, usually the patriarch of the family, and consisting of several legally separate companies engaged in highly diversified activities. Furthermore, he argues that there is no separation of ownership from control in these houses. Not only did these houses have access to subsidized loans they also had considerable institutional access to the boards of state-run financial institutions, which were the main disbursers of long-term loans to the manufacturing sector. A third of directors of important state-run financial institutions such as the Pakistan Industrial Credit and Investment Corporation (PICIC), the Investment Corporation of Pakistan (ICP) and the National Investment Trust (NIT) were from these houses77. An outcome of this corporate structure was the concentration of industrial assets in the hands of 44 monopoly houses that controlled 48% of gross fixed assets of the large-scale manufacturing sector in 1970 (Amjad 1982). These houses were also the main beneficiaries of loans disbursed by the two major Development Finance Institutions (DFIs) run by the state, PICIC and Industrial Development Bank of Pakistan (IDBP). The formation of the Pakistan Peoples Party (PPP) government in the seventies (which had pledged a manifesto commitment to reduce industrial concentration), the creation of Bangladesh78 and the nationalization of the economic assets of the monopoly houses crushed their economic power. Amjad’s (1983) study shows that 11 out of the top 26 houses lost more than 50% of their assets in this period. The private sector was no longer considered the main agent of industrialization and the emphasis of the state’s industrial policy shifted towards developing public sector industries. The new beneficiary of state policy was the public sector, as a result the share of the public sector in large-scale manufacturing investment increased from 13% in 1972-73 to 78% by 1976-77. The Bhutto (PPP) government also nationalized Pakistan’s banking sector during the seventies. Banking nationalization extended political control over the entire financial sector and with minor modifications this structure persisted until the late nineties. Political control over the banking sector was strengthened by weakening State Bank of Pakistan’s (SBP) regulatory and supervisory role through the creation of the Pakistan Banking Council (PBC), which became the operational controller of banks (section 6). The Federal government retained the right to select the members of the PBC, and through the PBC it retained effective control over the appointments of boards of individual banks. This change heightened political control over credit ‘transfers’ to industry. General Zia-ul-Haq and subsequent democratically elected governments sought to revive the role of the private sector during the eighties and early nineties. During the eighties, government policy attempted to stimulate and direct industrialization by boosting profitability through measures such as, “tax holidays, tax credits, accelerated depreciation allowance, concessions in import duty on machinery and equipment 77 Amjad (1982). 78 Monopoly houses lost both private assets and a large internal market as a result of the creation of Bangladesh.


and raw materials, exemption of sales and excise taxes” and tariff protection given to the manufacturing sector (Hamid 1992). In addition, the government provided an additional incentive to industry in the form of the availability of raw materials (cotton and hides and skins) at below world prices by placing restrictions or duties on their exports. Subsidized credit79 continued to provide essential state-created incentives for corporate growth during the eighties-nineties. However, the conduit for ‘credit transfers’ was no longer only the state-run financial institutions but also commercial banks that had been nationalized under Bhutto (1971-77). The aid dividend from the Soviet-Afghan war had created significant foreign exchange liquidity for the ‘state’ to make liberal ‘transfers’ to industry. An important consequence of this intervention was increased leveraging in Pakistan’s corporate sector (Table 1.1). Availability of cheap state-provided credit and inflated profits due to other state-created incentives significantly diluted the Pakistani corporations’ need to mobilize equity finance through capital markets.

Table 1.1. Leveraging in Pakistan’s Private Manufacturing Sectors 1980 1985 1990 1995 1998 Textiles 0.7 5.4 1.1 1.1 1.0 Others 0.3 0.9 1.2 2.5 0.2 Source: State Bank of Pakistan (2001). Note: The textile data is separately reported as textile companies dominate the listed company’s sector in terms of numbers. By the early nineties, the state lowered entry barriers into the industrial sector, which had been in place during the past two decades. Liberal provision of cheap state-provided credit combined with liberal entry control resulted in a number of important consequences, which are illuminated by Cheema’s (1999) case study of the spinning sector80. First, the availability of cheap ‘state credit’ resulted in rapid new entry into key manufacturing sectors, like spinning, during the nineties (Table 1.2, column 2).

Table 1.2. Entry Rates and Credit Access in Pakistan’s Spinning Sector

Period (1)

Gross Entry

Rate (per annum)

(2)

Market Share of Incumbent Companies

(3)

Market Share

of New Companies

(4)

Incumbent Companies

Share in State Credit

(5)

New Companies

Share in State Credit

(6) 1981-85 1.8% 95% 5% 97% 3% 1986-90 4.5% 77% 23% 79% 21% 1990-94 11% 63% 37% 53% 47%

Source: Cheema (forthcoming)

Second, column (4) shows that the entry of new companies grew at an increasing rate during the mid-to-late eighties and the early nineties. Column’s (3) and (4) show that not only did new companies enter the sector they were also able to wrestle away market shares from incumbent companies. Third, columns (5) and (6) show that access to state credit provided an important means to underwrite the entry of new

79 Cheema (1999) shows that during the 1980s and early 1990s the rate of interest on long-term loans was only 40% of the open market price of capital, which constituted a significant subsidy for the industrial sector. 80 We rely on this case study, as there is a paucity of rigourous material analyzing the impact of state policy on industrialization during the eighties and nineties.


companies in Pakistan’s corporate sector. The proportionate disbursement of state credit to new entrants more than doubled during the early nineties. Fourth, Table 1.3 shows that the main beneficiaries of changes in the ownership pattern were not only the established monopoly houses, as had been the case during the sixties. Instead it shows that by 1994 single-company entrepreneurs had doubled their share of spinning capacity from 27% in 1981 to 45% in 1994, or from 66 companies in 1981 to 234 companies in 1994. These new entrants were much smaller in size; the average size of a single-company mill was 14,500 spindles in 1994, while an Industrial Group mill averaged 24,000 spindles. Cheema’s (1999) estimates show that these new entrants on average tended to be low-productivity companies, many of whom ended up as major loan defaulters by the mid to late nineties, which points to, among other things, the existence of poor project selection, political corruption, and weak lending practices in the state-run banking sector.

Table 1.3. Ownership Profile of Spinning Entrepreneurs

Percentage of Installed Capacity Owned by Different Groups

1981 1990 1994 Monopoly Houses Established Before 1979 47% 56% 39% Monopoly Houses Established During the Eighties

26% 13% 17%

Single-Company Entrepreneurs 27% 31% 45% Source: Cheema (1999) Note: All companies belonging to an Industrial Group or to one of its family members have been consolidated as Industrial Group Ownership. If a family has split up into different groups then this has been taken into account. An analysis of Pakistan’s industrialization experience shows that state provided incentives, given in various forms over the decades, have helped to inflate internal profits of industry. An important subsidy given by the state to the private sector in all decades, barring the seventies, has been cheap credit. Evidence, however, suggests that unlike the sixties state-provided credit disbursements are no longer monopolized by a handful of business groups. Protection profits and access to cheap credit has determined the nature of corporate finance in Pakistan, which has historically been debt and internal finance dependent. In turn, this pattern of corporate finance has reduced the corporates incentive to mobilize capital through equity markets, which has undoubtedly contributed to the underdevelopment of capital markets in Pakistan (see section 3 for a detailed discussion of Pakistan’s capital markets). Mounting non-performing loans in Pakistan’s banking sector, tighter regulation of the banking sector, liberalization of interest rates and the adoption of more market-based lending practices, by the mid-nineties, had made state-credit an unattractive means to finance corporate growth (see section 6). This resulted in a downward trend in leveraging ratios, especially in sectors other than textiles (Table 1.1). The reversal in the easy availability of state credit leaves the corporates with two options, either they rely on internal financing for growth or they will have to raise equity through the capital markets. There are limitations on the former option because of the liberalization of product and factor markets in Pakistan, which will reduce protection profits for industry. Therefore, capital market development has acquired a premium in the current context of Pakistan’s growth history. 2. Pakistan’s Corporate Governance System


A historical analysis of Pakistan’s corporate growth experience gives many clues into the state of underdevelopment of the country’s capital markets. In this section, we argue that Pakistan’s existing corporate governance structure provides another important reason for the underdevelopment of capital markets in Pakistan. Recent literature has emphasized the relationship between corporate governance systems and capital market development. It is received wisdom that corporate governance reforms are an important pre-requisite for capital market development as they provide essential protections for external investors. Shleifer and Vishny (1997) pose the governance question as one of how external investors could ensure that managers or majority controllers would provide them with ample return and would not expropriate their investment. The issue of corporate governance arises because of the separation of ownership from control in corporations. The agency costs that arise due to a disjuncture between ownership and control could exist not just between shareholders and managers, but also between controlling and minority shareholders and between shareholders and creditors (Berglof and Von Thadden 2000). These agency costs raise the expropriation risk for investors and make them shy of investing in companies. Zhuang et. al (2000) define a corporate governance system as consisting “of (i) a set of rules that define the relationships between shareholders, managers, creditors and the government and (ii) a set of mechanisms that help directly or indirectly to enforce theses rules” (pg. 5). A well-designed corporate governance system will not only protect investors’ investment, but will also help reduce market risk and maintain financial stability. By doing this, a corporate governance system helps create the environment for capital market development and for the growth of the corporate sector. The next two sections raise the simple, but essential, question, that is, whether Pakistan’s current corporate governance system is compatible with the requirements of capital market development? 2.1 An Overview of Pakistan’s Corporate Sector Pakistan’s manufacturing sector can be used as a first approximation to measure the importance of the corporate sector in Pakistan’s economy. Table 2.1 reveals four interesting features about Pakistan’s manufacturing sector81. First, it shows the dominance of the private sector in both Pakistan’s large and small and medium manufacturing industries. Second, it reveals the small presence of foreign controlled units in terms of numbers. Third, and for our purpose, most importantly, it highlights the relative underdevelopment of the corporate sector in Pakistan’s private large-scale manufacturing industry. Finally, it shows the lack of development of the widely held companies sector in Pakistan.

Table 2.1. Legal Status of Pakistan’s Manufacturing Units, 1988

Large82 (% of large units)

Small & Medium83 (% of small and medium

units) Foreign Controlled Units 0.04% - Private Sector Units 42.0% 85.8% Individual Proprietorship 13.2% 82.8% Partnership 7.06% 2.5% Private Limited 18.4% 0.3% Public Limited 2.6% 0.13%

81 This exercise could not be conducted for other sectors and for recent years because of the paucity of data. 82 100 or more workers. 83 Less than 100 workers.


Others 0.09% 0.01% Source: Census of Establishments (1988) These findings are reinforced by Table 2.2, which underscores the relative dominance of the closely held sector in terms of numbers. However, as in India, publicly listed companies become more prominent if importance is estimated in terms of the book value of equity. We also find that Pakistan trails India in terms of the contribution of the widely held sector, when measured as a share of paid-up capital. This discussion suggests a two-pronged conclusion. First, Pakistan is clearly under performing in the area of corporate development. Second, capital market development clearly requires growth in the widely held sector.

Table 2.2. A Comparative Overview of Pakistan’s Corporate Sector 2001

Pakistan India Number Percent Number Percent

Private Limited (Closely held)

2173 75% 487,111 86%

Public Limited (Widely held)

723 25% 76,029 14%

All Companies

2896 100% 563,140 100%

Paid-up Capital Pak Rupees

(Billion)

Share

Indian Rupees (Billion)

Share Private Limited (Closely held)

190 42% 1,013 33%

Public Limited (Widely held)

261 58% 2,063 67%

All Companies

451 100% 3,076 100%

Source: SECP For Pakistan. Goswami (this volume) for India. Note: (1) The Pakistani data does not control for non-operational publicly listed corporations. In effect, the share of the listed sector will be smaller in Pakistan once we decontaminate the listed companies register. (2) The Pak rupee is 58 to a U.S dollar, while the Indian rupee is 48 to a U.S dollar. 2.2 The Listed Companies Sector in Pakistan The ownership composition of Pakistan’s top 40 publicly listed companies84 gives important insights into the salient characteristics of widely held corporates in the country. Table 2.3 highlights the importance of government and semi-government ownership in Pakistan’s top listed corporations. Equally importantly, it emphasizes the significance of local private companies both in terms of numbers and as a percentage of the top 40 companies’ market capitalization. Interestingly, the share of MNCs as a percentage of the market capitalization of the top 40 companies is, contrary to popular opinion, not that high.

84 We use the top 40 companies as a benchmark because they account for over 80% of market capitalization.


Table 2.3. Ownership Composition of Pakistan’s Top 40 Listed Companies

Percent of top 40 Companies Percent of top 40 Market Capitalization

Ownership Type

All Non-Financial All Non-Financial

Local Private 52.5 59.0 30.2 29.8 Government 12.5 12.0 36.5 36.8 Semi-Government

22.5 14.0 16.3 15.6

MNCs 12.5 15.0 17.0 18.0 Source: Authors’ calculation based on information gathered from the Karachi Stock Exchange website. Note: All companies that are not controlled by either MNCs or by government are classified as Local private companies. An analysis of investor composition in listed companies reveals interesting variations across ownership type (Tables 2.4 (a) and (b)). The major investors in MNCs are management followed by financial institutions; together they own 76% of an average MNC’s equity capital. Banks and financial institutions also emerge as important investors in government corporations; where they own 40% equity in an average government listed company, which is second only to the direct ownership of government. While direct individual ownership is not insignificant in government corporations and MNCs, it does not appear to dominate equity ownership in these corporations. This data suggests that multinational and government listed companies may not be extremely widely held and appear to be dominated by concentrated ownership in the hands of management and government, respectively.

Table 2.4. (a) Investor Composition in Listed Government Companies and MNCs (percentage shares owned by an investor type)

Investor Type Government MNCs Banks/Financial Institutions 40.1 16.9 Corporations 1.3 2.5 Employees 0.01 0.04 Foreigners 1.6 2.8 Affiliated Companies 0.2 1.1 Government 44.4 4.1 Individuals 11.5 12.3 Management 0.5 58.8 Modaraba85 and Leasing Companies

0.2 0.6

Others 0.1 1.1 Source: Authors’ calculation with data obtained from the SECP. Note: Details of the sample are given in Appendix 1. The dominance of the family is apparent in listed local private companies (Table 2.4 (b)). The family as a unit controls approximately half of the equity of an average listed Textile Company either through direct ownership or by virtue of ownership through associated companies. Family dominance is also evident in

85 Modaraba is trust financing: one party provides 100 percent of the capital, the other provides management. Profits are distributed in a pre-agreed ratio. Losses are borne only by the provider of capital.


sectors other than textiles, Pakistan’s largest manufacturing sector86, where the family directly and indirectly controls approximately one-third of the equity of an average company.

Table 2.4 (b) Investor Composition in Listed Local Private Companies

(percentage shares owned by an investor type) Investor Type Textile Non-Textile Direct Holding by Family Members

29.3 9.1

NIT/ICP 8.4 11.1 Financial Institutions 5.1 8.2 Foreign Investors 1.9 14.3 Joint Stock Companies 23.2 16.9 Associated Companies of the controlling family

17.4 21.4

Source: Authors’ calculation from 2002 Annual Reports of the sample companies. Note: Details of the sample are given in Appendix 1. The textile sample is separately reported as textile companies dominate the listed company’s sector in terms of numbers. The non-textile sample reflects randomly drawn family companies from other sectors. The significant presence of family-based local private companies in Pakistan’s listed sector (Table 2.3), in terms of both numbers and market capitalization, clearly reveals the potential of these entities as future providers of growth in the publicly listed corporate sector. Given the significance of family-based corporates it is instructive to question whether their current ownership and control structure is compatible with capital market development and with the attainment of corporate efficiency. An adequate answer to this question can only be provided after analyzing the family-based corporate model in Pakistan. 2.3. Features of Pakistan’s Family Based Corporate Sector One of the benefits of CG reforms in Pakistan is information disclosure, regarding family ownership of stocks in publicly listed companies, that has recently been mandated by the SECP. This data allows analysts to document Pakistan’s family-controlled corporate model. The findings of this section are based on an analysis of this data. The most fundamental characteristic revealed by our sample data is that the control of the owning family over the company is absolute and all-important decisions are taken by members of the family. Table 2.5 reveals the extent of family control that persists in Pakistan’s privately owned domestic publicly limited companies. We define family control as the percentage of an average company’s shares under the control of a family at different thresholds of control. A family can control shares in a target company either by owning shares directly or indirectly through associated companies, which are under their control. Interestingly, Table 2.5 shows that the concentration of family control in Pakistan, at any given threshold level, is much higher than in many East Asian economies, which are known for excessive family control.

Table 2.5. Family Control in Asian Corporates (Percentage of the sample companies)

Percent of Family

Pakistan (Textiles)

Pakistan (Non-

Indonesia

Korea Malaysia Taiwan Thailand

86 The textile sector accounts for approximately one-third of large-scale manufacturing production.


Control Textiles) 10% cut

off 92.987% 88.9% 67.1% 67.9% 57.7% 65.6% 50.8%

30% cut off

85.888%%

55.5% 58.7% 20.1% 45.6% 18.4% 54.8%

> 40% 50.089% 38.9% 35.4% 3.5% 14.7% 5.0% 38.9% Source: Claessens, Djankov and Lang (1999) for East Asia. Authors’ calculation for Pakistan. Note: The sample size of the Pakistani data is 32 domestically owned listed companies. The sample does not include MNCs or government corporations. Proxy holding bias has not been removed for either East Asia or Pakistan. Similarly, family control data for all countries includes control through associated companies. In addition, table 2.6 shows that in Pakistan ownership is not as concentrated as is the case in most East Asian economies.

Table 2.6. Ownership Concentration in Asian Corporates

Country Concentration Ratio (%) of Top Five Shareholders

Pakistan 37.090% Indonesia 67.5%

Korea 38.5% Malaysia 58.8%

Philippines 60.2% Thailand 56.6%

Source: Zhuang et. al. (1999) for East Asia. Authors’ calculation for Pakistan. Note: The sample size of the Pakistani data is 32 domestically owned listed companies. Proxy holding bias has not been removed for either East Asia or Pakistan. Table 2.6 read together with table 2.5 shows that while concentration of control is much higher in Pakistan than in East Asia, ownership concentration is not as high. This could partly be a consequence of the quality of data, which does not control for ownership by individuals who act as proxies for the family. However, the finding that ownership is not as concentrated as control is in line with findings for other South Asian economies such as India (Bagchi 1999, Bertrand et. al. 2000). It is also consistent with findings from earlier periods of Indian and Pakistani corporate history (Amjad 1982, Lokanathan 1935, Hazari 1966). This data once put together suggests that there is evidence supporting the notion that a separation of ownership from control may exist in Pakistan’s publicly listed corporations. 2.4. Separation of Ownership from Control and Private Benefit Seeking in Pakistan Why should the separation of ownership from control be a matter of concern? This is an extremely important issue that requires some analytical clarification. At a conceptual level a separation of ownership from control in a publicly limited company implies that the controller (a family-based owner 87 The figure implies that in 92.9% of our sample companies the family controls equal to or more than 10% of the total share capital. 88 The figure implies that in 85.8% of our sample companies the family controls equal to or more than 30% of the total share capital. 89 The figure implies that in 50% of our sample companies the family controls more than 40% of the total share capital 90 Implies that the top five shareholders of an average company in Pakistan own 37% of the share capital.


manager in the Pakistani case) retains effective decision-making control over capital that has been invested by external investors (banks and minority shareholders). This allows the controller considerable discretion over the use and allocation of the external investors’ capital. In developing countries this discretion is strengthened by weak disclosures and a poorly regulated auditing infrastructure that continues to plague these economies91. Among other things, this discretion allows the family controller to seek private benefits, which are attained by tunneling external investors’ capital to associated companies (for Indian evidence see Bertrand et.al. 2000) and by allocating profits to expenditures that benefit the controller. The types of expenditures that typically represent private benefits in developing countries include; political lobbying investment, expenditures on posh cars and offices; travel; and provision of expensive personal housing, lavish expense accounts, etc. The insets provide some recent evidence collated by the SECP regarding private rent seeking by Pakistani corporate controllers.

Box 1. Case Study – Leasing Sector An inspection of Company A revealed that investments in Musharika92 Finance were disbursed to eight fictitious parties to transfer the funds to an associated company. Furthermore, lease financing to related, associated and favored parties, that had become non-performing, constituted about 60% of the total portfolio. In addition to this, the directors and management of the company not only increased salaries and benefits, but also created final settlements for themselves on account of excessive claim of gratuity, leave encashment and commissions before handing over possession to a new management. As a consequence of these activities, the equity of the company was reduced to approximately Rs. 21 million as compared to a paid up capital of some Rs. 110 million. Several reasons can be pointed out that led to this outcome. First, there was a lack of professional management and of internal checks and balances in the company. Secondly, about 150 fake National Identity Cards were recovered that had been used for showing fake morahaba financing to these individuals or as shareholders in the company. Third, the ownership and management had been concentrated in a single person, who had been the main sponsor and this individual had appointed company drivers and other staff as Directors of an associated company! Source: SECP Audit Reports.

Box 2. Case Study – Leasing Sector

Inspection of a Company D revealed that about 168% of the equity of the company had been invested into its associated companies and concerns even though the financial condition of the latter was questionable and deteriorating. Furthermore, the company maintained deposits of Rs. 43 million with an associated undertaking. Despite the fact that the mark-up on this investment had been suspended, the company went on to place an additional Rs. 20 million with the same undertaking. As a result, the Company’s viability as a going concern is doubtful and the break up value per share stands at a negative Rs. 2.15. The main reason behind this has been the lack of foresight and prudence in the decisions taken by the director. Additionally, the main concern had been to finance and support the associated companies with

91 A detailed discussion regarding the Pakistani context is given in section 5. 92 Musharika is profit and loss sharing agreement. Both parties provide capital, both provide management, and then share profits in a pre-arranged ratio.


no regard for their continuously deteriorating financial position. Finally, the Chief Accounting Officer of the company did not possess the requisite qualifications to hold the office. Source: SECP Audit Reports.

Box 3. Case Study – Modaraba Sector In a Special Audit of Company X, it was found that an amount of Rs. 76.9 million had been misappropriated by granting finance facilities to a number of fictitious parties. In defiance of Prudential Regulations, the Company failed to make provisions of Rs. 91.6 million against morahaba/musharika financing. Finally, again in violation of the law, the company invested Rs. 49 million in unquoted shares of group companies. As a consequence, the financial statements issued by the management presented misleading information to certificate and other stakeholders. Furthermore, the funds of the modaraba were eroded to the tune of Rs. 100 million. The factors leading up to this outcome included the fact that the company was primarily concerned with providing benefits to the associated firms at the expense of the certificate holders. These facilities had been renewed/rescheduled by the directors without recovery of any mark-up and principal amount. Additionally, the ownership and management of the modaraba was concentrated in a single person, namely the Chairman/sponsor director. The directors had never applied collective wisdom and discharged their statutory and fiduciary duties while approving the transactions. Finally, no internal checks existed to safeguard the assets of the modaraba. Source: SECP Audit Reports. Understandably, the concern for external investors is that excessive private benefit seeking by controllers often comes at the expense of their profits and dividends. This concept is simple to understand. Consider a company that has declared a profit of $100, in which the controller owns only 10% of total ownership. Therefore, for every dollar of profit that is reallocated, by the controller, to private benefits (say towards a wholly owned private limited company) he loses only 10 cents (given his 10% ownership) of profits. That is, the cost of a dollar of private benefit is very low for controllers being only 10 cents in this particular example. However, the cost of a dollar of private benefits is a dollar of profits for the company. Therefore, external investors who do not gain from these private benefits would much rather take this money in the form of declared profits or dividends. However, the problem is that they do not have effective control to veto the reallocation of capital towards private benefits. In countries like Pakistan external investors lack effective means to control private benefit seeking by family controllers for two reasons. First, as pointed out in the last section, external investors in general do not share in the control of local corporations in Pakistan. Second, external investor control is further diluted as the family retains majority votes and as a result has complete dominance over the Board of Directors93. Therefore, concentrated control in the hands of the family increases the controller’s discretion to create private benefits. Furthermore, private benefit seeking sets incentives for family controllers to establish corporate structures that ensure and reinforce majority control. There are indications that many corporates in Pakistan use cross-shareholdings and interlocking directorships to fulfill the objective of retaining majority control.

93 This is discussed at length for the Pakistani case in section 4.


Similarly, data suggests that Pakistani corporates may be using pyramid structures to retain majority control. Berle and Means (1932) define pyramid structures as “owning a majority of the stock of one corporation which in turn holds a majority stock of another - a process that can be repeated a number of times.” The control of an operating company routed through the ownership and control of a holding (or trading) company has the advantage of ensuring majority control without commensurate concentration of ownership. For example, if a family owns 51% of the stock of publicly listed company A, which in turn owns 51% of company B, the family retains majority control in company B (51% of votes). However, in this example majority control is retained despite the fact that the family does not own a commensurate amount of shares (only 26%) in company B Cross-shareholdings, pyramid structures and interlocking directorships are advantageous for family controllers as they allow them to make cash transfers across family companies. Cash transfers are made through various means: companies give each other high (or low) interest loans, manipulate transfer prices, sell assets to each other at above or below market prices etc. The SECP Annual Report 2002 lists a range of rich stories regarding the nature of these transfer payments in Pakistan (see Appendix 2). How prevalent are these structures in a country like Pakistan? Amjad (1982) has documented the extensive use of interlocking directorships in Pakistan’s corporate structure during the sixties (see Appendix 3 figure A.3.1). Cheema (1999) confirms the persistence of this structure among monopoly group companies in the textile sector during the eighties. Table 2.7 shows that the use of pyramids is pervasive in our sample companies and the incidence of pyramiding is much higher in Pakistan than in most East Asian economies. Case study evidence also suggests the existence of pyramiding and cross-shareholdings in Pakistani corporate groups (see Appendix 3 figures A.3.2 and A.3.394). The figures show a significant use of inter-corporate holdings by corporate groups in Pakistan.

Table 2.7. Incidence of Pyramiding in Asia (Percentage of the sample)

Incidence of pyramiding

Incidence of pyramiding with greater than 10%

ownership Pakistan (textiles) 66.7% 47.6%

Pakistan (non-textiles) 78.3% 56.5% Indonesia 66.9% n.a.

Korea 42.6% n.a. Malaysia 39.3% n.a.

Philippines 40.2% n.a. Thailand 12.7% n.a.

Source: Claessens, Djankov and Lang (1999) for East Asia. Authors’ calculation for Pakistan. Note: Pyramiding is equal to one if the controlling owner exercises control through at least one publicly limited company. Sample size is 32 companies.

This discussion suggests that concentrated control in Pakistan, which is buttressed by interlocking directorships, cross-shareholdings and pyramid structures, may strengthen incentives for excessive private benefit seeking in Pakistan.

94 In both figures we show that apart from direct family holdings, families also control companies through cross-holding using associated private and public companies.


2.5. Potential consequences of Private Benefit Seeking in Pakistan Concentrated control that is a defining feature of Pakistani CG has a number of consequences for the development of the corporate sector and capital markets in Pakistan. As pointed out above, a first consequence of concentrated control is the opaqueness in the use of public money, which may lead to excessive private benefit seeking. This is the conclusion suggested by SECP audits discussed in the last section. Although, it is important to point out that further work is needed to rigourously estimate the magnitude of these transfers, whose size cannot be established on the basis of our small sample. Furthermore, it needs to be pointed out that family reputation with external investors operates as an effective constraint on private benefit seeking. In fact, South Asian economies, including Pakistan, have seen the emergence of a number of family controlled corporations that have created transparent CG structures in order to protect their reputation with external international investors. In this regard, it is interesting to point out that in India it was the Confederation of Indian Industries (CII) that took the lead in drawing up India’s draft CG code. Nonetheless, such corporates remain small in numbers and as yet have not come to dominate the corporate sector in the region. While, it is true that excessive and opaque control by families over companies will dampen capital market reforms, nonetheless, it should be appreciated that private benefits, which result from concentrated control, set strong incentives for these families to maximize the generation of operating surpluses. The second consequence is that family controllers seldom trade their companies’ shares. This increases the cost of takeovers and protects family controllers from the potential loss of control, thereby, diluting the effectiveness of an important mechanism to penalize inefficiency. This expectation is confirmed for Pakistan. Table 2.8 shows that the incidence of share trading is extremely low in family controlled corporates in Pakistan. The protection of family control is an important reason why share turnover is extremely low in most family-based listed companies. The result is illiquid stock markets in Pakistan (see section 3), which reduce the value of the exit option for minority shareholders and end up raising their risks.

Table 2.8 Annual Share Turnover in a Sample of Pakistan’s Listed Companies, 2000

Ownership Type

Turnover in an Average Company (as a percentage of total annual turnover of the entire sample)

S.D Family-based 0.91% 0.9 Government 4.6% 8.6 MNCs 9.3% 16.1 Source: Authors’ calculation based on data provided by Dr. A. Mian. Details of the data and sample are given in Appendix 1. The third consequence is that family based controllers are reluctant to declare dividends and would prefer to reallocate profits to obtain private benefits. Tables 2.9 confirms this expectation, it shows that more than 50% of Pakistani corporates do not declare dividends. Although there is an increased trend in favour of declaring dividends, nonetheless, the number of companies not declaring dividends remains quite high.

Table 2.9. Dividend Declaration Performance in Pakistan’s Listed Companies

% of Companies not declaring dividends in each Sector

1999 67.5%


2000 59.1% 2001 52.5% 2002 59.7%

Source: SECP (2002). The fourth consequence is that family based controllers tend to oppose reforms that dilute their control over listed companies and that increase disclosure requirements95. In our view, these reforms are opposed in part because they are expected to curtail low cost access to private benefits. The incentive to retain control also explains why local companies are reluctant to use capital markets to raise funds. The objective of retaining control by families is an important reason behind shallow capital markets in Pakistan (see section 3). These reasons give good cause to doubt the expectation that local corporates will be enthusiastic partners in Pakistan’s CG reform effort. In fact, it comes as no surprise that most corporates are lukewarm about CG reform in Pakistan and continue to informally threaten the SECP with de-listing96. This tendency persists despite the fact that without CG reform both the corporate sector and the country may end up paying a heavy price in the form of underdeveloped capital markets and the reluctance of external equity investors to finance corporate growth in Pakistan. However, it is the rationale of retaining majority control that continues to motivate the politics of a large number of Pakistani corporations, although there are notable exceptions to this general tendency. The objective of maximizing majority control, in turn, results in inadequate demand for capital market reform. 3. Capital Markets While, there appears to be a demand side constraint for capital market reform there is also a concern that Pakistan’s capital markets are not adequately structured to supply the large-scale mobilization of external investor capital. In this section, we describe some supply side constraints on capital market development that stem from inefficiencies in Pakistan’s existing structure of market trading. However, we start by giving an overview of Pakistan’s stock markets and their regulator the SECP. 3.1 An Overview of the Stock Market and the SECP The Karachi Stock Exchange (KSE), established soon after independence in 1947, continues to be the main stock market in Pakistan. In 2001, KSE captured 74% of the overall trading volume in Pakistan. The Lahore Stock Exchange (LSE) was commissioned during the 1970s and is the second largest stock exchange. The Islamabad Stock Exchange, commissioned in 1992, is the third stock exchange in Pakistan, capturing 4% of the trading volume. In 2002, SECP gave a license for the first electronic stock exchange; however, it has not started operations as yet. The Securities and Exchange Commission of Pakistan (SECP) was established under the Securities and Exchange Commission of Pakistan Act, which was passed and promulgated by the Parliament in 1997. Unlike its predecessor the Corporate Law Authority (CLA), which was an attached department of the Ministry of Finance, the SECP is an autonomous body. SECP started operations from January 1999, and CLA stood dissolved from that date. The 1997 Act gives the SECP the responsibility for: 1) regulating the issue of securities; 2) regulating the business of stock exchanges and other security markets; 3) supervising depository and clearing houses; 4) 95 This tendency clearly came out in interviews with owners of family based corporates. 96 Another reason for delisting is the initial reduction and the eventual elimination in the tax differential between public and private limited companies, which GoP is committed to bring about by 2007.


registering stock brokers and sub-brokers; 5) regulating investment schemes and funds; 6) preventing fraud in securities markets; 7) regulating share acquisition and mergers/takeovers of companies; and 8) regulating the issues of securities. The Act thus makes SECP the apex body for regulating the corporate and equity markets. The State Bank of Pakistan (SBP) and SECP jointly announced that, from July 1, 2002, SECP would perform supervisory functions for most Non-Bank Financial Institutions (NBFIs), including investment banks, discount houses and housing finance companies. So, other than commercial banks and DFIs, all companies come under the supervision of the SECP. SECP is organized into six divisions:

• Securities market division • Specialized companies division (including NBFIs but not insurance) • Company law administration division • Enforcement Division • Insurance division • Support services division

Each division has an executive director at the apex, who in turn reports to the Commissioners, although usually a particular Commissioner is asked to take care of a division. There are currently five Commissioners at the SECP, including the chairperson. The chairperson amongst the Commissioners is the chief executive of the SECP. The tenure of the Commissioners is for a period of three years, extendable by another three. No Commissioner can serve uninterrupted at the Commission for more than six years at a stretch. The Commissioners are appointments made by the Ministry of Finance, but they are usually experts from the field of capital markets. 3.2. Market Performance Table 3.1 allows us to track some of the performance measures for the Karachi Stock Exchange (KSE), the biggest stock market in Pakistan. Although the Karachi Stock Exchange has grown over the 1990s (Table 3.1) additional data shows that the number of listed companies still form only about 2% of registered companies, there were only 6 new equity issues in 2001-2002, and for the financial year 2000 only four companies97 accounted for 80 to 85% of the total trading volume in KSE. Khwaja and Mian (2003) highlight the small size of the KSE (in terms of market-capitalization/GDP) in comparison to other stock markets around the world. The shallowness of the market notwithstanding, KSE does have high turnover (dollar-volume/market-capitalization) when compared to other developing country markets across the world. The high turnover is coupled with high price volatility of KSE. Over the 1997-2002 period, Khwaja and Mian (2003) show that the highest price of the KSE-100 price index98 was about three times the lowest prices. This is also the period when Pakistan has been going through a low GDP growth phase, and not many new issues have been offered on the market. There has not been any growth in listing of companies since 1995, although for the last year or so the market capitalization has increased significantly, and in June 2003 the KSE-100 index stood at 3,200. Finally it is not only the case that the distribution of firms is highly skewed in terms of turnover (top 25 firms account for more than 85% of the overall turnover), it is highly skewed in terms of size-distribution as well and the top 25 firms account for 75% of the overall market capitalization (see Appendix 3 figure A.3.4). Table 3.1. Performance of Karachi Stock Exchange

(Amount in billion Rupees)

97 Pakistan Telecommunication Corporation Limited, Hubco, Pakistan State Oil and ICI. 98 A weighted price index of the top 100 firms listed on the stock market.


End period FY91 FY95 FY00 Dec. 2002 No. of listed companies 497 746 762 711 Listed capital 31.1 118.8 229.0 Market capitalization 90.0 293.3 391.9 588.4 KSE-100 index 1,855 1,612 1,521 2,701 Yearly trade volume (million) 361 2,293 48,109 -

Source: State Bank of Pakistan. Various Publications. The equity market in Pakistan, after 50 years of development, is still very small, shallow, and highly skewed, in terms of both capitalization and turnover, in favor of the larger players. Khwaja and Mian (2003) also show that the market is not transparent either. In fact, they show that some insiders (brokers) make ‘substantially higher returns’ compared to others. This is partly due to the shallow and volatile nature of the market and partly due to the poor information revelation mechanism available to the participants. More importantly, the perception and reality of manipulation a) discourages outside investors from investing in the market, and b) implies large ‘participation costs for rational and sophisticated agents trying to raise or invest capital in equity markets’99. Reforms are consequently required in the equity markets, and the introduction of CG reform, introduced by the SECP for corporations as well as stock exchanges in Pakistan, is an important part of the overall capital market reform programme. But implementation of these reforms, even where the right reforms can be identified easily, is not going to be straightforward. One implication of the analysis of Khwaja and Mian (2003) is that since brokers and insiders in general stand to gain from the current structure, they are going to resist change and are not going to be willing partners in creating the impetus and pressure for change. The political economy story tells us that if rents earned by a small number of individuals are large enough then even these small number of people can prevent reforms that may be beneficial to the economy at large100. SECP will thus have to design ways of eliciting cooperation from these groups in addition to coming up with rules and regulations that improve governance. The development of capital markets in Pakistan might significantly depend on the ability of the SECP to motivate the changes in the governance structure by buying in the more powerful and organized stakeholders in a skillful manner. 4. SECP’s Recent CG Reform Effort The SECP has come up with an ambitious set of recommendations to regulate the existing structure of the corporate sector in Pakistan. A Code for Corporate Governance was introduced by the SECP in early 2002 for the stated purpose of establishing a framework of good Corporate Governance, whereby a listed company can be managed in compliance with international best practices. The Code has been prepared after a review of the leading international reports prescribing best practices for Corporate Governance101. It is the result of joint efforts of the commission and Institute of Chartered Accountants Pakistan (ICAP). The Code has been adopted by all the stock exchanges of the country by way of its incorporation in their respective listing regulations. As a result all listed companies in Pakistan are now required to comply with the provisions of the Code. The introduction of the code has been followed by amendments to the Companies Ordinance 1984, which are aimed to strengthen corporate governance in Pakistan. The major thrust of the code is to restructure the board of directors in order to make it accountable to all shareholders; to strengthen internal control systems of corporations; to foster better disclosure and to 99 Khwaja and Mian (2003), pg. 29. 100 The diffused benefits to the society-at-large prevent effective organization of the larger group to counter the pressure from the smaller but more organized group. 101It appears to be particularly influenced by the Cadbury Report and the Combined Code, which seem to have had a strong influence on its eventual shape and its exhaustive scope.


strengthen internal and external audit requirements of listed companies (SECP 2002). In addition, the Companies Ordinance 1984 has been amended to strengthen minority shareholder rights. However, at present the requirements suggested by the Code have not been extended to non-listed companies nor have they been enacted as part of the Companies Ordinance. This section describes the salient features of the Code and the company law provisions that impinge on corporate governance in Pakistan. We concentrate on the proposed reform of the board of directors and minority shareholder protection, reforms related to disclosure and audit are described in section 5. In order to maintain analytical tightness we have chosen to highlight the key features of the law rather than conduct an exhaustive review, which is detailed in Appendix 5. The section also assesses the effectiveness of Pakistan’s current legal provisions as a means to create an environment of improved corporate governance and external investor protection. An analysis of these provisions is important because, as pointed out in section 2, concentrated control in Pakistan’s corporations appears to be antithetical to external investor protection. 4.1 Strengthening the Board of Directors (BOD) SECP (2002) points out that the “Code primarily aims to establish a system whereby a company is directed and controlled by its directors in compliance with best practices so as to safeguard the interests of a diverse range of stakeholders”(pg. 114, emphasis added). The two underlying objectives of the reform of the BOD are to: (a) Introduce representation by minority shareholders. (b) To set incentives for directors to discharge their fiduciary responsibilities in the larger interest of all shareholders and not just in the sectional interest of controlling shareholders. (c) To make the BOD a more structured and efficient forum of shareholder monitoring. The following sub-sections describe the proposed reforms that have been laid down to meet these stated objectives. 4.1.1 The Role of Non-Executive Directors (NEDs) The Code attaches special importance to the role of NEDs. It visualizes the NEDs as performing two significant functions, namely: (1) A careful independent review of the performance of the Board and of the Chief Executive; and (2) Taking the lead where potential conflicts of interest arise. In effect the Code is using NEDs to provide a check in situations when the specific interests of the executive management and the wider interests of minority shareholders diverge e.g. over takeovers, boardroom succession, or directors’ pay. Clause (i-a) of the Code takes some progressive and highly significant steps in this direction by encouraging listed companies to ensure effective representation of independent102 NEDs, including those representing minority interests, on their Boards of Directors. The Code visualizes and lays out certain

102 An independent director in this context is defined to mean a director who is not connected with the listed company or its promoters or directors on the basis of family relationship and who does not have any other relationship, whether pecuniary or otherwise, with the listed company, its associated companies, directors, executives or related parties. Such an independent director is to be selected by such investors through a resolution of its Board of Directors and the policy for election on the Board of Directors of the investee company is to be disclosed in the Director’s Report of the investor company.


helpful procedural steps to ensure that minority shareholders as a class are facilitated to contest election of directors by proxy solicitation. Additionally, Clause (i-b) of the Code recommends that the Boards of Directors of listed companies include at least one NED representing institutional equity interest of a banking company, Development Financial Institution, Non-Banking Financial Institutions (including a modaraba, leasing company or investment bank), mutual funds and insurance companies. It is further recommended by Clause (i-c), that for listed companies, the executive directors (working or whole-time directors) as a group should not constitute more than 75% of the elected directors (including the Chief Executive). Therefore, the Code takes a number of important steps that bring CG regulations in Pakistan in line with international best practice. It is also important to point out that the introduction of the concept of NEDs in Pakistan’s CG regulations is an important additionality brought about by the code, as the Companies Ordinance (1984) visualizes no such provision. However, at this juncture the Code does not require companies to appoint NEDs, it merely recommends this as a practice. 4.1.2 The Role of the Chairman and the CEO The Code makes a bold attempt at giving some definite shape and direction to the role of the Chairman of the BODs in Pakistan’s Corporate Governance environment. Clause (ix) lays down that the Chairman of a listed company is to be preferably elected from among the NEDs. It also requires that the Board of Directors is to clearly define the respective roles and responsibilities of the Chairman and CEO, whether or not these offices are held by separate individuals or the same individual. Likewise, Clause ix requires the Board of Directors to clearly define the role and responsibilities of the Chief Executive. It further requires (Clause viii-e) that the appointment, remuneration and other terms and conditions of employment of the CEO and other executive directors should be determined and approved by the Board of Directors. This provision is expected to increase the accountability of management to the BODs. Again, it appears that the Code represents additionality to the current law, which does not lay down a well-defined and distinct role for both the Chairman of the BODs and the Office of the CEO. This essentially means that two important Corporate Offices had not received any detailed attention in the Companies Ordinance. In fact, Section 160 (3) of the Companies Ordinance 1984 proposes an extremely vague definition of the Chairman’s role:

The Chairman of the Board of Directors, if any, shall preside as Chairman at every general meeting of the company, but if there is no such Chairman, or if at any meeting he is not present within fifteen minutes after the time appointed for holding the meeting, or is unwilling to act as Chairman, any one of the directors present may be elected to be Chairman, and if none of the directors are present or are unwilling to act as Chairman, the members present shall choose one of their numbers to be Chairman.

However, at present the provisions detailed above are recommended and are neither part of the statute nor are they mandatory requirements for listed companies. Furthermore, at present neither the Code nor the Companies Ordinance specifically precludes the possibility of the same person holding the office of the Chairman and the CEO. 4.1.3 Strengthening Decision Making at the Level of the BODs The Code aims to strengthen decision making at the level of the BOD by stipulating the frequency of its meetings; by defining the tenure of office of the directors; and by proposing a list of significant issues that


should be put before the BODs for consideration and decision. Again, in most of these areas the Code provides additionality to the Companies Ordinance. Clause (xi) of the Code says that the Board of Directors of a listed company is to meet at least once in every quarter of the financial year. This provision has been made part of the Companies Ordinance through an amendment to Section 193. This provision takes a significant step forward in strictly mandating an active role for the BOD as a decision making body. Clause (VI) affirms the existing tenure limit in the Companies Ordinance (Section 180) by stating that the tenure of office of directors is to be three years. This provides a good balance in allowing directors to develop a strategic long-term vision, while not getting too entrenched in a company’s governance structure. Further, the Code (Clause xiii) proposes a list of significant issues which should be put before the Board of Directors for information, consideration and decision, in order to strengthen and formalize the corporate decision making process (see Appendix 4). Again, the code represents additionality, as previously there was no requirement for the BOD to specifically perform these functions. 4.1.4 Increasing Accountability at the Level of the BODs 4.1.4.1 Statement of Ethics and Business Practices In order to strengthen accountability at the level of directors the Code (Clause viii-a) requires that every listed company prepare and circulate a ‘Statement of Ethics and Business Practices’ on an annual basis. The objective of publishing this statement is to establish a standard of conduct for directors and employees by requiring each of them to sign the statement and acknowledge his (her) acceptance and understanding of the standard of conduct. Again the Code has taken a step that is not provided in the existing provisions of the Companies Ordinance 1984. 4.1.4.2 Disclosure by Directors and Management The Code has come up with some important disclosure requirements and limitations on the actions of directors and management that will help increase their accountability to external investors: (a) For listed companies, the Code (Clause xxvi) has come up with the further requirement that any director, chief executive, executive or their spouses selling, buying or taking any position, whether directly or indirectly, in the shares of a listed company of which s/he is director, chief executive or executive, as the case may be, is to immediately notify the Company Secretary of such intentions and deliver a written record of the price, number of shares, form of share certificates and nature of the transaction. Such notice has to be presented by the Company Secretary at the meeting of the board of directors immediately subsequent to such transaction. (b) Clause xxvi requires that each company determine a closed period prior to the announcement of interim/final results and any business decision, which may materially affect the market price of its shares. It also requires that no director, chief executive or executive shall, directly or indirectly, deal in the shares of that company in any manner during the closed period. The Companies Ordinance 1984 contains some important restrictions that form part of the governing ethical regime of companies and are meant to promote the above-mentioned initiatives by the Code.


(a) Section 195 of the Ordinance provides an extensive ban on the direct or indirect extension by a company of any loans to, or the provision of any guarantee or security in connection with a loan made by any other person to, or to any other person by, a director of the company or his relatives. (b) Section 197 of the Ordinance prohibits a company from contributing any amount to any political party or for any political purpose to any individual or body, or else face penalties. (c) Section 197-A of the Ordinance prohibits the distribution of gifts by a company in any form to its members at its meetings, or face penalties. (d) Section 191 of the Ordinance says that the remuneration of a director, for performing extra services, including holding the office of the chairman, shall be determined by the directors or the company in general meeting in accordance with the provisions in the company’s articles. The remuneration to be paid to any director for attending the meetings of the directors or a committee of directors shall not exceed the scale approved by the company or the directors, as the case may be, in accordance with the provisions of the articles. The Companies Ordinance 1984, also stipulates disclosure requirements and limitations on the part of directors, which help further the accountability of directors to shareholders. The following are the main requirements found in the Companies Ordinance: (a) Directors and Officers are mandated by Sections 214 and 215 of the Companies Ordinance 1984 respectively, to disclose the nature of their direct or indirect concerns or interests in any contract or arrangement entered into or to be entered into by or on behalf of the company. (b) Section 216 of the Companies Ordinance precludes discussion of or voting on any contract or arrangement in which the said director is, directly or indirectly, concerned or interested. (c) A violation of the above sections can (apart from a financial penalty) lead to a court, declaring a director as lacking fiduciary behaviour, under Section 217 of the Ordinance. (d) Section 218 of the Ordinance mandates disclosure to members of a director’s interest in contracts; appointing the chief executive, managing agent, whole-time director or secretary. Again, non-compliance leads to a pecuniary fine. (e) Section 224 of the Companies Ordinance prohibits trading of listed equity securities within six months of appointment on part of any director, Chief Executive, managing agent, chief accountant, secretary or auditor of a listed company or any person owning at least 10% beneficial interest in listed equity securities, either directly or indirectly. (f) Section 203 of the Ordinance mandates that the Chief Executive cannot engage, directly or indirectly, in a business competing with the company’s business. The Section further requires that the Chief Executive disclose to the company in writing, the nature of such business and his interest therein. 4.1.4.3 Disclosure With Regard to Associated Companies Section 2 pointed out the incidence of pyramiding and cross-shareholdings in Pakistan’s listed companies. In this sub-section we analyze the state of the law with regard to inter-corporate transfers and disclosures related to these transfers. An implication of our analysis in section 2 is that controlling shareholders need to be made accountable to external investors with regard to these transfers.


An amendment to Section 208 of the Companies Ordinance (1984) aims to raise the cost of tunneling for private controllers and to make inter-corporate transfers more accountable to the shareholders. The amended section reads as follows, “A company shall not make any investment in any of its associated companies or associated undertakings except under the authority of a special resolution...” The section has also stipulated strong penalties in the event of non-compliance with the law. 4.1.4.4 Summing Up The analysis in section 4.1 shows that Pakistani corporate law provides a significant number of limitations and disclosure requirements that should help make corporate controllers accountable to external investors. This suggests that the problem of weak corporate accountability of controllers to shareholders is not on account of inadequate legal rules. Instead, we will show in section 4.3 that the problem lies in the enforceability of these rules. 4.2 Minority Shareholder Protection In corporate structures, with concentrated promoter control the rights of minority shareholders play an essential part in protecting the interest of external investors. The stronger these rights the higher the probability that rogue controllers can be held accountable and penalized for excessive private benefit seeking. Basic shareholder rights, usually specified in company laws, include the right to (i) participate and vote in Annual General Meetings (AGMs) and special general meetings (SGMs), including electing members of the board and participating in making key decisions, such as amendments to the articles of association; (ii) low cost judicial recourse on behalf of the company; (iii) share in the residual profits of the company; (iv) appoint directors; and (v) convey or transfer shares. The strength of shareholder rights depends upon voting procedures as well as the structure of ownership and control. The proxy-voting rule, allows shareholders not in attendance to exercise voting rights, which increases shareholder participation. Similarly, cumulative voting103 strengthens the position of minority shareholders under concentrated ownership structures. An important consideration regarding voting rules is whether or not they tilt the balance of power away from family controllers and in favour of external and minority shareholders. This section details the substantive provisions regarding minority shareholder protection found in the Pakistani law. 4.2.1 Right to Attend and Call Annual General Meeting (AGMs) and Special General Meetings (SGMs) Again, the rights described in this section appear to be in line with modern Anglo-Saxon company law. 4.2.1.1 Annual General Meetings Section 158 of the Companies Ordinance mandates that every company is to hold, in addition to any other meetings, a general meeting, as its annual general meeting, within 18 months of its incorporation and thereafter once at least in every calendar year. The AGM has to be held within a period of six months following the close of the company’s financial year and not more than 15 months after the holding of its last preceding annual general meeting. For listed companies, the SECP, and for other companies, the Registrar may for any special reason extend the time within which any annual meeting is to be held.

103 Zhuang et. al. (2000, pg. 9) define cumulative voting as a procedure that allows shareholder to cumulate their votes, e.g. for directors, by multiplying the number of votes the shareholder is entitled to cast by the number of directors for whom they are entitled to vote and casting the product for a single candidate or by distributing the product among two or more candidates.


4.2.1.2. Extraordinary General Meetings Section 159 of the Ordinance allows the directors to call an extraordinary general meeting to consider any matter that requires the approval of the company in a general meeting. However, at least one-tenth of the votes are required to call an extraordinary general meeting. The requisitionists, or a majority of them in value, may themselves call a meeting, if the directors do not proceed to call the meeting within 21 days from the date of requisition. Any default entails penalties. 4.2.1.3 Power of the Registrar to call Meetings Section 170 of the Ordinance gives the Registrar the power to call, inter alia, any annual general meeting or extraordinary general meeting, if there has been a default in the holding of any such meetings. The meeting can be called either on the motion of the registrar or on the application of any director or member of the company. Furthermore, there is a penalty for any default in complying with the Registrar’s directions. 4.2.1.4 Minority Shareholders Right to Pass Special Resolutions Section 164(2) of the Ordinance gives members with at least 10% voting power in the company the right to give notice of a resolution, which they want considered at a general meeting. Similarly, Section 167(c) and (d) of the Ordinance require the Chairman to order a poll upon the demand of, inter alia, any member or members present in person or by proxy having at least one-tenth of the total voting power in respect of the resolution. However, Section 28 of the Ordinance requires a special resolution passed by three-fourths of the members of a company for it to alter any of its articles of association. In the event that the alteration affects the substantive rights or liabilities of a class of members then at least three-fourths of this class need to vote in favour of the alteration, for it to take effect. 4.2.2 Voting Rules 4.2.2.1 One Share-One Vote Section 160(4) of the Ordinance allows every member to have votes proportionate to the paid-up value of the shares or other securities carrying voting rights held by him according to the entitlement of the class of such shares or securities, as the case may be. Similarly, Section 160(5) of the Ordinance states that no member carrying shares or other securities carrying voting rights shall be debarred from casting his vote, nor shall anything contained in the articles have the effect of so debarring him. Therefore, Pakistani law allows the possibility of offerings share with non-voting rights, which may weaken the power of minority shareholders, especially as the capital market in Pakistan is fairly inefficient. 4.2.2.2 Proxy and Cumulative Voting The Pakistani law allows for proxy voting thereby strengthening the rights of minority shareholders. Section 160(7) of the Ordinance says that on a poll, votes may be given either personally or by proxy. However, the Ordinance dilutes this right by denying members the right to cast proxy votes by mail. The Ordinance also appears to allow a form of cumulative voting. Section 178(5)(b) says that a ‘a member may give all his votes to a single candidate or divide them between more than one of the


candidates in such manner as he may choose’. Again, this provision goes some way in strengthening minority shareholder rights. 4.2.3 Right to Claim Dividend The Ordinance does not mandate any consequential compulsory payment of dividends. All that Section 248 mandates is that no dividend can exceed the amount recommended by the directors. However, the Ordinance does place a time limitation within which dividend once announced has to be paid. Section 251 of the Ordinance requires that when a dividend has been declared, it has to be paid within forty-five days of the declaration. A default on this provision exposes the CEO for a prison term of up to two years and fines up to a million rupees. The Pakistani law makes the BOD the relevant forum for deciding on dividends. 4.2.4 Judicial Recourse Available to Minority Shareholders Section 108 of the Ordinance provides that if ten percent or more of the class of shareholders have been aggrieved by any such variation of their rights, they may, within thirty days of the date of the resolution varying their rights, apply to the Court for an order cancelling the resolution. The Court is thus entrusted with the task of ensuring that these shareholders are not the victims of any unfair prejudice. 4.2.5. Minority Shareholder Rights Related to Divesture and Transfer of Shares The Code strengthens minority shareholder protection through Clause xxix. It states that in the event of a divesture of not less than 75% of the total shareholding of a listed company, the directors are allowed such a transfer only after it has been ascertained that an offer in writing has been made to the minority shareholders for acquisition of their shares at the same price at which divesture of majority shares was contemplated. Section 289 of the Ordinance provides for minority shareholder protection in the event of transfer of shares between companies. It binds the transferring company to acquire the shares of dissenting shareholders on the same terms as the ones on which shares of the approving shareholders are being acquired. It also states that for a transfer of shares between companies to take place requires the approval of at least 9/10th of the holders of the company’s shares in terms of value. Finally, Section 86 of the Ordinance states that where directors decide to increase capital by issuance of further shares, such shares are to be issued to each existing member strictly in proportion to his present shareholding, irrespective of the class of shares held. 4.3 Analyzing Pakistan’s Legal Provisions Related to BODs and Minority Shareholders - The Ground Realities The last two sections have detailed the substantive regulatory and legal provisions that strengthen the BOD structure and give effective protection to minority shareholders. The reader would have noticed that many of these provisions are compatible with the standards provided by the Anglo-Saxon legal framework. Therefore, while one can venture a prima facie conclusion that Pakistan’s corporate law provisions appear fairly adequate as a means to govern corporations - nonetheless -it is important to ask whether these provisions provide an effective means to protect external shareholders in a de facto sense. This question gains added importance when it is recognized that many of the legal provisions in the Companies Ordinance, and additions made by the Code, are influenced by Anglo-Saxon thinking,


whereas these provisions are being applied to a corporate structure that is extremely different from the Anglo-Saxon one. 4.3.1 Analyzing the Effectiveness of Provisions of the Code Related to the BOD We have pointed out that the Code has provided an emphasis on restructuring the BOD with an aim to increase minority shareholder representation. The main vehicle chosen for this representation is the induction of NEDs in the BOD. In addition, a number of limitations have been placed on directors’ actions that are meant to make the BOD accountable to the shareholder. The Code has also redefined and increased the decision-making role of the BOD by placing before it certain key decisions, which have traditionally been the prerogative of management. Finally, the Code has indicated a preference for the separation of the office of the Chairman from the CEO. These measures, while immensely important, may not be sufficient to create an environment of external investor protection for the following reasons. First, as mentioned earlier, Pakistan’s local private corporations tend to be family dominated. A feature of these corporations is that there is collusion between BODs and management, not because the latter dominates the former in terms of positions on the board, but because the family as a unit controls both the BOD and management. Table 4.1 shows the extent to which the family dominates the BOD of an average local private company in Pakistan. While interpreting these numbers it should be kept in mind that these numbers are understatements as it was not possible to identify non-family proxy directors appointed by a family on the BOD of companies controlled by them. Therefore, even with the best legal provisions it is difficult to visualize the BOD not being a representative body of the majority owners in Pakistan’s local private companies. It also means that the separation of the office of the Chairman from the CEO really does not matter in Pakistan’s current corporate structure. This suggests that there are limitations to using the BOD as a body that is accountable to all shareholders.

Table 4.1 Constitution of the BOD of Local Private Companies in Pakistan

Sectors

Average No. of Directors on the BOD

Average No. of Family Directors on the BOD

Textiles 7.3 4.0 Non-Textiles 7.0 3.0

Source: Authors’ calculation from 2002 Annual Reports of the sample companies. Note: (1) Details of the sample are given in Appendix 1. (2) The textile sample is separately reported as textile companies dominate the listed company’s sector in terms of numbers. The non-textile sample reflects randomly drawn family companies from other sectors. (3) This data does not control for the presence of non-family BOD members who are de facto appointees of the family. However, we would expect CG reforms to be more effective in MNCs and in companies that tend to be widely held. Even though presently there appears to be a paucity of the latter corporate type, nonetheless, the Code has taken an important first step in defining an environment that has the potential to make the BOD structure more streamlined and accountable when and if there is a growth of widely-held companies on the stock markets. Second, there are limitations in using NEDs as a means of minority shareholder representation. A preliminary analysis of data suggests a bi-modal distribution of shareholding, with family and management controllers, in the case of local private companies and MNCs respectively, having majority ownership, and the remaining shareholders having considerably diluted ownership. Hart (1995) has already raised the issue of NEDs, with small shareholdings, and independent directors, with no shareholdings, having sub-optimal incentives to put in monitoring effort. We have pointed out earlier that


the Code does not have any recommendations regarding NEDs’ compensation. Until the issue of NED incentives is sorted out there cannot be much expectation that these directors, who either have small or no ownership, will put in the requisite effort on behalf of external investors. Alternatively, NEDs could be drawn from high profile professionals whose incentive to perform may be a function of protecting their reputation rather than being contingent on monetary incentives. However, again the issue of remuneration for these directors needs to be worked out by corporates in order to make the system effective. It is also important at this juncture to be cognizant of some recent developments in Pakistani law, which may have an adverse impact on the functioning of the NEDs, as visualized by the Code. The National Accountability Bureau Ordinance (1999) (NAB Ordinance) is a recent law, which furnishes a new regime of anti-corruption and accountability measures, including, inter alia, the issue of willful default. According to the NAB Ordinance, a person is said to commit ‘Willful default’ if “…he does not pay, or continues not to pay, or return or repay the amount to any bank, financial institution, cooperative society, or a Government department or a statutory body or an authority established or controlled by a Government on the date that it became due as per agreement containing the obligation to pay….” For purposes of this Section and the rest of the NAB Ordinance, a “Person” includes in the case of a corporate body, the sponsors, Chairman, Chief Executive, Managing director, elected directors, by whatever name called, and the guarantors of the company or anyone exercising direction or control of the affairs of such corporate body….” This definition of ‘Person’ seems to be wide enough to encompass the NEDs proposed by the Code. This means that potential candidates for the position of NEDs may be highly reluctant to act as directors as they may be risking large potential liabilities. Furthermore, as mentioned above, there seems to be a legislative trend currently en vogue in Pakistan, which is generally extending the ambit of accountability to company directors. If this trend continues, very few people may be willing to act as NEDs, and this would then force a reconsideration of the role of the NEDs in the regulatory mechanism being visualized by the Code. 4.3.2 Analyzing the Effectiveness of Provisions of the Code Related to Minority Shareholder Rights In Pakistan, there is significant compliance with regard to the holding of AGMs, which is an important means to make shareholder rights effective. Not only is the level of compliance high with regard to the timely holding of AGMs, it appears to indicate an improving trend (Table.4.2).

Table 4.2. Compliance with Timely Holding of the AGM

Year Total Listed Companies

Number of Compliant Companies

% Compliance

2002 617 548 89 2001 635 534 84

Source: SECP Annual Report (2002) The effectiveness of legal provisions related to minority shareholder rights needs to be examined in the context of Pakistan’s ownership and control structure. We have pointed out in section 2, that in Pakistan, controllers of MNCs, Government Corporations and Local Private companies tend to have majority ownership, while case study evidence suggests the existence of diluted ownership amongst external investors. This suggests that the provisions related to minority shareholder/external investor protection may be too demanding thereby compromising their effectiveness in Pakistan’s current corporate governance structure. For example, it appears that the requirements for action by minority shareholders are relatively stringent: the representation requirement for judicial recourse is ten percent; a call for an


extraordinary shareholder meeting is ten percent; and calls for special resolution ten percent. These provisions appear onerous in the context of diluted shareholding by external investors. As pointed out in section 4.2, current legal provisions appear to dilute the effectiveness of proxy voting. Furthermore, the right to issue non-voting shares in the context of Pakistan’s inefficient capital markets may end up making external investor protection even weaker. Finally, the BOD is the empowered forum to declare dividends. However, the extent of family dominance over the BOD raises fears that it may not be a judicious forum for the protection of cash-flow rights of external shareholders. These reasons suggest that under the current structure of ownership and control external investor and minority shareholder rights may not be as strong as they appear on paper. 5. Financial Reporting and Disclosure The quality of transparency and disclosure depends crucially on accounting and auditing standards. Independence of auditing is the key to ensuring that the information is disseminated reliably and credibly. The adoption of internationally acceptable accounting standards will certainly help to improve the quality of transparency. Good financial reporting systems facilitate easy access to reliable and credible information by external investors and help develop confidence in capital markets. It is also important to assess the prevailing incentives in the market for auditors and accountants, in order to ascertain incentive-compatibility with the requirements of better disclosure and adoption of standards. 5.1. Financial Disclosure and Audits The basic idea behind the emphasis on disclosure and reporting is the advantage to investors, analysts, and other users and ultimately to the company itself of financial reporting rules which limit the scope for uncertainty and manipulation. Information is the lifeblood of markets and barriers to the flow of relevant information represent imperfections in the market. What shareholders (and others) need from the report and accounts is a coherent narrative, supported by the company’s performance and prospects. The cardinal principle of financial reporting is that the view presented should be true and fair. Boards should aim for the highest level of disclosure consonant with presenting reports, which are understandable, while avoiding damage to their competitive position. Boards should also aim to ensure the integrity and consistency of their reports and they should meet the spirit as well as the letter of reporting standards. 5.1.1 Nature, Quality and Frequency of Financial Reporting The Code (Clause xxiv) tightens and augments the existing provisions by requiring that a listed company cannot circulate its financial statements unless the Chief Executive and the CFO present such statements, endorsed under their signatures, for consideration and approval by the board of directors and the board, after such consideration and approval, authorizes their issuance and circulation. In addition to this, the Company Secretary is required to furnish a secretarial compliance certificate to the Registrar to certify that the secretarial and corporate requirements of the Companies Ordinance 1984 have been duly complied with. The Code (Clause xix) further bolsters the categories of information to be provided under a Director’s Report under Section 236 of the Companies Ordinance by requiring that it provide statements to the effect that: (a) the financial statements of the company present a fair picture (b) proper books of account have been maintained (c) appropriate accounting policies have been consistently applied (d) international accounting standards, as applicable in Pakistan, have been followed (e) a sound internal control system has been effectively implemented and monitored (f) the listed company can continue as a ‘going concern’, beyond significant doubt


(g) there has been no departure from the best practices of Corporate Governance, as detailed in the amended listing regulations of the stock exchanges after the introduction of the Code. The Code further requires additional disclosures, where necessary, which pertain to diverse areas such as: key operating and financial information and deviations; dividends; taxes; corporate plans and decisions; investments; director attendance at board meetings; pattern of shareholding; and trading in shares of company by directors, chief executive, other executives and their spouses and minor children. The Code (Clauses xx, xxi, xxii and xxiii) takes disclosure requirements a step further by requiring, inter alia, (a) the publication and circulation of quarterly un-audited financial statements along with directors’ report; (b) a limited scope review of half-yearly financial statements by statutory auditors in a manner approved by the SECP; (c) immediate dissemination to the SECP and stock exchanges, of all such material information relating to business and other affairs of company that will affect its market price (the Code lists the potential areas such information may relate to). The Companies Ordinance also provides a regime of detailed financial disclosure requirements on part of a company. Section 233 of the Ordinance mandates the presentation by directors of a balance sheet and a profit and loss account at every annual general meeting. These reports are to be accompanied by a proper auditor’s report and a director’s report which is then required to be sent to every member of the company and a specified number of copies are required to be sent to the SECP, the stock exchange and the Registrar. The Ordinance also addresses the quality of information to be disclosed. Section 234 of the Ordinance states that the contents of the balance sheet should give a true and fair view of the affairs of the company and the profit and loss account/income and expenditure statement should give a true and fair view of the profit and loss/income and expenditure of the company for the financial year. Detailed standard schedules are required to be followed in the preparation of these financial statements. In the case of listed companies, International Accounting Standards notified by the SECP in the Official Gazette are to be followed. Furthermore, a statement of changes in the financial position or statement of sources and application of funds is to form part of the balance sheet and profit and loss account. Accounting policies are required to be stated and if there is any change in such policies, auditors are to report whether they agree with such a change. The Companies Ordinance also mandates the preparation of Director’s Reports. Section 236 of the Ordinance requires such reports for public companies or private companies which are subsidiaries of a public company, to disclose, inter alia, (while stating the company’s affairs, recommended dividends etc.,) (i) any material changes and commitments affecting the financial position of the company; (ii) any material changes that have occurred during the financial year concerning the nature of the business of the company or in the classes of business in which the company has interest; (iii) full information and explanation as regards any reservation, observation, qualification or adverse remark contained in the auditor’s report; (iv) information about the pattern of holding of shares; (v) earning per share information; (vi) reasons for incurring loss and reasonable indication of future profit prospects; and (vii) information about defaults in payment of debts, if any, and reasons thereof. Section 246 of the Ordinance gives SECP the authority to require companies to prepare and send to members, Registrar, etc; such other periodical statements of accounts, information or other reports in such form and manner and within such time as may be specified by it. It can be seen from the above analysis that existing law mandates many disclosure requirements, which are further supplemented and tightened by the requirements introduced by the Code. There are areas of overlap as far as some statutory regimes are concerned. One potential issue though is whether some of


the additional requirements introduced by the Code may prove to be too onerous for the smaller listed companies in Pakistan. 5.1.2 Additional Rights of Shareholders to get Information from the Company The following are some other disclosure requirements under the Companies Ordinance, which give specific rights to the members of a company to have access to information. All these are tools for shareholders and creditors (when applicable) to remain informed as to how the company is being run and to protect their respective rights. Sections 35 and 36 of the Ordinance require the Company to provide copies of updated memorandum and articles of the company, upon request, within fourteen days of such a request. Section 136 of the Ordinance provides the right to inspect copies of instruments creating mortgages and charges and the company’s register of mortgages to members, creditors and other persons during prescribed times and a defaulting company faces penalties. Sections 147 and 149 of the Ordinance require a company to maintain a register of members and a register of debenture holders in the prescribed form. Section 150 of the Ordinance mandates that these registers be open to inspection at prescribed times and default entails penalties. Section 156 mandates that a company file an annual list of members with the Registrar. Section 173 of the Ordinance mandates the maintenance of books containing minutes of proceedings of general meetings and meetings of directors, which are open to the inspection of members at prescribed times. The Companies Amendment Ordinance also introduces additional language here, which is “A copy of the minutes of meeting of the board of directors shall be furnished to every director within fourteen days of the date of the meeting.” Section 205 of the Ordinance mandates the maintenance by companies of a regularly updated register of their directors and officers, at its registered office, which is to be open to inspection of members and other persons at prescribed times. Permissible investments under Section 209 of the Ordinance are required to be recorded and open to the inspection of members, debenture-holders and creditors, during prescribed times. Section 219 of the Ordinance mandates the maintenance of a register of contracts, arrangements and appointments in which directors, etc are interested, and this register is to be open to inspection of members of the company during prescribed times. Section 220 of the Ordinance requires every listed company to maintain a register as respects each director, chief executive, managing agent, chief accountant, secretary or auditor of the company and every person holding at least 10% of the beneficial interest in the company, the number, description and amounts of any shares in or debentures of the company and other related entities, which are held by him or in trust for him etc. Such register is to be open to inspection during prescribed times. It is the duty of directors to make disclosures to the company under Section 221 of the Ordinance for it to comply with the requirements of Section 220 of the Ordinance. The above analysis supplements the analysis of the disclosure requirements under Pakistani law conducted in Section 5.1.1. It is meant to visualize the existing regime of access to meaningful information on part of shareholders in order to exercise better control over the running of the company. The additional disclosure provisions in the Code have to be gauged in this context and once again the issue as to whether some of the additional requirements introduced by the Code may prove to be too onerous for the smaller listed companies in Pakistan becomes relevant. 5.2 The Role of Audit Committees, and Internal & External Auditors 5.2.1 Audit Committees The audit functions supply an important safeguard against fraud. Audit committees provide a forum for discussing issues related to reporting in detail, and can identify gaps in internal reporting and ensure that


legal requirements are fully met. The UK’s Cadbury report states that audit committees should be formally constituted, and should have more than three members, and they should mostly be Non-Executive Directors (NEDs). It also states that external auditor and the finance director should also attend the meetings of the committee. It also recommends that the audit committee should have the power to investigate all relevant matters. The Code (Clauses xxx, xxxi, xxxii, xxxiii and xxxiv) comes up with detailed requirements for listed companies in the areas of audit committees with provisions as to their composition, frequency of meetings, attendance at meetings, terms of reference and reporting procedure. Listed companies are required to establish audit committees comprising of not less than three members (including the Chairman, with the majority of the members coming from the NEDs of the company and the chairman of the audit committee preferably being an NED). The audit committee is required to meet once every quarter of a financial year and also whenever requested by the external auditor or head of internal audit. The CFO, head of internal audit and a representative of the external auditors are required to attend meetings of the audit committee, at which issues relating to account and audit are discussed. At least, once a year, the audit committee is required to meet the external auditors without the CFO and head of internal audit. The board of directors of a listed company are required to determine the terms of reference of the audit committee and they shall, among other things, recommend the appointment of external auditors to the board of directors as well as provide direction in other related matters such as resignation/removal of external auditors, their audit fees and the provision of additional services by external auditors. The Code actually lays out several ingredients, which the terms of reference of the audit committee should contain. The terms of reference include, inter alia, measures to safeguard company’s assets, review of periodic financial statements with a focus on important stated areas, facilitation of the external audit, coordination of the internal and external audit functions, review of the scope and extent of internal audit, consideration of various major findings of internal investigations, internal financial and operational controls, accounting systems, reporting structures, compliance with statutory requirements, institution of special projects/value for money studies, monitoring compliance with the Code and other issues or matters assigned by board of directors. The audit committee is required to appoint a secretary of the committee responsible for circulating minutes of meetings of audit committee. Audit Committees are a new concept being introduced and formalized through the Code and serve as an additional tier of audit control in a company. While one can see its obvious positives, the question again arises whether it is too much to ask and really necessary for a small listed company to maintain three tiers of audit. An analysis of disclosures of a sample of 32 family-based domestic private listed companies reveals that more than 45% of the annual reports checked had not reported the creation of an audit committee. Furthermore, the data suggests that the audit committee’s that have been created tend to be dominated by family members. This once again suggests that there is some time to go before the audit committees can start playing the role of an independent monitor in Pakistan’s corporate governance structure. 5.2.2 Internal Audit The Cadbury Report propounds it as a good practice for companies to establish internal audit functions to undertake regular monitoring of key controls and procedures. Heads of internal audit should have unrestricted access to the chairman of the audit committee in order to ensure the independence of their position. Directors should report on the effectiveness of their system of internal control, and the auditors should report on their statement.


The Code (Clauses xxxv and xxxvi) also requires that there be an internal audit function in every listed company whose head has access to the person chairing the audit committee. All listed companies are required to ensure that internal audit reports are provided for the review of external auditors and that auditors discuss any major findings in relation to the report with the audit committee, which shall report matters of significance to the board of directors. Once again the same comments as those for audit committees made above apply here too. Internal audit too is a relatively new concept for Pakistan, and it too can be onerous for the smaller firms on the stock markets. 5.2.3 External Audit The Cadbury Report emphasizes the annual audit as one of the cornerstones of Corporate Governance. The audit provides an external and objective check on the way in which the financial statements are prepared and presented, and it is an essential part of the checks and balances required. The question is not whether there should be an audit, but how to ensure its objectivity and effectiveness. Audits are a reassurance to all who have a financial interest in a company, quite apart from their value to boards of directors. The most direct method of ensuring that companies are accountable for their actions is through open disclosure by boards and through audits carried out against strict accounting standards. One central requirement of the entire process is to ensure that an appropriate relationship exists between the auditors and the management whose financial statements they are auditing. Shareholders require auditors to work with and not against management, while always remaining professionally objective that is to say, applying their professional skills impartially and retaining a critical detachment and a consciousness of their accountability to those who formally appoint them. Another important requirement is that there is a full disclosure of fees paid to audit firms for non-audit work. The essential principle is that disclosure must enable the relative significance of the company’s audit and non-audit fees to the audit firm to be assessed. It is also a good practice for audit committees to keep under review the non-audit fees paid to the auditor both in relation to their significance to the auditor and in relation to the company’s total expenditure on consultancy. For listed companies, a periodic change of audit partners should be arranged to bring a fresh approach to the audit. The Cadbury Report clarifies that the auditor’s role is to report whether the financial statements give a true and fair view. The auditor’s role is not to prepare the financial statements, nor to provide absolute assurance that the figures in the financial statements are correct, nor to provide a guarantee that the company will continue in existence. The audit is essentially designed to provide a reasonable assurance that the financial statements are free of material misstatements. The external auditors should be present at board meetings when the annual reports and accounts are approved and preferably when the half-yearly report is considered as well. The Code (Clauses xxxvii to xliv) bolsters and supplements existing law by reemphasizing and requiring, inter alia, that only those firms are appointed as external auditors; (a) which have been given a satisfactory rating by the Quality Control Review Program of Institute of Chartered Accountants of Pakistan (ICAP) and (b) which are compliant with International Federation of Accountant’s (IFAC) guidelines on Code of Ethics, as adopted by ICAP. Additionally, listed companies are now required to change their auditors every five years and if for any reason this is impractical then as a minimum they are required to rotate the partner in charge of its audit engagement after obtaining the consent of the SECP. The Code further requires that no listed company shall appoint as CEO, CFO, an internal auditor or a director someone who was a partner of the firm of its external auditors (or an employee involved in the audit of the listed company) at any time during the two years preceding such appointment. The Code also requires that a partner of the firm of the external


auditors shall be required to attend the Annual General Meeting at which audited accounts are placed for consideration and approval of shareholders. All listed companies are required by the Code (Clause xxvii) to ensure that the firm of external auditors or any partner in that firm and his spouse and minor children do not at any time, hold, purchase, sell or take any position in shares of the listed company or any of its associated companies or undertakings. Section 252 of the Companies Ordinance states that external auditors have to be appointed at every Annual General Meeting to serve till the next general meeting (in case of the appointment of the first auditors, the appointment is made by the directors) and where the company fails to appoint auditors at the stated time or there is a vacancy for any other reason, SECP can appoint a person to fill the vacancy. The remuneration of auditors is fixed by the directors or the SECP or the company in a general meeting or in such a manner as the general meeting may determine, depending on who makes the appointment. Companies Amendment Ordinance now further provides that auditor or auditors appointed in a general meeting may be removed before conclusion of the next annual general meeting through a special resolution, and that they may not be removed during their tenure in any other manner. Section 254 of the Ordinance mandates that the auditor for a public company or a private company which is the subsidiary of a public company or a private company having a paid up capital of three million rupees or more, has to be a Chartered Accountant within the meaning of the Chartered Accountant Ordinance of 1961. A person cannot be appointed as an auditor if; (a) he was, at any time during the preceding three years, a director, other officer or employee of the company; (b) he/she is a partner of, or in the employment of a director, officer or employee of the company; (c) he/she is the spouse of a director of the company; (d) he/she is indebted to the company; and (e) it is a body corporate. 5.2.4 Summing Up The additional provisions introduced by the Code can help create a more effective external auditing environment for companies. It must be noted that the Code empowers audit committees by saying that they shall, among other things, recommend the appointment of external auditors to the board of directors as well as provide direction in other related matters such as resignation/removal of external auditors, their audit fees and the provision of additional services by external auditors. Therefore, audit committees in that sense are a sine qua non for the Code’s regime of external auditors. However, as we have pointed out that in the Pakistani case family members may end up dominating audit committees in which case their role as impartial monitors of the companies’ affairs may get compromised. 5.3 The Market for Auditors and Accountants in Pakistan The last section shows that many of the provisions stipulated by the Code regarding the audit function are in line with international best practice. However, it is important to assess whether the market for Chartered Accountants provides them with adequate incentives for conducting high quality and impartial disclosures. This section provides an answer to this question by analyzing the organization and incentive structure regulating the profession in Pakistan. The Institute of Chartered Accountants of Pakistan (ICAP) is the regulator of the Chartered Accountancy profession. It is a statutory autonomous body established under the Chartered Accountants Ordinance 1961. Its many functions include the function of maintaining high standards of professional conduct and ethics by all its members. The strength of ICAP membership was 3,036 as of June 30, 2002. However, only 17% of its members were working as full time Chartered Accountants in Pakistan’s domestic market. The bulk of ICAP membership was employed in commerce and industry with some presence in finance and banking.


ICAP certifies Chartered Accountants and adopts and amends the Accounting Standards applicable in Pakistan. ICAP Bye-laws require compliance with prescribed Accounting Standards by Chartered Accountants. During the last decade, ICAP has set up a Quality Control Review Committee with the explicit purpose of auditing the auditors. As a result, ICAP has two tools, at its disposal, to ensure better disclosure and transparency of information by the accounting profession. ICAP has taken bold steps in the adoption of International Accounting Standards. It has adopted 37 out of 41 International Accounting Standards. It has also institutionalized some bold steps for ensuring compliance with these standards by the profession. The Council of ICAP formed the Quality Control Review (QCR) Committee in 1987. Initially, the QCR was a peer review process, where peers in practice conducted reviews of other practicing members. However, the process never gained legitimacy among members, who were hesitant to share information with competitors. In order to address this concern the Council decided to form a separate department in 1998, called the Professional Standards Compliance Department (PSC), which is manned by full time chartered accountants to carry out QCRs. Currently two reviewers are based in Karachi (Southern region) while the other is in Lahore (Northern region). The Executive Director of the Institute has overall responsibility for the programme. Furthermore, the Institute is presently bearing all costs for the QCR programme, and the firms are not charged for this service. The QCR process followed by PSC selects audit working paper files from an audit practice’s list of clients, which are reviewed to ensure that they conform to the benchmark set in the International Standards on Auditing and conform to local laws and regulations. QCR is applicable to all firms engaged in professional practice who audit companies or other large entities. Management consultancy, taxation and corporate services, and internal audit are currently not included in QCR. However, the QCR is at present not mandatory, as according to the Chartered Accounts Ordinance (1961, Schedule II, Part I clause (1)), working paper files of a client cannot be disclosed to any other person without the consent of the client, which implies that ICAP cannot require auditing firms to submit working paper files for QCR. Therefore, QCRs are conducted for only those firms that obtain authorization from their clients to submit working paper files for review, if such authorization is not forthcoming than a review is not possible. However, all firms submitting themselves for QCR are required to undergo the process at least once in two years. For those firms who submit for QCR, the PSC selects a sample of five to six clients from the annual audit list of the firm. Preference is given to audits of Publicly Listed Companies. A review is scheduled at the premises of the audit practice. A QCR checklist is used to record weaknesses in the working paper files. All identified issues are first discussed with the partner/manager of the practicing firm for comments. In the event that the reviewers are not satisfied with the comments a formal review report is prepared along with recommendations for improvement. Therefore, the QCR ends up not only being an audit of auditors, it also contributes to auditor training and education. If a QCR reports no issues or issues of a minor nature then the review report declares the firm to be “in-accordance with International Standards on Auditing.” In the event that the performance of the firm is not satisfactory, a “not-in accordance with International Standards on Auditing” conclusion is expressed. In this case a period of six months is given to the firm to improve its performance. A revisit is scheduled after 6 months to ensure compliance with the recommendations for improvement. In the event that the QCR gives a “gross negligence” conclusion, the work of the reviewer is reconfirmed by another reviewer, and after deliberations in the QCR committee, the matter is sent to ICAP’s Investigation Committee for appropriate action.


There are two major impediments in the QCR process taking root. First, as stated earlier, under the current law ICAP cannot require all of its member firms to undergo QCR. This limits the scope and effectiveness of the process. This limitation has been removed in the case of listed companies, by a recent SECP directive, which requires these companies to appoint only those auditors who have a satisfactory QCR rating (see section 5.2). This directive has helped create a demand for QCR in Pakistan. Second, firms auditing non-listed companies have not been shy in using the court to limit ICAP’s attempts to mandate QCR for its entire membership. A group of Lahore based practices has already taken the ICAP to court, and won, based on the argument that the law does not allow auditors to disclose privileged client information without authorization. This suggests that there is resistance to the general application of the QCR requirement. This is understandable as there is no incentive for either non-listed firms or their auditors to comply with QCR in the current system. There is also the fear that QCR will end up raising compliance costs for smaller companies. However, the opposition is also possibly due to the companies and the auditors protecting private rents.

Table 5.1. Market Segmentation in the Adoption of QCR, 2002

Auditors for Listed Companies

Numbers

Percentage

Other

Auditors

Numbers

Percentage Total Number 86 100% Total Number 217 100% Consented to Review

78 91% Consented to Review

28 13%

Yet to be Reviewed

8 9% Yet to be Reviewed

189 87%

Review Rating for Listed Company Auditors

Numbers

% of Firms Submitting to Review

Review

Rating for Other

Auditors

Numbers

% of Firms Submitting to Review

In-Accordance

62 79% In-Accordance

15 53%

Not-in Accordance

16 21% Not-in Accordance

13 47%

Source: ICAP

Table 5.1 clearly shows that there is a segmented application of the QCR function. There are a much larger proportion of listed companies’ auditors, 91% as opposed to13% for other auditors, who are submitting themselves for QCR. As stated earlier, this is largely driven by the SECP directive requiring auditors of listed companies to go through QCR. Furthermore, compliance, measured by the number of auditors “in-accordance” with ISA as percentage of the total number submitting for review, is much higher in listed companies’ auditors, at 79%, as opposed to other auditors at merely 53%. Compliance appears to be high in firms with foreign affiliations. Data suggests that 80% of Pakistani auditing firms with foreign affiliations have received an “in-accordance” rating.104

104 Of course we cannot determine the direction of causality by the correlation alone, i.e., it is not obvious whether better quality firms are opting for foreign affiliations or whether foreign affiliation status sets the necessary incentives for quality improvement.


However, with regard to other auditors the data suggests that not only have the bulk of these auditors not gone through the QCR process, but a large proportion of those reviewed are currently “not in-accordance” with ISA. This evidence clearly points towards market segmentation. On the one hand are listed companies’ auditors who have much better compliance with ISA but are small in number. On the other hand are the non-listed companies’ auditors who constitute a very large proportion of the overall accounting market and many of whom are currently non-compliant with ISA. Therefore, while the SECP directive and the changes in the structure of the accounting profession have set incentives for the consolidation of a high quality segment within the profession, a major proportion of the profession remains locked into the medium to low quality segments. This segmentation equilibrium can, in large part, be explained by the small size of the listed companies sector, which creates insufficient demand for high quality auditors. Unless the demand for high quality auditors and consultants emerges, which will have to await the growth of the listed companies sector, changes in the law mandating QCR on all firms, while an important step, will possibly have limited effect in improving the quality of the profession. 6. Financial Sector and Corporate Governance

This section shows that Pakistan’s concentrated and largely state-owned financial sector resulted in distortions and inefficiencies, during the eighties to mid-nineties, which resulted in mounting non-performing loans that threatened the viability of Pakistan’s financial sector. In response to this crisis GOP has instituted reforms of the market structure, regulatory regime and prices, which are expected to create high-powered incentives and more prudent dealings between creditors and debtors. We argue that while these reforms have had a number of positive effects, the financial sector continues to be plagued by weak contractual rights, which has made it excessively risk-averse and unwilling to take on term lending. Therefore, urgent changes are needed in strengthening efficient judicial processes that strengthen creditors’ rights. 6.1. Pre-Reform Structure in 1990 6.1.1 Financial Sector Institutions Pakistan’s banking sector was dominated by the public sector as late as the early nineties (Table 6.1). This was largely the result of policy initiatives that had been undertaken during the 1970s, which persisted throughout the 1980s. These initiatives substantially increased the role of government in the banking sector through nationalizations and through restrictions on private sector entry in deposit mobilization and credit allocation. Table 6.1. Structure of Pakistan’s Financial Sector in 1990

(Amount in Rs. billion, share in percent)

Assets Advances Investment Number

s Amoun

t Share Amount Share Amoun

t Share

Banks 24 425.6 61.6 218.5 48.7 111.3 89.0 State-owned 7 392.3 56.7 201.2 44.8 104.1 83.2 Private - - - - - - - Foreign 17 33.4 4.8 17.3 3.9 7.3 5.8 NBFIs 36 133.9 19.4 98.3 21.9 13.7 11 State-owned 13 124.3 18 94.7 21.1 13.3 10.6 Private 23 9.6 1.4 3.6 0.8 0.4 0.3


CDNS 1 131.9 19.1 131.9 29.4 - - Equity markets105

2 90 - - - - -

Total 63 691.5 100 448.7 100 125.1 100 NBFI: Non-Bank Financial Institution, CDNS: Central Directorate of National Savings Source: Pakistan: Financial Sector Assessment 1990-2000. State Bank of Pakistan (SBP). The public sector also dominated the Non-Bank Financial Institutions (NBFIs) during the 1980s despite an easing of entry regulations that allowed greater private investment into the sector (Table 6.1). Although the number of private Non-Bank Financial Institutions was 23 out of a total of 36, their asset base, as well as their share in advances and investment remained extremely small. Within the NBFIs, it was the state-owned Development Finance Institutions (DFIs), twelve in number, which dominated the share of assets (78.6%) and advances (80.4%). The Central Directorate of National Savings, again a public sector institution, had a network of 300 plus branches, and had mobilized a total of Rs. 131.9 billion until 1991. Therefore, the structure of Pakistan’s financial sector that emerged during the eighties and nineties was characterized by significant and concentrated state ownership with restrictions on competition from the private sector. We will show that this structure had a considerable impact, not only, on corporate financing but also on the efficiency with which external finance was used. 6.1.2. Supervisory Structure In 1990, three bodies were playing a supervisory/regulatory role vis-à-vis Pakistan’s financial sector. The State Bank of Pakistan (SBP) dispensed its functions under the SBP Act (1956); the Pakistan Banking Council (PBC) monitored the performance of nationalized banks under the Banks (Nationalization) Act (1974), and the Corporate Law Authority (CLA) regulated the equity market under the Securities and Exchange Ordinance (1969). The SBP, the apex regulatory institution of the country, had the responsibility for: conducting the monetary policy of the country; managing the exchange rate; and performing banking supervision. The PBC operated as a holding company for the government, and was responsible for, among other things, ensuring that directed credit policies were properly implemented in state-owned banks. The PBC reported to the Ministry of Finance and was placed below direct political control. The PBC had the same regulatory role as the SBP, but its additional responsibilities and its exposure to political control created substantial distortions in the banking sector. Furthermore, the regulatory structure that emerged was fragmented and the overlapping jurisdiction of different supervisory bodies made the structure inefficient. 6.1.3 Consequences Concentrated state control over credit disbursement and a fragmented and polticized regulatory structure led to a number of distortions in the system. The first consequence was the accumulation of a large portfolio of Non-Performing Loans (NPLs) that nationalized banks became (and still are to an extent) burdened with. Second, direct mobilization of funds through CDNS, at high interest rates, lowered the ability of the financial sector to raise deposits. CDNS was offering tax incentives and high interest rates (up to 15%) for deposits that were risk-free, while banks could only give a 7-9% interest on their deposits. These factors led to not only low returns on bank portfolios, but also to dis-intermediation in the banking system.

105 Market capitalization of KSE is not included in the total.


Third, absolute credit ceilings and sectoral credit allocation targets limited the banks’ ability to benefit from de-centralized decision-making and sectoral profit-making opportunities. Administered interest rates further limited the scope for responding to risk differentials. Finally implicit deposit risk insurance, offered by the state, implied significant moral hazard for state-owned banks and DFIs. Entry restrictions on private domestic and foreign banks limited competition for state-owned institutions, which resulted in the creation of service related inefficiencies as well as the creation of rents for distribution on the basis of patronage. As mentioned earlier, one consequence of these practices has been the large portfolio of non-performing loans (NPLs) that the financial institutions, especially state-owned ones, have been burdened with (Table 6.3). 6.2. Financial Sector Reforms During the 1990s The aim of financial sector reforms instituted by the Government of Pakistan (GoP) during the 1990s is to create efficiencies in the financial market. The reforms attempt to achieve these objectives through a series of interventions that are detailed and analyzed in this section. 6.2.1 Institutional Reform GOP took a number of reform measures during the 1990s. In order increase competition the government started privatizing the nationalized banks and other financial institutions through amendments to the Banks (Nationalization) Act (1974). Three large nationalized banks, Muslim Commercial Bank, Allied Bank and United Bank, have so far been privatized. Further amendments to the 1974 act lowered entry barriers for the private sector to enter the banking industry. As a result, some 13 private domestic banks have been commissioned to start commercial banking. The reforms have taken a number of steps to streamline and increase the efficacy of financial sector practices and regulations. The Banking Companies Ordinance (1962) has been amended to allow stronger self-governance by banks. Furthermore the state has also introduced strong restructuring programmes in all banks and DFIs that continue to operate in the state sector. These restructuring plans include initiatives like branch and employee rationalization, and voluntary early retirement plans. In two years (up to December 1999) state-owned banks had reduced their workforce from 99,954 to 81,079, and had reduced the number of branches by 718 (by June 2000). GOP has also made significant changes to Prudential Regulations in order to increase the sustainability of banking institutions. The changes include an increase in the capital adequacy ratio and the minimum paid-up capital requirement. Furthermore, SBP has mandated NBFIs to obtain credit ratings. The SBP has streamlined the loan recovery process by requiring disclosure of substandard and doubtful loans; by establishing quarterly recovery targets; and by increasing the number of banking tribunals to process recovery cases. Furthermore, the Banking Companies (Recovery of Loans, Advances, Credits, and Finances) Act (1997) has been instituted to allow for the establishment of banking courts to further facilitate and expedite the recovery process. These changes allow for quicker decisions for foreclosure and sale, and takeover of property (where warranted) without filing a suit. Finally, in order to create powerful market incentives targeted lending schemes have been reduced and SBP has dismantled the regime of administered interest rates. 6.2.2. Banking Supervision Reform106 106 More detailed account of the legal changes is given in Appendix 5.


The most important steps taken by GOP are: to amend the SBP Act (1956) to make SBP autonomous; to prohibit any government body from issuing any directive to banks (and NBFIs) regulated by the SBP; and to ensure that the SBP has the requisite powers for formulating and implementing the country’s monetary policy. Furthermore, GOP amended the Banks (Nationalization) Act (1974) in 1997 and consolidated all regulatory functions pertaining to banks under the SBP, abolished the PBC, and gave SBP the right to regulate the affairs of the state-owned banks as well. GOP has placed limitations on the political control of financial institutions by placing them under the supervision of an autonomous central bank, as opposed to a politically controlled PBC. Reforms in the Banking Companies Ordinance have also strengthened the SBP’s role as a regulator of financial institutions. Section 40A gives SBP the power to ensure that banks comply with all statutory requirements and banking rules and regulations, and in case of non-compliance SBP can take remedial action. Section 41D empowers SBP to direct prosecution of a director or CEO, who has caused loss to depositor’s money or income of the bank. 6.3 Impact of Financial Sector Reforms

This section assesses whether the reforms have, indeed, been successful in creating a competitive, market-driven environment that sets incentives for prudent lending and efficient investment allocation. We also analyze the constraints that continue to persist in Pakistan’s financial sector despite these reforms. 6.3.1. Impact on the Financial Structure The reforms of the 1990s have transformed the structure of the financial sector in Pakistan. The asset share of banking institutions in the private sector has increased from 7.8% in 1990 to about 55% in 2002.107 Furthermore, the compound annual growth rate of assets and deposits was almost fourfold in the private sector as compared to the public sector. Consequently, in terms of GDP, the share of private banking institutions jumped from 3.9% in 1990 to more than 27% in 2002. The same trend was visible in the NBFIs as well. This suggests that the reforms have been successful in engendering greater competition in Pakistan’s financial sector. The reforms have also stressed the objective of dismantling of the role of the government in credit allocation. As a result, concessionary credit, as a percentage of total credit, decreased from 44.2% in 1990 to 31.4% in 2000. This has ensured that bank allocations are driven increasingly by profit motives and not by state policy. 6.3.2 Impact on Banking Supervision As pointed out earlier, SBP introduced stronger Prudential Regulations after the 1997 amendments in its powers. Most banks have complied fairly thoroughly with the new regulations. By 2000 only three, out of 39, banks had a lower than 8% capital to risk-weighted asset ratio. By June 2001, out of 80 financial institutions, credit ratings of fifty institutions had been completed. SBP has also improved its regulatory capacity by investing in change management. As a result, in many cases it has been able to identify problems early and to take early remedial action. Board and management of Bankers Equity Limited (BEL) were removed by SBP in August 1999 when it was clear that the bank was in trouble. SBP was able to payback most account holders by February 2000. Similarly, the license for Indus Bank Limited was cancelled after early warnings in 2000, and SBP has now almost finished the liquidation process. SBP has recently created a subsidiary State Bank of Pakistan 107 The figure includes the estimated changes from recent privatization of United Bank Ltd.


Banking Services Corporation (SBPBSC) that will look after banking services exclusively. This will allow SBP to offer even better regulation and monitoring. 6.3.3. Performance Evaluation Post-Reform First, compared to some its regional competitors and countries that are at a roughly comparable level of development, Pakistan still has a long way to go in terms of financial sector development (Table 6.2). On the whole Pakistani indicators are poorer than the East Asian countries and Turkey, and some indicators are weaker than other South Asian countries as well. This just shows that Pakistan still has a long way to go before it can claim to have a deep, entrenched, fairly efficient and extensive financial sector. Table 6.2. Indicators of Financial Depth and Efficiency

(Percent)

2000

Pakistan

India

Bangladesh

Sri Lanka

Philippines

Malaysia

Turkey

M2/GDP 46.5 56.9 43.3 38.2 62.5 102.6 44.6 Currency/M2 27.8 17.5 14.2 13 9.3 6.4 5.6

Currency/GDP 12.9 9.9 6.2 5 5.8 6.6 2.5 Money

Multiplier 3.2 4.1 4.6 4.7 4.7 4.1 5.6

Demand Deposit 43.2 14.9 14.5 13.3 10.6 17.4 12 Time Deposit 56.8 85.1 85.5 86.7 89.4 82.6 88

Credit to Government

41.8 44.5 22.2 27.8 23.4 -2.2 52.7

Source: Pakistan: Financial Sector Assessment 1990-2000. State Bank of Pakistan (SBP). Second, Non-performing loans (NPLs) of financial institutions have continued to grow throughout the 1990s (Table 6.3). However, the average rate of growth did slow down from 17.4% to 10.1% after 1997. In December 2002, NPLs of banks stood at Rs. 244.2 billion up from the 2000 figure of Rs. 173.6 billion. Public sector banks accounted for 50% of NPLs, which was much higher than the figure for private and foreign banks (Table 6.3). In December 2002, the NPLs to total loans ratio stood at 23.7% for all banks and at 37.1% for public sector banks. Table 6.3. Volume and Concentration of NPLs

(Amount in billion Rs., shares in percent)

1990 1995 2000 All banks and NBFIs (Amount) 66.1 142.6 271.4

All banks 41.1 94.9 173.6 State-owned banks 39.0 89.3 153.0

Private banks - 2.4 13.6 Foreign banks 2.1 3.2 7.0

NBFIs 25.0 47.7 97.8 DFIs 22.8 39.6 83.4 HFC 0.6 4.3 9.3

Others 1.6 3.7 3.0


Share in NPLs (percent) All banks and NBFIs 100 100 100

All banks 62.1 66.5 64.0 State-owned banks 59.0 62.6 56.4

Private banks - 1.7 5.0 Foreign banks 3.1 2.3 2.6

NBFIs 37.9 33.5 36.0 DFIs 34.6 27.8 30.7 HFC 1.0 3.0 3.4

Others 2.4 2.7 1.9

State-owned institutions 96.9 96.0 91.6 Source: Pakistan: Financial Sector Assessment 1990-2000. State Bank of Pakistan (SBP). The poor recovery process of NPLs is partly a consequence of policy but partly it is explained by weak creditors’ rights. There are several important issues to note here. As the section on Pakistan’s corporate governance structure shows, Pakistani corporations, even listed ones, tend not reveal sufficient credible information, and tend not maintain credible and transparent governance structures. In addition, even though creditor’s rights as judged on the basis of five widely accepted international best practices (La Porta et al 1998 and 1999)108 are well protected in the Companies Ordinance 1984, banks do not have confidence in the judicial system enforcing their rights effectively (see Table 7.1 and section 7 for details). Given this constraint banks have either become reluctant to fund long-term projects, or have started asking for more than 100% collateral. Both these effects have helped to lower the flow of debt to the corporate sector. GOP has responded to this situation of weak creditors’ rights in two ways. First, amendments have been made to the Banking Companies (Recovery of Loans, Advances, Credits, and Finances) Act, in 1997 and 2001, which try to address these concerns about creditor’s rights109. These changes aim at not only providing summary proceedings for recovery, but for the first time, they have also introduced the idea that the bank can sell mortgaged property without intervention from the courts. Sections 10 and 11 of the Recovery of Finances Ordinance 2001 allow for summary hearing and quick decree if no substantial point of law is present on the side of the defendant. Section 15 allows for the creditor to sell mortgaged property, in case of default, and after due notices have been given, through public auction and without intervention from the court. Section 16 allows for recovery of moveable property from the defaulter without intervention of the court if such a provision had been made in the initial agreement. Section 23 restricts debtors from alienating disputed property until the decision of the court. These reforms have been instituted to expedite the loan recovery process by bypassing the court system. Second, as pointed out in Section 4.3.1, the NAB Ordinance (1999) has instituted a regime of more or less unlimited liability for directors of companies, which is again meant to expedite recovery. However, the attempt to pierce limited liability has reduced the demand for debt among corporates (section 1). Third, as a result of higher risks and weak creditors’ rights banks have become reluctant to provide long-term finance to the corporate sector. As has been shown, the corporate sector has traditionally relied on DFIs and other specialized institutions to acquire term financing. This has not only created the aforementioned problems of NPLs, due to poor governance and politicised incentive structures in DFIs

108 These are 1) restrictions for going into reorganization, 2) no automatic stay on secured assets, 3) secured creditors first, 4) management does not stay, 5) legal reserve. These are discussed in detail, for Pakistan, in Appendix 5. 109 The issue of implementation and the effectiveness of judiciary are discussed separately in section 7.


and public sector banks, it has also created rents that were distributed to ‘insiders’ or firms that were able to tap into the existing patronage network. However, the reform environment has marginalized the DFIs and NBFIs. Their marginalization is a consequence of their inability to mobilize funds; a drastic squeeze in their foreign funding lines; and structural weaknesses that burdened them with significantly infected portfolios and high levels of NPLs. Sharp increases in NPLs have, in turn, restricted their lending operations. As a result, their role in the overall financial industry has become quite small (Table 6.4). This analysis suggests that the future of the DFI model is weak in Pakistan’s current financial sector environment. This means that the old model of corporate financing has come under strain and corporates will have to look elsewhere to obtain external finance. Table 6.4. Sanctions and Disbursements by Selected DFIs and Specialized Banks

(million Rupees)

Financial Year 1990 Financial Year 2000 Deposit Sanctions Disbursed Deposit Sanctions Disbursed

NDFC 12,422 5,123 2,272 28,338 127 225 RDFC 128 459 239 601 - - BEL 1,771 4,152 1,462 3,895 - 15

PICIC 1,191 8,591 1,239 3,263 988 193 Source: Pakistan: Financial Sector Assessment 1990-2000. State Bank of Pakistan (SBP). The key question is that as DFIs and specialized institutions are scaled down, will these legal provisions be enough to allow banks and NBFIs to enter term financing market, and finance the development of the corporate sector in the country? A lot will depend on the efficacy of the legal system in enforcing the protections that have been given to creditors. This is discussed in detail in the next section. 7. Judicial System Governments are supposed to define the legal framework within which individuals and organizations are to function and set up mechanisms and institutional arrangements for ensuring rule compliance and conflict resolution in a fair manner. Deficiencies in both design of the legal framework and in the way it works affects the performance of the economy. Laws and regulations in Pakistan tend to be complicated, cumbersome and at times defective (Bari et al 2003). Incentives for strict and fair implementation are weak and widespread bureaucratic and political interference make matters much worse. Consequently inadequate knowledge of the relevant laws, and more importantly, the high cost (in terms of time and resources) of seeking and securing redress partly explain why those adversely affected do not take recourse to legal remedies or exert pressure on the enforcement agencies to take appropriate corrective action. It also implies that in both cases when the right laws are not there, or when enforcement is weak, parties to a transaction will try to either avoid the transaction, design second best solutions to cover their downside, or just bear the higher transaction cost. But in all of the above the cost of transaction will go up and efficiency, compared to the optimal, will be much lower. One poignant example of this has been the reluctance of banks and NBFIs to go into term financing. La Porta et. al.’s (1999) estimates show that in Pakistan the issue is not the legal structure of credit protection but judicial enforcement, a point we have emphasized throughout this chapter (Table 7.1). It is because of the weaknesses in judicial enforcement that banks have over-collateralized loans, or have used other means to manage risks. The same is the case with enforcement, through courts, of minority shareholder rights as well. Corporate governance reforms, if they are going to work, will need to rely on strong reforms in the judicial system.

Table 7.1 Investor Protection in Asia and Latin America


Creditor Protection1 Judicial Enforcement2 Pakistan 4 4.3 India 4 6.1 Sri Lanka 3 5 Malaysia 4 7.7 Philippines 0 4.1 Indonesia 4 4.4 Thailand 3 5.9 Argentina 1 5.6 Brazil 1 6.5 Chile 2 6.8 Colombia 0 5.7 Mexico 0 6

Source: La Porta et. al. (1998 and 1999) Note: 1) An index of how well the legal framework protects secured creditors. It will equal four (best) when: (a) there are minimum restrictions e.g. creditors’ consent for firms to file reorganization; (b) there is no automatic stay on collateral; (c) debtor loses control of the firm during reorganisation; and (d) secured creditors are given priority during reorganisation. 2) An index measuring the quality of judicial enforcement ranging from 1 (worst) to 10 (best) equal to the average of five sub-indexes measuring: (a) efficiency of the judicial system; (b) rule of law; (c) corruption; (d) risk of expropriation; and (e) risk of contract repudiation. The main weaknesses of the judicial system stem from the very low disposal rates of cases. Parties to a dispute can take recourse to three appellate forums: District Courts, the High Court and the Supreme Court, and since interim orders can be subjected to the three forums as well, delays become endemic and weaken property rights and contract enforcement. Parties can rely on delays in the judicial system since they have become quite predictable. The low salary structure of the civil judiciary, coupled with the possibility of delaying decision-making, lead to significant opportunities for corruption. Historically, civil courts that applied ordinary civil and procedural laws, handled the process of debt recovery as well (enforcing creditor rights). The problems posed by lack of judges trained in commercial, corporate, banking and tax laws are compounded by the procedural and legal complications (mentioned above) in liquidating collateral. Procedural loopholes alone could delay action for years reducing the value of the collateral significantly apart from imposing direct costs on the creditor. Furthermore, corruption makes the outcome even more unpredictable. This adversely impacts upon the availability of debt. Financial institutions are reluctant to advance loans to parties that are not ‘blue chip’ as the value of collateral is undermined by procedural and legal complications. The above circumstances also encourage financial institutions to become excessively stringent in requiring collateral. In February 1997 the federal government established 34 banking courts across the country to admit cases of loan defaulters below Rs. 30 million. For cases above Rs. 30 million, two judges from the Lahore High Court and one judge each from Sindh and Baluchistan High Courts were nominated to deal exclusively with such cases. Though more banking courts have been added to the judicial system, and the judicial process for recoveries has been improved, the general problems that have been identified above still hamper the working of the judiciary and continue to impose significant transaction costs on the companies and providers of finance. These need to be addressed quickly, and on a priority basis. 8. Conclusions


In this chapter we have argued that Pakistan has entered a new phase in its corporate growth history. The government is phasing out the old model of corporate growth that relied on state-disbursed credit and inflated internal finance through protectionist policies. Furthermore, recent reforms in the financial sector appear to have made financial institutions excessively risk-averse when it comes to corporate lending practices. The risk-aversion of financial institutions is also a consequence of weak creditors’ rights that arise on account of inefficiencies in the judicial enforcement structure. This means that future financing for corporate growth will either come from internal profitability or from external equity capital. However, we have also argued that currently Pakistan’s capital markets are prone to inefficiencies because of their shallowness and because they remain extremely skewed in terms of both market capitalization and turnover. Opaque information and a distorted market structure appear to create many opportunities for making profits through market manipulation rather than efficient portfolio investment. This suggests that if Pakistan is to achieve large-scale corporate growth it must reform its capital markets. An important question that needs to be addressed is the source of future growth of the corporate sector. At first glance it appears that in Pakistan’s current economic environment family-based corporates offer the greatest potential source for corporate growth. However, we have shown that the ownership and control structure of the family-based corporates is such that their main objective becomes one of maximizing family control. We have also argued that the control maximization objective is inimical to capital market development. Furthermore, concentrated control leads to a number of inefficiencies, which include:

1. Opaqueness in the use of public money 2. Excessive private benefit seeking through tunneling and other means 3. Low share trading which reduces market liquidity 4. Lack of incentives to declare dividends

Many of these practices lower external investor protection and are contrary to the requirements of capital market development. However, we have also pointed out that private benefits, which result from concentrated control, set strong incentives for these families to maximize the generation of operating surpluses. This suggests that there may be a trade-off between profit maximization and the development of capital markets in Pakistan. It is this structure that the SECP is attempting to regulate through the prescription of a bold Code for Corporate Governance. The Code has taken a number of important steps that are in line with international best practices. These include: a greater role for Non-Executive Directors on the BODs; strengthening minority shareholder rights; and improving the audit and disclosure mechanisms in Pakistan. These steps have laid down a framework that will help define tomorrow’s corporate environment. However, we have argued that in the current structure many of these provisions will not be as effective as they would have been in a more developed capital market. For example, the dominance of the family on the BOD and on audit committees will make these forums partial to majority controllers and it cannot be expected that these forums will end up playing the role that is envisaged of them. We have also argued that concentrated control of votes in the hands of the family tends to make the actual enforcement of minority shareholder rights difficult and onerous. Again, this means that the de facto force of these rights will be much less than their de jure force. Where the SECP’s new Code has made a perceptible difference is in the consolidation of a higher quality segment in the audit market. The Code’s requirement of a quality control review for listed companies’ auditors combined with ICAP’s role in adopting ISA and enforcing their compliance has helped to maintain a high-quality market segment. However, we have shown that this high-quality market segment is small and there is much room for upgrading the quality of other auditors in the market. The resistance to this change amongst auditors is partly because the small size of the corporate sector reduces the


premium that can be obtained from moving up into the high quality segment and partly because opaque corporate practices create ‘rents’ not only for corporates but also for complementary professions. Given this situation, where are capital market development and the growth of the widely held sector going to come from? In our opinion there are two potential sources of this growth. The first is an increase in the liquidity of Pakistan’s stock market through greater participation by foreign portfolio investors. Large-scale inflow of funds brought in by institutional investors may help create the necessary carrot for local corporates to bite on. Along side this institutional investors with concentrated control over investment may have the needed ability to discipline local corporates and make them bargain away some control in exchange for the large-scale availability of reasonably priced risk-sharing capital. However, this scenario is contingent upon how foreign investors react to the improvement in Pakistan’s macro situation that has emerged partly by virtue of the September 11th dividends and partly on account of government policy. Alternatively, growth in Pakistan’s corporate sector will have to wait for the emergence of Pakistani corporations that are striving to grow in the global market. This has already happened in India’s IT sector. However, this would mean a major change in the entrepreneurial vision of the Pakistani corporate controller, who is currently locked into making profits either on the basis of processing domestically available raw material or on the basis of high protection “rents” in the domestic capital-intensive sectors. 9. Bibliography Amjad, R. (1982). Private Industrial Investment in Pakistan, 1960-70. Cambridge University Press. Bagchi, A.K (eds.) (1999). Economy and Organization. Sage. Bari, F. Cheema, A. & S.H. Kardar (2003). Private Sector Development Strategy for Pakistan. Asian Development Bank, March. Basudeb, G.K and F. Bari (2000). Sources of Growth in South Asian Countries. Global Development Network.

Bergloff, E. and E.L. von Thadden (2002). The Changing Corporate Governance Paradigm: Implications for Developing and Transition Economies in B. Pleskovic and J.E. Stiglitz (eds.) The Annual World Bank Conference on Development Economics, 1999. World Bank, Washington. Berle, A. and G. Means (1932). The Modern Corporation and Private Property. Macmillan. Bertrand, M., P. Mehta and S. Mullainathan (2000). Ferreting out Tunneling: An Application to Indian Business Groups. MIT working paper. Cheema, A. (1999). Rent-Seeking, Institutional Change and Industrial Performance: The Effect of State Regulation on the Productivity Growth Performance of Pakistan’s Spinning Sector, 1981-1994. Dissertation submitted to the University of Cambridge, UK. Cheema, A (forthcoming). State and Capital in Pakistan: The Changing Politics of Accumulation in A. Mukherjee-Reid (eds.) Corporate Capitalism in Contemporary South Asia. Macmillan. Claessens, S., S. Djankov and L. Lang (1999). Who Controls East Asian Corporations? Manuscript. Financial Economics Unit, Financial Sector Practice Department, World Bank.


Goswami, O. (this volume). Getting There --- Pretty Rapidly: The State of Corporate Governance in India. Hamid, N. (1992). Industrial Incentive Structure: A Need for Reform, in A. Nasim (eds.) Financing Pakistan’s Development in the Nineties. Lahore, OUP. Hart, O. (1995). Corporate Governance: Some Theory and Implications, Economic Journal, Vol. 105, Issue 430. Hazari R. K. (1966). The Structure of the Corporate Private Sector: A Study of Concentration, Ownership and Control. Asia Publishing House. Khwaja, A.I. & A. Mian (2003) Price Manipulation and “Phantom” Markets: An In-depth Exploration of a Stock Market. Draft paper, February. La Porta, Rafael, F. Lopez-de-Silanis, A. Shliefer and R. Vishny (1998). Law and Finance, Journal of Political Economy 106. La Porta, Rafael, F. Lopez-de-Silanis, A. Shliefer and R. Vishny (1999). Corporate Ownership Around the World, Journal of Finance 54. Lokanathan, P.S (1935). Industrial Organization in India. Allen Unwin. Noman, A. (1992). Liberalization of Foreign Trade and International Competitiveness, in A. Nasim (eds.) Financing Pakistan’s Development in the Nineties. Lahore, OUP. Papaneck, G. (1967). Pakistan’s Development: Social Goals and Private Incentives. Harvard University Press. Securities and Exchange Commission of Pakistan (2002). Annual Report 2002. Islamabad. Shleifer, A, and R. Vishny (1997). A Survey of Corporate Governance, Journal of Finance 52.

State Bank of Pakistan (2003). Quarterly Performance Review of the Banking System, Quarter Ended December 2002. Banking Supervision Department. State Bank of Pakistan (2002). Quarterly Reports on the State of the Economy. Various Issues. State Bank of Pakistan (2002). Pakistan: Financial Sector Assessment 1990-2000. Research Department. State Bank of Pakistan (2002). Balance Sheet Analysis of Joint Stock Companies (various issues). Karachi. World Bank (2002). World Development Indicators. World Bank Washington. Zhang, J, D. Edwards, D. Webb and M.V. Capulong (1999). Corporate Governance and Finance in East Asia. Asian Development Bank.


Appendix 1. Sample Description

1. Table 2.4 (a) Sample: The sample included 7 companies; 4 of which were MNCs and 3 were government enterprises. Data for calculation was obtained from the SECP Securities. Names of the companies included in the sample are as follows: Multi-Nationals Hubco ICI Pakistan Lever Brothers Shell Pakistan Government Enterprises SNGPL SSGC PSO 2. Table 2.4 (b) Sample Total companies included in the sample were 43. The sample included 21 textile companies and 22 non-textile companies. Name of the companies are as follows: Textile Companies Alhamd Textile Mills Bilal Fibres Brothers Burewala Ellcot Spinning Mills Ghazi Fabrics Ibrahim Fibres Ideal Spinning Mills Idrees Textile Mills Ishaq Textile Mills Khalid Siraj Muhammad Farooq Textile Mills Nagina Cotton Mills Prosperity Weaving Mills Ruby Textile Mills Shaheen Cotton Mills Shahtaj Textile mills Shahzid Textile mills Tata Textile Mills Tritex Cotton Zaman Textiles Non-Textiles


Allwin Eng Atlas Battery Baluchistan Glass Chakwal Cement Crescent Boards Crescent Jute Crescent Steel and Allied Products Dandot Cement Company Data Agro Dewan Salman DG Cement Dynea (Dyno Pak) General Tyre Indus Motor Company Kohinoor Genertek Maple Leaf Cement Factory Pakistan Synthetics Ltd Pel Appliances Shabbir Tiles and Ceramics Suhail Jute Mills Transpak Corporation Ltd United distributors 3. Table 2.5 (Data for Pakistan) The sample consisted of 32 total companies; 14 of which were textile companies and 18 were non-textile companies. Data was acquired from the company reports of these companies Names of the companies are given as follows: Non-Textiles Indus Motor company Dyno Pak Shabbir tiles and ceramics limited Crescent Boards Crescent Steel and allied products Pakistan Synthetics Ltd DG Cement Maple leaf cement factory Crescent Jute Allwin Engineering Industries ltd Transpak Corporation Ltd Pel Appliances Ltd Dandot Cement Company ltd Kohinoor Genertek ltd Atlas Battery (Atlas Group)


United Distributors Pakistan ltd Dewan Sohail Jute Mills Limited Textile Mills Zaman Textile mills Brothers Idrees TM Kohinoor textile mills Bilal Fibres Limited Muhammand Farooq Textile Mills Ideal spinning mills Tata Textiles Ghazi Fabrics Ibrahim Fibres limited Ellcot Spinning Mills Tritex cotton Nagina Cotton Prosperity Weaving mills 4. Table 2.6 (Data for Pakistan) Sample: Same sample is used as in Table 2.5 5. Table 2.7 Sample: The sample consisted of 33 companies. Of these, 18 companies were family based, 12 were government and 3 were multi-national companies. The relevant data was provided by Dr. A. Mian of the University of Chicago. Names of the companies are as follows: Family Based

Bolan Bank Chakwal Cement D.G.Cement Dewan Salman Engro Chem. Fauji Cement Faysal Bank IbrahimFibres Japan Power Kohinoor Energy Lucky Cement M. C. B. Maple Leaf Cement Nishat Mills Prime Bank


Soneri Bank Union Bank World Call Payphones Government K. E. S. C. P.I.A.C. (A) P.N.S.C. P.T.C.L.A Askari Bank B.O.Punjab Fauji Fert FFC JORDAN P.I.C.I.C. P.S.O. Sui Northern Sui South Gas MNCs Hub Power Nimir Ind. Chem Pak Tobacco 6. Table 4.1 Sample: The sample included 34 total companies. Of these 16 were textile companies and 18 were non-textile companies. The required data was acquired form the company reports of these companies. Names of the companies are given as follows: Non-Textiles Allwin Engineering Atlas Hodna Crescent boards Crescent Jute Crescent steel and allied products Dandot Cement Dewan Salman DG cement Dyno Pak Indus Motor Company Kohinoor Gertek Malpe leaf cement factory Pakistan Synthetics Pel Appliances Shabir tiles and ceramincs Suhail Jute mills


transpak corporation United Distributers Textiles Amin Textiles Apollo Textile Mills Burewala Textiles Chakwal Spinning Colony Sarhad Colony Thal CresKnit Globe Textile Ibrahim Filbres Kohinoor textile mills Lawrencepur Nishat Mills Sapphire Textile Mills Shams Textile Mills Tritex cotton mills Zaman Textiles


Appendix 2. Relevant Excerpts from the SECP Annual Report 2002

4.3.11 Inter-corporate Financing While inter-corporate financing constitutes a major source of funding for productive investment and capital formation, this avenue has been greatly abused by managements and sponsors for transfer of funds to their own companies. In order to curb this misuse of funds, the Companies Ordinance, 1984 has placed certain restrictions on investments in associated companies. During the year under review, efforts were made by the EMD to deter unlawful inter-corporate financing. As a result of its proactive monitoring, the EMD was able to detect material deficiencies in the information provided by certain companies in the proposed resolutions and statements of material facts annexed to notices of general meetings. Timely interference by the EMD caused four companies to withdraw the proposed resolutions for making investments aggregating Rs. 120 million in their associated companies. In another case, a company was prevented from selling its investment in a subsidiary at a “throw away” price. Another company was restricted to pass a resolution for making advances to associated undertakings without any return thereon. A number of cases were also identified where investments were either made in associated companies without approval of shareholders or in excess of the prescribed limit or free of any return. Proceedings were initiated against 15 companies for violation of the mandatory provisions of the Companies Ordinance. Of these, five cases were disposed of during the year while others were pending adjudication as of June 30, 2002. As a result of actions taken by the EMD, more than Rs. 1.1 million, along with return thereon at not less than the borrowing cost of the investing companies, would be returned to these companies. The details of cases disposed of during the year are given in the table below. TABLE 20 Cases of Unlawful Inter-corporate Financing Disposed of During the Year S. No. Company Amount Invested

(Rs. In Million) Action Taken

1 Spencer and company (Pakistan) Limited

504.697 Penalty of Rs. I million imposed on the CEO and direction given to recover the investment along with return.

2 Gharibwal cement Limited

510.841 Penalty of Rs. 1.5 million imposed on the CEO and directors and direction given to recover the investments.

3 Mandviwalla Mauser 18.000 Penalty of Rs. 200,000 imposed on the CEO and direction given to recover the investment and return thereon.

4 Yousaf Textile Mills Limited

5.626 Penalty of Rs. 10,000 imposed on the CEO.

5 Ghani Glass Limited 49.935 Penalty of Rs. 135,000 imposed on the CEO and directors and direction given to recover the return on investments.

Total 1,089.099 Further to the orders made by the Executive Director, EMD, appeals were filed before the Appellate Bench of the Commission in the matter of Spencer and Company (Pakistan) Limited and Gharibwal Cement Limited. While the decision of the Executive Director was upheld by the Appellate Bench in the case of Spencer and Company (Pakistan) Limited, the penalty, in the case of Gharibwal Cement Limited, was reduced from Rs. 1.5 million to Rs. 600,000. The case of Spencer and Company (Pakistan) Limited is now pending before the Honorable Sindh High Court. In another case, the Honorable Sindh High Court has stayed the show cause proceedings initiated by the EMD against a listed company for making


unlawful investments in its associated companies. 4.3.12 Sale of Substantial Assets at a Loss to Minority Shareholders During the year under review, the EMD also took note of situations where sale proceeds of assets of companies were used to settle their outstanding debts, including the amounts borrowed from sponsors. Effectively, this practice results in a loss in the value of investment of minority shareholders. The EMD took a number of remedial measures to discourage this practice. Based on a review of notices published in newspapers regarding sale of assets by companies, appropriate directions were issued to concerned companies to ensure that minority shareholders were adequately compensated. This policy was adopted in the case of companies in which either there was no chance of revival of operations or the future returns to shareholders were considered negligible. During the year, two companies were directed not to sell a sizable part of their assets without the approval of the Commission. Accordingly, these companies were unable to undertake business that was prejudicial to the interest of minority shareholders. 4.3.13 Proper Exercise of Powers by Directors Provisions of the Companies Ordinance, 1984 place certain restrictions on exercise of powers by directors. During the year under review, two cases were identified where directors had exceeded their powers in violation of statutory provisions and had, in each case, disposed of a sizeable part of the undertaking without seeking the consent of shareholders in general meetings. Taking cognizance of these violations, the EMD issued show cause notices to the directors of these companies. While one of the cases was pending adjudication at the end of financial year 2002, the directors of the other company have obtained the stay order of the Court in respect of proceedings initiated by the EMD. 4.3.14 Loans to Directors Section 195 of the Companies Ordinance, 1984 prohibits public companies and private companies, which are subsidiaries of public companies, to provide loans, or give guarantees in connection with loans, to their directors. These restrictions equally apply to loans or guarantees to relatives of directors and private companies or firms in which such directors have substantial interest. During the year under review, the EMD issued directives to the following companies whose funds had been transferred in contravention of the statutory requirements. (i) The CEO and directors of Associated Industries Limited were directed to recover an amount of Rs.

18.3 million, along with mark-up, from its associated company, Quality Food Products (Private) Limited. This amount was unlawfully advanced to the associated company and no interest was being charged under the pretext of non-trading transactions. The company, on the directions of the Commission, recovered an amount of Rs. 46.1 million on account of principal and mark-up.

(ii) The CEO and directors of United Distributors Pakistan Limited were directed to recover the amount

of interest-free loan of Rs. 34.7 million from its associated company, International Brands (Private) Limited. The full amount of the loan has been recovered by the company on the directions of the Commission.

(iii) The directors of Brothers Textile Mills Limited were directed to cancel the guarantee provided to a

bank in connection with a loan given by the said bank to one of its associated undertakings. The company has complied with the direction of the Commission and consequential proceedings have been dropped accordingly.

Section 195 allows that a company, subject to the approval of the Commission, can extend a loan to a


whole time working director for the purpose of construction or acquisition of a house or other purposes enumerated in the said Section. During the year, only one application was received from a company to seek approval for giving a house-building loan to its director. The application was suitably processed and disposed of. 4.3.15 Irregularities in Holding of Election of Directors In case of 22 listed companies, the EMD took cognizance of lack of disclosure in notices of general meetings regarding proposed resolutions for election of directors. Explanations were called and remedial actions were taken by the EMD. However, on a complaint by NIT that election of directors in a company was held through show of hands and not in compliance with the procedure prescribed in Section 178 of the Companies Ordinance, 1984, necessary proceedings were initiated against the company. As a result, the CEO of the company was fined for violating mandatory provisions of the Companies Ordinance, 1984.


Premier

Hoti

Khanzada Zafarul Ahsan

Ferozesons

Wazir Ali

Bawany

R a n g o o n

wala

A d a m j e e

Husein

Dadabhoy

Rahimtoola

Nishat Dada Valika

Arag

Saigol

Shahnawaz

D a w o o d

A.K. K h a n

Isphani

Haroon

Crescent

Colony (F)

Reyaz-o-Khalid

A. Khaleeli

Habib

Represents at least one directorship by a family member of a monopoly house in a firm under the control of another monopoly house.

Colony (N)

Hyesons

Faruque

Amins

Figure A 3.1 Interlocking directorates 1970

Appendix 3. Case Study Evidence on Corporate Structures


Family’s Direct Holding

Post-Privatization Acquisition

Flagship Company

Associated Public Ltd. Operating Co.

Associated Public Company

Associated Pvt. Ltd. Co. holding

0.27 6.93 (% of total share value)

19.28

31.66

0.63 0.04

0.24

30

Figure A 3.2 Pyramiding in a Prominent Pakistani Business Group 1

Inter-Corporate Holding


Flagship Co. 1 Flagship Co. 3

Associated Pvt. Co. 1





73.82 0.67 0.77 (% of total share value)

50.01

19.86

19.52

1.91

0.24

5.72

0.11 16.10

1.60 4.68

5.06

Flagship Co. 2 60.28

Family’s Direct Holding


Figure A 3.3 Pyramiding in a Prominent Pakistani Business Group 2

Inter-Corporate Holding


Figure A 3.4 Cumulative Share of Market Capitalization and Turnover by Firm$


Securities and Exchange Commission of Pakistan

Appendix 4. The Code of Corporate Governance March 28, 2002 BOARD OF DIRECTORS (i) All listed companies shall encourage effective representation of independent non-executive

directors, including those representing minority interests, on their Boards of Directors so that the Board as a group includes core competencies considered relevant in the context of each listed company. For the purpose, listed companies may take necessary steps such that:

(a) minority shareholders as a class are facilitated to contest election of directors by proxy

solicitation, for which purpose the listed companies may:

• annex to the notice of general meeting at which directors are to be elected, a statement by a candidate(s) from among the minority shareholders who seeks to contest election to the Board of Directors, which statement may include a profile of the candidate(s);

• provide information regarding shareholding structure and copies of register of members to the candidate(s) representing minority shareholders; and

• on a request by the candidate(s) representing minority shareholders and at the cost of the company, annex to the notice of general meeting at which directors are to be elected an additional copy of proxy form duly filled in by such candidate(s) and transmit the same to all shareholders in terms of section 178 (4) of the Companies Ordinance, 1984;

(b) the Board of Directors of each listed company includes at least one independent director

representing institutional equity interest of a banking company, Development Financial Institution, Non-Banking Financial Institution (including a modaraba, leasing company or investment bank), mutual fund or insurance company; and

Explanation: For the purpose of this clause, the expression "independent director" means a director who is not connected with the listed company or its promoters or directors on the basis of family relationship and who does not have any other relationship, whether pecuniary or otherwise, with the listed company, its associated companies, directors, executives or related parties. The test of independence principally emanates from the fact whether such person can be reasonably perceived as being able to exercise independent business judgment without being subservient to any apparent form of interference. Any person nominated as a director under sections 182 and 183 of the Companies Ordinance, 1984 shall not be taken to be an "independent director" for the above said purposes. The independent director representing an institutional investor shall be selected by such investor through a resolution of its Board of Directors and the policy with regard to selection of such person for election on the Board of Directors of the investee company shall be disclosed in the Directors' Report of the investor company.

(c) executive directors, i.e. working or whole time directors, are not more than 75% of the

elected directors including the Chief Executive:

Provided that in special circumstances, this condition may be relaxed by the Securities and Exchange Commission of Pakistan.



Provided further that nothing contained in this clause shall apply to banking companies, which are required by Prudential Regulation No.9 for Banks to have not more than 25% of the directors as paid executives of the banks.

(ii) The directors of listed companies shall, at the time of filing their consent to act as such, give a

declaration in such consent that they are aware of their duties and powers under the relevant law(s) and the listed companies’ Memorandum and Articles of Association and the listing regulations of stock exchanges in Pakistan.

QUALIFICATION AND ELIGIBILITY TO ACT AS A DIRECTOR (iii) No listed company shall have as a director, a person who is serving as a director of ten other

listed companies. (iv) No person shall be elected or nominated as a director of a listed company if:

(a) his name is not borne on the register of National Tax Payers except where such person is a non-resident; and

(b) he has been convicted by a court of competent jurisdiction as a defaulter in payment of any

loan to a banking company, a Development Financial Institution or a Non-Banking Financial Institution or he, being a member of a stock exchange, has been declared as a defaulter by such the stock exchange; and

(v) A listed company shall endeavour that no person is elected or nominated as a director if he or his spouse is engaged in the business of stock brokerage (unless specifically exempted by the Securities and Exchange Commission of Pakistan).

TENURE OF OFFICE OF DIRECTORS (vi) The tenure of office of Directors shall be three years. Any casual vacancy in the Board of

Directors of a listed company shall be filled up by the directors within 30 days thereof. RESPONSIBILITIES, POWERS AND FUNCTIONS OF BOARD OF DIRECTORS (vii) The directors of listed companies shall exercise their powers and carry out their fiduciary duties

with a sense of objective judgment and independence in the best interests of the listed company. (viii) Every listed company shall ensure that:

(a) a ‘Statement of Ethics and Business Practices’ is prepared and circulated annually by its Board of Directors to establish a standard of conduct for directors and employees, which Statement shall be signed by each director and employee in acknowledgement of his understanding and acceptance of the standard of conduct;

(b) the Board of Directors adopt a vision/ mission statement and overall corporate strategy for the

listed company and also formulate significant policies, having regard to the level of materiality, as may be determined it;

Explanation: Significant policies for this purpose may include:



• risk management; • human resource management including preparation of a succession plan; • procurement of goods and services; • marketing; • determination of terms of credit and discount to customers; • write-off of bad/ doubtful debts, advances and receivables; • acquisition/ disposal of fixed assets; • investments; • borrowing of moneys and the amount in excess of which borrowings shall be sanctioned/

ratified by a general meeting of shareholders; • donations, charities, contributions and other payments of a similar nature; • determination and delegation of financial powers; • transactions or contracts with associated companies and related parties; and • health, safety and environment

A complete record of particulars of the significant policies, as may be determined, along with the dates on which they were approved or amended by the Board of Directors shall be maintained.

The Board of Directors shall define the level of materiality, keeping in view the specific circumstances of the listed company and the recommendations of any technical or executive sub-committee of the Board that may be set up for the purpose;

(c) the Board of Directors establish a system of sound internal control, which is effectively

implemented at all levels within the listed company; (d) the following powers are exercised by the Board of Directors on behalf of the listed company and

decisions on material transactions or significant matters are documented by a resolution passed at a meeting of the Board:

• investment and disinvestment of funds where the maturity period of such investments is six

months or more, except in the case of banking companies, Non-Banking Financial Institutions, trusts and insurance companies;

• determination of the nature of loans and advances made by the listed company and fixing a monetary limit thereof;

• write-off of bad debts, advances and receivables and determination of a reasonable provision for doubtful debts;

• write-off of inventories and other assets; and • determination of the terms of and the circumstances in which a law suit may be compromised

and a claim/ right in favour of the listed company may be waived, released, extinguished or relinquished;

(e) appointment, remuneration and terms and conditions of employment of the Chief Executive

Officer (CEO) and other executive directors of the listed company are determined and approved by the Board of Directors; and



(f) in the case of a modaraba or a Non-Banking Financial Institution, whose main business is investment in listed securities, the Board of Directors approve and adopt an investment policy, which is stated in each annual report of the modaraba/ Non-Banking Financial Institution.

Explanation: The investment policy shall inter alia state:

• that the modaraba/ Non-Banking Financial Institution shall not invest in a connected person, as defined in the Asset Management Companies Rules, 1995, and shall provide a list of all such connected persons;

• that the modaraba/ Non-Banking Financial Institution shall not invest in shares of unlisted companies; and

• the criteria for investment in listed securities.

The Net Asset Value of each modaraba/ Non-Banking Financial Institution shall be provided for publication on a monthly basis to the stock exchange on which its shares/ certificates are listed.

(ix) The Chairman of a listed company shall preferably be elected from among the non-executive directors of the listed company. The Board of Directors shall clearly define the respective roles and responsibilities of the Chairman and Chief Executive, whether or not these offices are held by separate individuals or the same individual.

MEETINGS OF THE BOARD (x) The Chairman of a listed company, if present, shall preside over meetings of the Board of

Directors. (xi) The Board of Directors of a listed company shall meet at least once in every quarter of the

financial year. Written notices (including agenda) of meetings shall be circulated not less than seven days before the meetings, except in the case of emergency meetings, where the notice period may be reduced or waived.

(xii) The Chairman of a listed company shall ensure that minutes of meetings of the Board of Directors

are appropriately recorded. The minutes of meetings shall be circulated to directors and officers entitled to attend Board meetings not later than 30 days thereof, unless a shorter period is provided in the listed company’s Articles of Association.

In the event that a director of a listed company is of the view that his dissenting note has not been satisfactorily recorded in the minutes of a meeting of the Board of Directors, he may refer the matter to the Company Secretary. The director may require the note to be appended to the minutes, failing which he may file an objection with the Securities and Exchange Commission of Pakistan in the form of a statement to that effect.

SIGNIFICANT ISSUES TO BE PLACED FOR DECISION BY THE BOARD OF DIRECTORS (xiii) In order to strengthen and formalize corporate decision-making process, significant issues shall

be placed for the information, consideration and decision of the Boards of Directors of listed companies.



Significant issues for this purpose may include:

• annual business plans, cash flow projections, forecasts and long term plans; • budgets including capital, manpower and overhead budgets, along with variance analyses; • quarterly operating results of the listed company as a whole and in terms of its operating

divisions or business segments; • internal audit reports, including cases of fraud or irregularities of a material nature; • management letter issued by the external auditors; • details of joint venture or collaboration agreements or agreements with distributors, agents,

etc; • promulgation or amendment of a law, rule or regulation, enforcement of an accounting

standard and such other matters as may affect the listed company; • status and implications of any law suit or proceedings of material nature, filed by or against

the listed company; • any show cause, demand or prosecution notice received from revenue or regulatory

authorities, which may be material; • default in payment of principal and/or interest, including penalties on late payments and other

dues, to a creditor, bank or financial institution or default in payment of public deposit; • failure to recover material amounts of loans, advances, and deposits made by the listed

company, including trade debts and inter-corporate finances; • any significant accidents, dangerous occurrences and instances of pollution and

environmental problems involving the listed company; • significant public or product liability claims likely to be made against the listed company,

including any adverse judgment or order made on the conduct of the listed company or of another company that may bear negatively on the listed company;

• disputes with labour and their proposed solutions, any agreement with the labour union or Collective Bargaining Agent and any charter of demands on the listed company; and

• payment for goodwill, brand equity or intellectual property. ORIENTATION COURSES (xiv) All listed companies shall make appropriate arrangements to carry out orientation courses for

their directors to acquaint them with their duties and responsibilities and enable them to manage the affairs of the listed companies on behalf of shareholders.

CHIEF FINANCIAL OFFICER (CFO) AND COMPANY SECRETARY APPOINTMENT AND APPROVAL (xv) The appointment, remuneration and terms and conditions of employment of the Chief Financial

Officer (CFO), the Company Secretary and the head of internal audit of listed companies shall be determined by the CEO with the approval of the Board of Directors. The CFO or the Company Secretary of listed companies shall not be removed except by the CEO with the approval of the Board of Directors.

QUALIFICATION OF CFO AND COMPANY SECRETARY (xvi) No person shall be appointed as the CFO of a listed company unless:



(a) he is a member of a recognized body of professional accountants; or

(b) he is a graduate from a recognized university or equivalent, having at least five years experience in handling financial or corporate affairs of a listed public company or a bank or a financial institution.

(xvii) No person shall be appointed as the Company Secretary of a listed company unless he is: (a) a member of a recognized body of professional accountants; or (b) a member of a recognized body of corporate/ chartered secretaries; or (c) a lawyer; or (d) a graduate from a recognized university or equivalent, having at least five years

experience of handling corporate affairs of a listed public company or corporation. REQUIREMENT TO ATTEND BOARD MEETINGS

(xviii) The CFO and the Company Secretary of a listed company shall attend meetings of the Board of

Directors.

Provided that unless elected as a director, the CFO or the Company Secretary shall not be deemed to be a director or entitled to cast a vote at meetings of the Board of Directors for the purpose of this clause. Provided further that the CFO and/ or the Company Secretary shall not attend such part of a meeting of the Board of Directors, which involves consideration of an agenda item relating to the CFO, Company Secretary, CEO or any director.

CORPORATE AND FINANCIAL REPORTING FRAMEWORK THE DIRECTORS’ REPORT TO SHAREHOLDERS (xix) The directors of listed companies shall include statements to the following effect in the Directors’

Report, prepared under section 236 of the Companies Ordinance, 1984: (a) The financial statements, prepared by the management of the listed company, present fairly its

state of affairs, the result of its operations, cash flows and changes in equity. (b) Proper books of account of the listed company have been maintained. (c) Appropriate accounting policies have been consistently applied in preparation of financial

statements and accounting estimates are based on reasonable and prudent judgment. (d) International Accounting Standards, as applicable in Pakistan, have been followed in

preparation of financial statements and any departure therefrom has been adequately disclosed.

(e) The system of internal control is sound in design and has been effectively implemented and monitored.

(f) There are no significant doubts upon the listed company’s ability to continue as a going concern.

(g) There has been no material departure from the best practices of corporate governance, as detailed in the listing regulations.

The Directors’ Reports of listed companies shall also include the following, where necessary:

(a) If the listed company is not considered to be a going concern, the fact along with reasons shall be disclosed.

(b) Significant deviations from last year in operating results of the listed company shall be highlighted and reasons thereof shall be explained.



(c) Key operating and financial data of last six years shall be summarised. (d) If the listed company has not declared dividend or issued bonus shares for any year, the

reasons thereof shall be given. (e) Where any statutory payment on account of taxes, duties, levies and charges is outstanding,

the amount together with a brief description and reasons for the same shall be disclosed. (f) Significant plans and decisions, such as corporate restructuring, business expansion and

discontinuance of operations, shall be outlined along with future prospects, risks and uncertainties surrounding the listed company.

(g) A statement as to the value of investments of provident, gratuity and pension funds, based on their respective audited accounts, shall be included.

(h) The number of Board meetings held during the year and attendance by each director shall be disclosed.

(i) The pattern of shareholding shall be reported to disclose the aggregate number of shares (along with name wise details where stated below) held by: • associated companies, undertakings and related parties (name wise details); • NIT and ICP (name wise details); • directors, CEO and their spouse and minor children (name wise details); • executives; • public sector companies and corporations; • banks, Development Finance Institutions, Non-Banking Finance Institutions, insurance

companies, modarabas and mutual funds; and • shareholders holding ten percent or more voting interest in the listed company (name

wise details).

Explanation: For the purpose of this clause, clause (b) of direction (i) and direction (xxiii), the expression “executive” means an employee of a listed company other than the CEO and directors whose basic salary exceeds five hundred thousand rupees in a financial year.

(j) All trades in the shares of the listed company, carried out by its directors, CEO, CFO,

Company Secretary and their spouses and minor children shall also be disclosed. FREQUENCY OF FINANCIAL REPORTING (xx) The quarterly unaudited financial statements of listed companies shall be published and circulated

along with directors’ review on the affairs of the listed company for the quarter. (xxi) All listed companies shall ensure that half-yearly financial statements are subjected to a limited

scope review by the statutory auditors in such manner and according to such Securities and Exchange Commission of Pakistan terms and conditions as may be determined by the Institute of Chartered Accountants of Pakistan and approved by the Securities and Exchange Commission of Pakistan.

(xxii) All listed companies shall ensure that the annual audited financial statements are circulated not later than four months from the close of the financial year.

(xxiii) Every listed company shall immediately disseminate to the Securities and Exchange Commission of Pakistan and the stock exchange on which its shares are listed all material information relating to the business and other affairs of the listed company that will affect the market price of its shares. Mode of dissemination of information shall be prescribed by the stock exchange on which shares of the company are listed.



This information may include but shall not be restricted to information regarding a joint venture, merger or acquisition or loss of any material contract; purchase or sale of significant assets; any unforeseen or undisclosed impairment of assets due to technological obsolescence, etc.; delay/ loss of production due to strike, fire, natural calamities, major breakdown, etc.; issue or redemption of any securities; a major change in borrowings including any default in repayment or rescheduling of loans; and change in directors, Chairman or CEO of the listed company.

RESPONSIBILITY FOR FINANCIAL REPORTING AND CORPORATE COMPLIANCE (xxiv) No listed company shall circulate its financial statements unless the CEO and the CFO present the

financial statements, duly endorsed under their respective signatures, for consideration and approval of the Board of Directors and the Board, after consideration and approval, authorize the signing of financial statements for issuance and circulation.

(xxv) The Company Secretary of a listed company shall furnish a Secretarial Compliance Certificate, in

the prescribed form, as part of the annual return filed with the Registrar of Companies to certify that the secretarial and corporate requirements of the Companies Ordinance, 1984 have been duly complied with.

DISCLOSURE OF INTEREST BY A DIRECTOR HOLDING COMPANY’S SHARES (xxvi) Where any director, CEO or executive of a listed company or their spouses sell, buy or take any

position, whether directly or indirectly, in shares of the listed company of which he is a director, CEO or executive, as the case may be, he shall immediately notify in writing the Company Secretary of his intentions. Such director, CEO or executive, as the case may be, shall also deliver a written record of the price, number of shares, form of share certificates (i.e. whether physical or electronic within the Central Depository System) and nature of transaction to the Company Secretary within four days of effecting the transaction. The notice of the director, CEO or executive, as the case may be, shall be presented by the Company Secretary at the meeting of the Board of Directors immediately subsequent to such transaction. In the event of default by a director, CEO or executive to give a written notice or deliver a written record, the Company Secretary shall place the matter before the Board of Directors in its immediate next meeting:

Provided that each listed company shall determine a closed period prior to the announcement of interim/ final results and any business decision, which may materially affect the market price of its shares. No director, CEO or executive shall, directly or indirectly, deal in the shares of the listed company in any manner during the closed period.

AUDITORS NOT TO HOLD SHARES (xxvii) All listed companies shall ensure that the firm of external auditors or any partner in the firm of

external auditors and his spouse and minor children do not at any time hold, purchase, sell or take any position in shares of the listed company or any of its associated companies or undertakings:

Provided that where a firm or a partner or his spouse or minor child owns shares in a listed company, being the audit client, prior to the appointment as auditors, such listed company shall take measures to ensure that the auditors disclose the interest to the listed Securities company within 14 days of appointment and divest themselves of such interest not later than 90 days thereof.



CORPORATE OWNERSHIP STRUCTURE (xxviii) Every company which is proposed to be listed shall, at the time of public offering, offer not less

than Rs. 100 million or 20% of the share capital of the company, whichever is higher, to the general public unless the limit is relaxed by the stock exchange with the approval of the Securities and Exchange Commission of Pakistan.

DIVESTITURE OF SHARES BY SPONSORS/CONTROLLING INTEREST (xxix) In the event of divestiture of not less than 75% of the total shareholding of a listed company,

other than a divestiture by non-resident shareholder(s) in favour of other nonresident shareholder(s) or a disinvestment through the process of privatization by the Federal or Provincial Government, at a price higher than the market value ruling at the time of divestiture, it shall be desirable and expected of the directors of the listed company to allow the transfer of shares after it has been ascertained that an offer in writing has been made to the minority shareholders for acquisition of their shares at the same price at which the divestiture of majority shares was contemplated. Where the offer price to minority shareholders is lower than the price offered for acquisition of controlling interest, such offer price shall be subject to the approval of the Securities and Exchange Commission of Pakistan.

AUDIT COMMITTEE COMPOSITION (xxx) The Board of Directors of every listed company shall establish an Audit Committee, which shall

comprise not less than three members, including the chairman. Majority of the members of the Committee shall be from among the non-executive directors of the listed company and the chairman of the Audit Committee shall preferably be a non-Securities and Exchange Commission of Pakistan executive director. The names of members of the Audit Committee shall be disclosed in ach annual report of the listed company.

FREQUENCY OF MEETINGS (xxxi) The Audit Committee of a listed company shall meet at least once every quarter of the financial

year. These meetings shall be held prior to the approval of interim results of the listed company by its Board of Directors and before and after completion of external audit. A meeting of the Audit Committee shall also be held, if requested by the external auditors or the head of internal audit.

ATTENDANCE AT MEETINGS (xxxii) The CFO, the head of internal audit and a representative of the external auditors shall attend

meetings of the Audit Committee at which issues relating to accounts and audit are discussed.

Provided that at least once a year, the Audit Committee shall meet the external auditors without the CFO and the head of internal audit being present. Provided further that at least once a year, the Audit Committee shall meet the head of internal audit and other members of the internal audit function without the CFO and the external auditors being present.



TERMS OF REFERENCE (xxxiii) The Board of Directors of every listed company shall determine the terms of reference of the

Audit Committee. The Audit Committee shall, among other things, be responsible for recommending to the Board of Directors the appointment of external auditors by the listed company’s shareholders and shall consider any questions of resignation or removal of external auditors, audit fees and provision by external auditors of any service to the listed company in addition to audit of its financial statements. In the absence of strong grounds to proceed otherwise, the Board of Directors shall act in accordance with the recommendations of the Audit Committee in all these matters.

The terms of reference of the Audit Committee shall also include the following:

(a) determination of appropriate measures to safeguard the listed company’s assets; (b) review of preliminary announcements of results prior to publication; (c) review of quarterly, half-yearly and annual financial statements of the listed company, prior to

their approval by the Board of Directors, focusing on: • major judgmental areas; • significant adjustments resulting from the audit; • the going-concern assumption; • any changes in accounting policies and practices; • compliance with applicable accounting standards; and • compliance with listing regulations and other statutory and regulatory requirements.

(d) facilitating the external audit and discussion with external auditors of major observations

arising from interim and final audits and any matter that the auditors may wish to highlight (in the absence of management, where necessary);

(e) review of management letter issued by external auditors and management’s response thereto; (f) ensuring coordination between the internal and external auditors of the listed company; (g) review of the scope and extent of internal audit and ensuring that the internal audit function

has adequate resources and is appropriately placed within the listed company; (h) consideration of major findings of internal investigations and management's response thereto; (i) ascertaining that the internal control system including financial and operational controls,

accounting system and reporting structure are adequate and effective; (j) review of the listed company’s statement on internal control systems prior to endorsement by

the Board of Directors; (k) instituting special projects, value for money studies or other investigations on any matter

specified by the Board of Directors, in consultation with the Chief Executive and to consider remittance of any matter to the external auditors or to any other external body;

(l) determination of compliance with relevant statutory requirements; (m) monitoring compliance with the best practices of corporate governance and identification of

significant violations thereof; and (n) consideration of any other issue or matter as may be assigned by the Board of Directors.

REPORTING PROCEDURE



(xxxiv) The Audit Committee of a listed company shall appoint a secretary of the Committee. The secretary shall circulate minutes of meetings of the Audit Committee to all members, directors and the CFO within a fortnight.

INTERNAL AUDIT (xxxv) There shall be an internal audit function in every listed company. The head of internal audit shall

have access to the chair of the Audit Committee. (xxxvi) All listed companies shall ensure that internal audit reports are provided for the review of external

auditors. The auditors shall discuss any major findings in relation to the reports with the Audit Committee, which shall report matters of significance to the Board of Directors.

EXTERNAL AUDITORS (xxxvii)No listed company shall appoint as external auditors a firm of auditors which has not been given a

satisfactory rating under the Quality Control Review programme of the Institute of Chartered Accountants of Pakistan.

(xxxviii)No listed company shall appoint as external auditors a firm of auditors which firm or a partner of which firm is non-compliant with the International Federation of Accountants' (IFAC) Guidelines on Code of Ethics, as adopted by the Institute of Chartered Accountants of Pakistan.

(xxxix) The Board of Directors of a listed company shall recommend appointment of external auditors for

a year, as suggested by the Audit Committee. The recommendations of the Audit Committee for appointment of retiring auditors or otherwise shall be included in the Directors’ Report. In case of a recommendation for change of external auditors before the elapse of three consecutive financial years, the reasons for the same shall be included in the Directors’ Report.

(xl) No listed company shall appoint its auditors to provide services in addition to audit except in

accordance with the regulations and shall require the auditors to observe applicable IFAC guidelines in this regard and shall ensure that the auditors do not perform management functions or make management decisions, responsibility for which remains with the Board of Directors and management of the listed company.

(xli) All listed companies are required to change their external auditors every five years. If for any

reason this is impractical, a listed company may at a minimum, rotate the partner in charge of its audit engagement after obtaining the consent of the Securities and Exchange Commission of Pakistan.

(xlii) No listed company shall appoint a person as the CEO, the CFO, an internal auditor or a director

of the listed company who was a partner of the firm of its external auditors (or an employee involved in the audit of the listed company) at any time during the two years preceding such appointment or is a close relative, i.e. spouse, parents, dependents and non-dependent children, of such partner (or employee).

(xliii) Every listed company shall require external auditors to furnish a Management Letter to its Board

of Directors not later than 30 days from the date of audit report. (xliv) Every listed company shall require a partner of the firm of its external auditors to attend the

Annual General Meeting at which audited accounts are placed for consideration and approval of shareholders.



COMPLIANCE WITH THE CODE OF CORPORATE GOVERNANCE (xlv) All listed companies shall publish and circulate a statement along with their annual reports to set

out the status of their compliance with the best practices of corporate governance set out above. (xlvi) All listed companies shall ensure that the statement of compliance with the best practices of

corporate governance is reviewed and certified by statutory auditors, where such compliance can be objectively verified, before publication by listed companies.

(xlvii) Where the Securities and Exchange Commission of Pakistan is satisfied that it is not practicable to comply with any of the best practices of corporate governance in a particular case, the Commission may, for reasons to be recorded, relax the same subject to such conditions as it may deem fit.

Clause Reference Brief Description Manner of

Enforcement Effective Date

(i) (ii) (iii) and (iv) (v) (vi) (vii), (viii)and (ix) (x), (xi)and (xii) (xiii) (xiv) (xv) (xvi) and(xvii) (xviii) (xix) (xx), (xxi),(xxii) and (xxiii) (xxiv) and(xxv) (xxvi)

Representation of independent non-executive directors, including those representing minority interests, on the Board of Directors of listed companies Filing of consent by directors Qualification and eligibility to act as a director Election/ nomination of a broker on the Board of Directors Tenure of office of directors Responsibilities, powers and functions of the Board of Directors Meetings of the Board of Directors Significant issues to be placed for decision by the Board of Directors Orientation courses Appointment and removal of CFO and Company Secretary Qualification of CFO and Company Secretary Requirement for CFO and Company Secretary to attend Board meetings The directors' report to shareholders Frequency of financial reporting Responsibility for financial reporting and corporate compliance Disclosure of interest by a director holding company's

Voluntary Mandatory Mandatory Voluntary Mandatory Mandatory Mandatory Mandatory Mandatory Mandatory Mandatory Mandatory Mandatory Mandatory Mandatory Mandatory

When next election is due When next election is due When next election is due When next election is due Immediate July 1, 2002 Immediate July 1, 2002 July 1, 2002 July 1, 2002 Immediately for new appointments Immediate For accounting periods ending on or after June 30, 2002 For accounting periods ending on or after June 30, 2002 For accounting periods ending on or after June 30, 2002 Immediate



(xxvii) (xxviii) (xxix) (xxx),(xxxi),(xxxii), (xxxiii) and(xxxiv) (xxxv) and (xxxvi) (xxxvii), (xxxviii), (xxxix) and (xl) (xli) (xlii) (xliii) (xliv) (xlv) and (xlvi)

shares Auditors not to hold shares Corporate ownership structure Divestiture of shares by sponsors/ controlling interest Audit Committee Internal Audit Appointment of external auditors Rotation of external auditors Appointment of a partner or employee of the external auditors in a key position within the listed company Management letter issued by external auditors Attendance of external auditors at Annual General Meeting Compliance with the Code of Corporate Governance

Mandatory Mandatory Mandatory Mandatory Mandatory Mandatory Mandatory Mandatory Mandatory Mandatory Mandatory

Immediate July 1, 2002 July 1, 2002 July 1, 2002 July 1, 2002 When next appointment of auditors is due When next appointment of auditors is due Immediately for new appointments For accounting periods ending on or after June 30, 2002 For accounting periods ending on or after June 30, 2002 For accounting periods ending on or after June 30, 2002


Appendix 5 The Legal Aspects of Corporate Governance in Pakistan By Osama Siddique Introduction Recent years have seen a spate of activity in and tremendous emphasis on the area of corporate governance all over the world. This development has been for a variety of reasons, ranging from a downturn in economic performance exposing otherwise undisclosed corporate governance weaknesses to downright corruption in the uppermost echelons of global corporations. The reasons why this area has been comparatively less studied in Pakistan have more to do with the level of development of its corporate sector. The past few years, however, have been very significant in terms of legal developments in the corporate governance area and some recently introduced laws and regulations are progressive and up to speed with the latest global trends. There is growing awareness in the legal and corporate circles in Pakistan that corporate governance is not just a sophisticated buzzword but is profoundly important to the sound functioning of a corporate system and fundamental to the establishment of investor and creditor confidence The following overview of the fast evolving legal regime governing corporate governance in Pakistan has been prepared, keeping in view certain internationally accepted standards and principles of good corporate governance. While there is a wealth of contemporary literature on the subject, these benchmarks for ‘best practices’ of corporate governance have been gleaned primarily from the report of a committee set up in the United Kingdom to look into the financial aspects of corporate governance, which was submitted under the chairmanship of Sir Adrian Cadbury on 1st December, 1992110. This seminal report (now widely known as and hereinafter referred to as the “Cadbury Report”) is regarded as one of the most penetrative and exhaustive contemporary studies of the issues of modern corporate governance and puts forward detailed findings and recommendations. The output of the Cadbury Report has been widely discussed in recent years and forms the basis of several subsequent reports on corporate governance and codes of best practices, including a code for corporate governance, which has been recently introduced in Pakistan. One significant area of corporate governance, which was not within the ambit of the Cadbury Report, is creditors’ rights. Partially to fill this gap and partially to supplement the Cadbury Report with another more recent study in the area, additional standards and principles, especially for the ‘creditor’s rights’ area have been obtained from a paper by La Porta, Lopez-de-Silanes, Shleifer and Vishny111 (the “La Porta Report”, the Cadbury Report and the La Porta Report are hereinafter collectively referred to as the “International Corporate Governance Reports”). The La Porta Report conducts an analysis of the corporate governance rules pertaining to the protection of the rights of shareholder and creditors in 49 countries, the origin of these rules and the quality and effectiveness of their enforcement. The La Porta Report thus offers standards with a very international appeal and applicability. This appendix states the corporate governance best practices from the International Corporate Governance Reports and then compares the best practice with Pakistani legal and regulatory provisions. The Corporate Governance Law Regime in Pakistan

110 Report of the Committee on the Financial Aspects of Corporate Governance. 1st December, 1992. 111 Rafael La Porta, Florencio Lopez-de-Silanes, and Andrei Shleifer -- Harvard University. Robert W. Vishny, University of Chicago. The Journal of Political Economy, Volume 106, Issue 6 (Dec, 1998), 1113-1155.


The following is a brief description of the main laws and primary agencies, which oversee and regulate corporate governance in Pakistan.

• Companies Ordinance, 1984 (Ordinance). This is the main overarching law in Pakistan relating to the governance and regulation of entities incorporated as companies and certain other associations. The Ordinance consolidates and amends the earlier laws relating to this area. The Ordinance also lays out the powers and functions of the Corporate Law Authority. The Corporate Law Authority is now replaced by the Securities and Exchange Commission of Pakistan (SECP) which inherited all the powers of the Corporate Law Authority under the Ordinance. The Ordinance further establishes the office of the Registrar who supervises the registration of companies and related documents and the corporate disclosure requirements and performs other related tasks. The Registrar is also equipped under the Ordinance with certain important investigative and fact-finding powers.

• Securities and Exchange Ordinance, 1969 (SE Ordinance). The Ordinance has been promulgated for the stated purpose of providing for the protection of investors, regulation of markets and dealings in securities and related matters and includes important provisions for the prevention of fraud and insider trading.

• Securities and Exchange Commission of Pakistan Act, 1997 (SECP Act). The SECP Act has established the SECP for the beneficial regulation of the capital markets and the superintendence and control of corporate entities. The SECP enjoys wide powers in this regard under the SECP Act. The SECP Act also lays out important provisions defining fraudulent and unfair trade practices as well as provisions defining powers of the SECP relating to the protection of minority shareholders, creditors, the regulation of the board of directors of listed companies and the internal management of the SECP.

• Financial Institutions (Recovery of Finances) Ordinance, 2001 (Recovery of Finances Ordinance). This Ordinance has been promulgated with the stated objective of safeguarding the interests of creditors/financial institutions. It prescribes a summary procedure for the facilitation of a swift recovery of defaulted loans.

• Provincial Insolvency Act, 1920. The Provincial Insolvency Act consolidates and amends the laws relating to insolvency.

Apart from the above main laws described above (Ordinance and related laws), the following recently introduced regulatory codes are playing an increasingly important role in contemporary corporate governance regulation in Pakistan.

• Code of Corporate Governance, 2002 (Code). The Code was introduced by the SECP in early 2002 for the stated purpose of establishing a framework of good corporate governance whereby a listed company can be managed in compliance with best practices. The Code has been prepared after a review of the leading international reports prescribing best practices for corporate governance, (including the Cadbury Report, which seems to have had a strong influence on its eventual shape) and is exhaustive in scope. (Please see Appendix A for the detailed text of the Code). The Code has been adopted by all the stock exchanges of the country by way of its incorporation in their respective listing regulations, so that all the listed companies in Pakistan are now required to comply with the provisions of the Code, according to a timeframe stated in the Code itself. The SECP plans to supervise such compliance by requiring that:

(i) All listed companies are to publish and circulate a statement along with their annual reports to set out the status of their compliance with the best practices of corporate governance;

(ii) All listed companies are to ensure that the statement of compliance with the best practices of corporate governance is reviewed and certified by statutory auditors,


where such compliance can be objectively verified, before publication by listed companies; and

(iii) Where the SECP is satisfied that it is not practicable to comply with any of the best practices of corporate governance in a particular case, SECP may, for reasons to be recorded, relax the same subject to such conditions as it may deem fit.

• Listed Companies (Prohibition of Insiders Trading) Guidelines, 2002 (Insider Trading Guidelines). The Insider Trading Guidelines deal extensively with the insider trading phenomenon and are a significant advancement in its regulation in Pakistan.

The Trichotomy of Shareholder/Creditor Rights protection in Pakistan It would be useful to compartmentalize the protection of the rights of the shareholders and creditors under Pakistani law under the following three heads.

1. Statutory Rights and Best Practice Guidelines. These are rights, which are already enshrined in the Ordinance and related laws and hence there are in-built protections in the laws. For example, the various rights and protections, which can be invoked by shareholders holding at least 10% of the value of the total shareholding can be put in this category because these are established rights which can be invoked whenever the requisite number of shareholders get together and decide to invoke them. To this list can be added the additional protections introduced by the Code and the Insider Trading Guidelines, which are of increasing importance.

2. Protection through the Regulatory Agencies. The SECP and the Registrar have special powers, which they can use on application of a shareholder or creditor or on their own initiative, to ensure that companies are not doing anything which can lead to fraudulent or negligent behaviour, resulting in a violation of the rights of shareholders and creditors.

3. Protection through the Courts. The Ordinance and related laws have special provisions, which provide shareholders and creditors with recourse to the courts under special circumstances. Over the years, the courts have made some significant contributions to the existing statutory protection for the rights of shareholders and creditors, by way of a further enhancement of and broadening of these rights.

The following is a synopsis of the laws, legal processes and guidelines, which currently exist in Pakistan, presented and structured under the standards derived from the International Corporate Governance Reports. These standards are laid out under the following broad categories:

(i) The structure and responsibilities of the Board of Directors (ii) Powers and duties of Executive Directors (iii) Role of the Non-Executive Directors (“NEDs”) and other executives (iv) Financial disclosure and reporting requirements of the Company (v) The role of Internal and External Auditors (vi) Prevention of Minority Shareholder oppression (vii) Other Shareholder rights (viii) Creditors’ rights

It is important to note here that the International Corporate Governance Reports provide relatively few generic benchmarks for creditors’ rights protection. This is owing to the primary emphasis of these reports on the relationship between boards of directors and shareholders as well as the diversity in the kinds and types of creditors and hence their rights, which make such rights less amenable to be reduced to some basic standards. For this reason, Creditors’ rights under the Pakistani legal system have been


discussed only to a limited extent in comparison with a set of internationally recognized standards and more as a self-contained, detailed analysis of the existing legal regime and its significant features. 1. Statutory Rights and Best Practice Guidelines

(i) The structure and responsibilities of the Board of Directors The basic idea being propounded by the International Corporate Governance Reports is that every public company should be headed by an effective board (with a Chairman of the Board of Directors, the Executive and Non-Executive directors, etc.), which can both lead and control the business. The board should meet regularly, retain full and effective control over the company and monitor the executive management. Furthermore, there should be a clearly accepted division of responsibilities at the head of the company, in order to ensure a balance of power and authority, such that no one individual has unfettered powers of decisions. Given the importance and particular nature of the Chairman’s role, it should in principle be separate from that of the Chief Executive. Where the Chairman is also the Chief Executive, it is essential that there should be a strong and independent element on the board, with a recognized senior member. The board is to collectively ensure, regardless of the particular responsibilities of certain directors, that it is meeting its obligations. Standard: Prevention of domination of Boards by one individual. Shareholders should properly constitute boards and to ensure that any one individual does not dominate the boards of their companies. To prevent any such domination, separate individuals should hold the offices of Chairman and Chief Executive. Standard: Responsibilities of Chairman. Chairman of the board is primarily responsible for the working of the board, for its balance of membership (subject to board and shareholder approval), for ensuring that all relevant issues are on the agenda, and for further ensuring that all directors (executive and non-executive alike) are enabled and encouraged to play their full part in its activities. The Chairman should be able to stand sufficiently back from the day-to-day running of the business to ensure that the board is in full control of the company’s affairs and alert to its obligations to the shareholders. Standard: Chairman’s nexus with the Non-Executive Directors (“NEDs”) and the Executive Directors. It is for the Chairman to make certain that the NEDs receive timely, relevant information tailored to their needs, that they are properly briefed on the issues arising at board meetings and that they make an effective contribution as board members in practice. It is equally for the Chairman to ensure that Executive Directors look beyond their executive duties and accept their full share of the responsibilities of governance. The above standards have been listed together because they are various facets of the same underlying idea, which is the vital importance of an effectively functioning and independent board. The following description essentially relates to all of the above standards. At the very outset it should be stated that the Ordinance and the related laws do not lay down a well-defined and distinct role for the Chairman of the board of directors. This essentially means that an essential component of the above standards, the role of the Chairman, has not received any detailed attention by the Ordinance and related laws. Therefore, it can be said that there is at least no statutory framework to ensure that the Chairman is actually required to meet the above-listed standards. Role of the Chairman Section 160 of the Ordinance deals with provisions as to ‘general meetings and votes’. Clause (3) of the section says “The chairman of the board of directors, if any, shall preside as chairman at every general meeting of the company, but if there is no such chairman, or if at any meeting he is not present within


fifteen minutes after the time appointed for holding the meeting, or is unwilling to act as chairman, any one of the directors present may be elected to be chairman, and if none of the directors are present or are unwilling to act as chairman, the members present shall choose one of their numbers to be chairman”. This shows that the Ordinance does not visualize a distinct individual performing a definite, continuing role as the Chairman along the lines of international standards. Furthermore, the Ordinance does not specifically preclude the possibility of the same person holding the office of Chairman and Chief Executive, thus leaving that possibility open. The Code, however, makes an attempt at giving some definite shape and direction to the role of the Chairman. The Code lays down that the Chairman of a listed company is to be preferably elected from among the NEDs of the listed company and that the board of directors is to clearly define the respective roles and responsibilities of the Chairman and the Chief Executive, whether or not these offices are held by separate individuals or the same individual (once again the possibility of a single person holding both these offices has not been precluded). The Code makes further attempts to formalize the role of the Chairman by requiring that, inter alia, (i) the Chairman, if present, preside over meetings of board of directors (which are required to meet at least once in every quarter of the financial year), and (ii) the Chairman ensure that the minutes of meetings of the board of directors are appropriately recorded and circulated. Role of the Chief Executive The Ordinance does provide certain checks on the powers of the Chief Executive. Section 203 of the Ordinance mandates that the Chief Executive cannot engage, directly or indirectly, in a business competing with the company’s business. The section further requires that the Chief Executive disclose to the company, in writing, the nature of such business and the interest therein. The mechanism for removing a Chief Executive who entrenches himself against the wishes of the directors is provided under Section 202 of the Ordinance which allows such a removal through a ‘special resolution’ (passed by at least three fourths of the total number of directors at the time). The Code also requires that the appointment, remuneration and other terms and conditions of employment of the Chief Executive and other executive directors of the listed company are determined and approved by the board of directors. Standard: Board meetings and general functioning. Boards should meet regularly, with due notice of the issues to be discussed, supported by necessary paperwork, and should record its conclusions. Standard: Appointment of committees by boards. The effectiveness of a board is buttressed by its structure and procedures. One aspect of the structure is the appointment of committees of the board, such as the audit, remuneration and nomination committees. Boards should recognize the importance of the finance function by making it the designated responsibility of a director, who should be a signatory to the accounts on behalf of the board and should have the right of access to the Audit Committee. Standard: Formal schedule of matters for Boards. Boards should have a formal schedule of matters specifically reserved for them for their collective decision, to ensure that the direction and control of the company remains firmly in their hands and as a safeguard against misjudgments and possible illegal practices. Quorum and frequency of Board meetings


Section 193 of the Ordinance lays down the quorum for a meeting of directors of a listed company as not less than one third of their number or four, whichever is greater. The directors of a public company are required to meet at least twice a year. In case of any default regarding the above there are financial penalties for the Chairman and the directors. Appointment of Committees by Boards The Ordinance and related laws do not elaborate upon the appointment of board committees. The Code has some important provisions relating to the appointment and functioning of audit committees, which are discusses under ‘the role of Internal and External Auditors’, later in this report. The Code generally visualizes and mentions the role of technical and executive subcommittees of the board, but does not elaborate much upon their exact duties and role. The decision making process of the board. The Ordinance and related laws do not shed any light on board decision making. However, the Code contains some important provisions to formalize and structure the decision making process of the board. One way that it tries to achieve this objective is through requiring more and better quality information so that the decisions of the board are informed. The other way is through laying out a fairly exhaustive list of areas that should be analyzed under the purview of strategic decision making. The following is a summary of these provisions: Key information to be placed for decision by the board of directors. In order to strengthen and formalize corporate decision making processes, the Code requires that significant issues be placed before the board for their information, consideration and decision of the directors of listed companies. The Code attaches an exhaustive list for this purpose. Vision/Mission statement and overall corporate strategy of the company. The Code requires that every listed company’s board of directors adopt a vision/mission statement and overall corporate strategy for the company. The Code lays out an extensive list of areas for which such significant policies may be made. It further requires that a complete record of the particulars of any such policies should be maintained by the company along with the dates on which they were approved or amended by the board of directors. The boards of directors are required further to define the level of materiality, keeping in view the specific circumstances of the company and the recommendations of any technical or executive subcommittee of the board that may be set up for the purpose. System of sound internal control. The Code further requires that the boards of directors of listed companies establish a system for sound internal control, which is effectively implemented at all levels within the company. It then lays out certain areas of decisions which should be taken by the boards of directors and documented through board resolutions, which include (with stated exceptions) (i) investment and disinvestments of funds; (ii) nature and limit of the loans advanced by the company; (iii) write-off of bad debts etc; (iv) write-off of inventories; and (v) compromise/waiver of lawsuits. Standard: Internal Codes of Ethics and Statement of Business Practice. It a good practice for boards of directors to draw up codes of ethics or statements of business practice and to publish them both internally and externally so that all employees know what standards of conduct are expected of them. Statement of Ethics and Business Practices. The Ordinance does not require the preparation of any such statement but once again the Code has tried to take an initiative in the area by requiring that every listed company is to prepare and circulate a ‘Statement of Ethics and Business Practices’ on an annual basis to


establish a standard of conduct for directors and employees, which statement is to be signed by each director and employee in acknowledgement of his acceptance and understanding of the standard of conduct. Restrictions under the Ordinance. The Ordinance does contain some important restrictions on certain practices, which form part of the governing ethical regime of companies. For instance, Section 195 of the Ordinance provides an extensive ban on the direct or indirect extension by a company of any loans to, or the provision of any guarantee or security in connection with a loan made by any other person to, or to any other person by, a director of the company or his relatives. Section 197 of the Ordinance prohibits a company from contributing any amount to any political party or for any political purpose to any individual or body, or else face penalties. Section 197-A of the Ordinance prohibits the distribution of gifts by a Company in any form to its members at its meetings, or face penalties. Standard: Board Remuneration. Shareholders are entitled to a full and clear statement of a director’s present and future benefits for their service and how they have been determined. Boards should appoint remuneration committees, consisting wholly or mainly of NEDs and chaired by a NED, to recommend to the board the remuneration of the executive directors in all its forms. Executive Directors should play no part in decisions on their own remuneration. Shareholders require that the remuneration of directors should be both fair and competitive. Section 191 of the Ordinance says that the remuneration of a director, for performing extra services, including holding the office of the chairman, shall be determined by the directors or the company in general meeting in accordance with the provisions in the company’s articles. The remuneration to be paid to any director for attending the meetings of the directors or a committee of directors shall not exceed the scale approved by the company or the directors, as the case may be, in accordance with the provisions of the articles. The process of setting remuneration, disclosure of such information and the appointment of remuneration committees are not mentioned in the Ordinance and related laws. Standard: Board’s responsibility towards prevention of fraud. The prime responsibility for the prevention and detection of fraud (and other illegal acts) is that of the board, as part of its fiduciary responsibility for protecting the assets of the company. Directors are responsible for maintaining a system of internal controls for the minimization of the risk of fraud. Once again the Ordinance and related laws do not dwell upon any mandatory mechanisms, which the directors are required to employ for the prevention of the commission of fraud. The preventive measures for detection and prevention of fraud can be analyzed, however, under four heads, namely:

(i) Statutory provisions. Under Pakistani law, these exists in the form of penalties which are expected to act as a deterrent against fraud, which are described below;

(ii) The control by creditors and shareholders through information made available to

them. The next section, which deals with director’s duties, and the one after which deals with disclosure and reporting requirements on part of the company, contain important disclosure requirements, which are the primary mechanism for shareholders and creditors to scrutinize the board and to detect the commission of any fraud.


(iii) The role of auditors. Both the internal and external audit functions of a company play a cardinal role in the detection and prevention of fraud. These are discussed in the separate section dealing with audits.

(iv) Insider Trading. This is a specific kind of fraudulent activity, which has become

increasingly important to manage in recent years and is dealt with in detail below. As mentioned above, the Ordinance does contain some specific penalties for fraudulent acts, which are as follows. Penalties for certain fraudulent acts

Penalty for fraudulently inducing persons to invest money. Section 66 of the Ordinance carries a penalty of up to three years imprisonment and up to a fine of Rs. 20,000 for anyone making any statement, promise or forecast which is untrue to induce other persons to acquire or dispose of shares. Section 153 lays down imprisonment of up to one year as a penalty for fraudulent entries or omissions from register of company. Prevention of insider trading The main objective of the Insider Trading Guidelines, a very recent legal initiative in this area, is to curb ‘insider trading’ in the security markets. The Insider Trading Guidelines prohibit the use of ‘unpublished price sensitive information’ by any person who at any time during the preceding six months has been associated with the concerned company either on his own or on behalf of someone else by dealing in such securities, disclosing such information to someone else or aiding him to deal in securities on the basis of such information. The Insider Trading Guidelines define ‘unpublished price sensitive information’ as the information concerning a company, which is not generally known or published by that company and is likely to materially affect the price of its securities. Any person found guilty of ‘insider trading’ is liable to penal action under section 15-B of the SE Ordinance. The Insider Trading Guidelines further provide that a person, dealing with the securities on the basis of unpublished price sensitive information shall be liable to compensate the person/entity suffering any loss or damage as a result of such transaction. If the issuer of a security fails to obtain prosecution of an action commenced against a person guilty of insider trading then the SECP or the person affected by such insider trading may obtain sanction of the court to enforce the liability. Under Para 7, the SECP may, on an application or suo moto, undertake to investigate into the books of accounts of an insider to check insider trading. The SECP may appoint an enquiry officer, who may be an auditor, for carrying out such investigation and the insider shall be under obligation to allow such officer access to his books and records, etc. Before taking any action on the basis of any enquiry, the SECP is bound to give the insider an opportunity of being heard and also to consider the explanations, if any, given by him. After receiving such explanation the SECP may, in order to protect the interest of investors and security markets and for due compliance of the SE Ordinance, restrain the insider from dealing in securities in any particular manner, or prohibit the insider from disposing of any of the securities acquired in violation of these regulations, or restrain the insider from communicating or providing counsel to any person in relation to dealing with the securities. The SE Ordinance also has sections relating to insider trading. Section 15-A of the SE Ordinance defines an insider and the act of insider trading in more or less the same terms as the guidelines, discussed above. Under Section 15-B of the SE Ordinance, the SECP may ask a person accused of insider trading to show cause as to why he should not be required to compensate any person who has suffered loss as a result of


insider trading. If the explanation given by the insider is not found satisfactory by the SECP then such person, in addition to his liability to compensate the sufferer, shall be punishable with the imprisonment for a term which may extend to three years or with a fine which may extend to three times the amount gained or loss avoided by such person. (ii) Director’s powers and duties

Standard: Qualifications and eligibility to act as a Director. Level and nature of checks on the Directors’ powers. (a) Qualifications and eligibility to act as a Director The basic qualification requirements for directors are an important first check to ensure that inappropriate people are not entrusted with the fiduciary position of a director. Section 187 of the Ordinance lays out some basic requirements for eligibility. These requirements pertain to requisite age, soundness of mind, solvency, absence of any conviction by a court for an offence involving moral turpitude, absence of an earlier debar from holding such office under the Ordinance and absence of any betrayal of lack of fiduciary behaviour with a declaration to that effect by a court and membership of company. The Code supplements these basic eligibility criteria with some additional mandatory requirements for listed companies, non-observance of which lead to disqualification of an ineligible nominee or director. These requirements are briefly as follows: In order to be eligible to become a director, a person should (i) have his name present on the register of National Tax Payers, except where such person is a non-resident; and (ii) such a person should have no prior conviction by a court as a defaulter in payment of any loan. Additionally, the Code says that listed companies are to endeavour that no person is elected or nominated as director if he or his spouse are engaged in the business of stock exchange brokerage (unless specifically exempted by the SECP). These additional requirements are self-explanatory in terms of the kind of people they want to preclude from directorships of listed companies and the reasons for doing so. (b) Level and nature of checks on the Directors’ powers Duties to disclose information on part of directors serve as the main mechanism for shareholders and creditors to remain abreast of the exact functioning and the performance of the directors. Furthermore, the quantity and quality of information disclosed determines their chances of detecting any foul play or conflict of interest, which may cloud the judgment and commitment to the welfare of the company of the directors. The quantity and quality of information which directors are obliged to communicate and the kind of activities they are precluded by law from engaging in are thus two important indications of the level of accountability control which the shareholders and creditors exercise over them. As to disclosure requirements on part of directors, the Ordinance provides various important checks and balances. The following are the main requirements. Directors and Officers are mandated by Sections 214 and 215 of the Ordinance to disclose the nature of their direct or indirect concerns or interests in any contract or arrangement entered into or to be entered into by or on behalf of the company. Section 216 of the Ordinance precludes discussion of or voting on any contract or arrangement in which the said director is, directly or indirectly, concerned or interested. A violation of the above sections can (apart from a financial penalty) lead to a court declaring a director as lacking fiduciary behaviour, under Section 217 of the Ordinance. There is also provision for disclosure of a director’s interest in contracts appointing chief executive, managing agent, full-time director or secretary, with non-compliance leading to a fine.


In addition to the provisions of the Ordinance, the Code has come up with some important disclosure requirements. Disclosure requirement for transactions in shares of the company. For listed companies, the Code has come up with the further requirement that any director, chief executive, executive or their spouses selling, buying or taking any position, whether directly or indirectly, in the shares of a listed company of which he is director, chief executive or executive, as the case may be, is to immediately notify the Company Secretary of such intentions and deliver a written record of the price, number of shares, form of share certificates and nature of the transaction. Such notice will be presented by the Company Secretary at the meeting of the board of directors immediately subsequent to such transaction. There is also a further provision requiring that each company determine a closed period prior to the announcement of interim/final results and any business decision, which may materially affect the market price of its shares, and no director, chief executive or executive shall, directly or indirectly, deal in the shares of that company in any manner during the closed period. There are prohibitions under Section 223 of the Ordinance on short selling and under Section 224 of the Ordinance on trading (in listed companies) of listed equity securities within six months on part of any director, chief executive, managing agent, chief accountant, secretary or auditor of a listed company or any person owing at least 10% beneficial interest in listed equity securities, either directly or indirectly. Standard: Training of Directors. Given the varying backgrounds, qualifications and experience of directors, it is highly desirable that they should all undertake some form of internal or external training; this is particularly important for directors, whether executive or non-executive, with no previous board experience. The Ordinance and related laws do not mandate that companies ensure any such compulsory training. The Code, however, has addressed this issue by requiring that all listed companies are to make appropriate arrangements to carry out orientation courses for their directors to acquaint them with their duties and responsibilities and to enable them to manage the affairs of the company on behalf of shareholders. Standard: Duration of Director’s service contracts. Director’s service contracts should not exceed three years without shareholders’ approval. This is an area where the Ordinance gives a specific mandatory direction. Section 180 of the Ordinance states that a director elected under the provisions of the Ordinance shall hold office for a period of three years unless he resigns earlier, becomes disqualified from being a director or otherwise ceases to hold office. The Code further affirms this by saying that the tenure of office of directors is to be three years. Standard: Access to professional advice by Directors. Directors should always be able to consult the company’s advisers for legal and financial advice in the furtherance of their duties. However, in this regard, if the directors consider it necessary to take independent legal or financial advice, they should be entitled to do so at the company’s expense through an agreed procedure. While the Ordinance and related laws provide mechanisms to ensure that directors have constant recourse to legal and financial advice from the company’s advisers, they do not provide the directors with a right to seek independent legal and financial advice. The Code has also not addressed this question (iii) Role of Non-Executive Directors (“NEDs”) and the Corporate Secretary


The Cadbury Report attaches special importance to the role of the NEDs. It visualizes the NEDs as performing two significant functions. First, NEDs will provide an independent review of the performance of the board and of the Chief Executive and an insurance that the Chairman (if the Chairman is also the Chief Executive, then a senior non-executive director) is aware of their views addressed to him regarding any concerns that they may have. Second, NEDs will take the lead where potential conflicts of interest arise with the recognition that the specific interests of the executive management and the wider interests of the company may at times diverge, e.g. over takeovers, boardroom succession, or directors’ pay. According to the Cadbury Report, the caliber of the non-executive members of the board is of special importance in setting and maintaining standards of corporate governance. NEDs are expected to bring an independent judgement to bear on issues of strategy, performance, resources, including key appointments, and standards of conduct. Standard: All boards should have a minimum of three non-executive directors, one of whom may be the Chairman of the company, provided he or she is not also its executive head. The majority of non-executives on a board should be independent of the company, which means that 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 judgment. The Ordinance and related laws do not visualize and provide a role for NEDs. The Code, however, takes some progressive and highly significant step in this direction by encouraging listed companies to ensure effective representation of independent NEDs, including those representing minority interests, on their boards of directors. The Code visualizes and lays out certain helpful procedural steps to ensure that minority shareholders as a class are facilitated to contest election of directors by proxy solicitation. Additionally, the Code recommends that the boards of directors of listed companies include at least one independent director representing institutional equity interest of a banking company, Development Financial Institution, Non-Banking Financial Institutions (including a modaraba, leasing company or investment bank), mutual funds and insurance companies. An independent director in this context is defined to mean a director who is not connected with the listed company or its promoters or directors on the basis of family relationship and who does not have any other relationship, whether pecuniary or otherwise, with the listed company, its associated companies, directors, executives or related parties. Such an independent director is to be selected by such investor through a resolution of its board of directors and the policy for such selection for election on the board of directors of the investee company is to be disclosed in the Director’s Report of the investor company. It is further recommended by the Code, that for listed companies, the executive directors (working or full-time directors) be not more than 75% of the elected directors including the Chief Executive. It must be noted that unlike all the other requirements in the Code, which are mandatory, the provisions pertaining to having NEDs on boards of directors of listed companies are on a voluntary adoption basis and just a recommended best practice. It remains to be seen whether these provisions will also become mandatory requirements in the fast changing corporate governance environment in Pakistan. Since the idea of introducing NEDs in Pakistani companies is still in relative infancy, the Code does not at this stage go into the further details pertaining to NEDS, which the Cadbury Report discusses. Standard: The role of the Company Secretary. The Company Secretary has a key role to play in ensuring that board procedures are both followed and regularly reviewed. All directors should have access to the advice and services of the Company Secretary and should recognize that the Chairman is entitled to the strong and positive support of the Company Secretary in ensuring the effective functioning of the board.


While Company Secretaries exist in the Pakistani corporate environment, the Ordinance and related laws do not specifically deal with the appointment and duties of the Company Secretary. The Code, however, takes an important step in this direction, as discussed below. Standard: Capability of the Secretary. The responsibility for appointment of a capable secretary and of ensuring that the secretary remains capable, and any question of the secretary’s removal, should be a matter for the board as a whole. Formalization of appointment of the Company Secretary and the CFO. The Code takes initiative in this area by formalizing the appointment and qualification requirements of both the Company Secretary as well as the Chief Financial Officer (CFO), two offices, which it considers important and which should be occupied by separate individuals. The Code requires that the Company Secretary and the CFO be appointed and their remuneration, terms and conditions of employment as well as removal be determined by the Chief Executive with the approval of the board of directors. Both the CFO and the Company Secretary are required by the Code to attend meetings of the board of directors. The Code requires that a Company Secretary be (a) a member of a recognized body of professional accountants; or (b) a member of a recognized body of corporate/chartered secretaries; or (c) a lawyer; or (d) a graduate from a recognized university or equivalent, having at least five years experience of handling corporate affairs of a listed public company or corporation. The Company Secretary is required to play an additional specific and important role, which is that in the event the director of a listed company is of the view that his dissenting note has not been satisfactorily recorded in the minutes of a meeting of the board of directors, he may refer it to the Company Secretary, requiring that the note be appended to such minutes (failing which he may file an objection with the SECP). As to the qualifications of the CFO, the Code requires that he be either, (a) a member of a recognized body of professional accountants; or (b) a graduate from a recognized university or equivalent, having at least five years experience in handling financial or corporate affairs of a listed public company or a bank or a financial institution. (iv) Financial Reporting and Disclosure Requirements The International Corporate Governance Reports underline the advantages to investors, analysts, other users and ultimately to the company itself of financial reporting rules which limit the scope for uncertainty and manipulation. They emphasize that the lifeblood of markets is information and barriers to the flow of relevant information represent imperfections in the market. What shareholders (and others) need from the report and accounts is a coherent narrative, supported by the company’s performance and prospects. The cardinal principle of financial reporting is that the view presented should be true and fair. Boards should aim for the highest level of disclosure consonant with presenting reports, which are understandable, while avoiding damage to their competitive position. Boards should also aim to ensure the integrity and consistency of their reports and they should meet the spirit as well as the letter of reporting standards. Standard: Yearly and Half-Yearly reporting. Listed companies must publish full financial statements annually and half-yearly reports in the interim. In between these major announcements, boards need to keep shareholders and the market in touch with their company’s progress. The guiding principle is openness and boards should aim for any intervening statements to be widely circulated, in fairness to


individual shareholders and to minimize the possibility of insider trading. Interim reports should be reviewed by auditors. Accounting rules for preparation of such interim reports should be clarified. The Ordinance provides a regime of detailed financial disclosure requirements on part of a company. The following are the main requirements. Annual accounts and balance sheet. Section 233 of the Ordinance mandates the presentation by directors of a balance sheet and a profit and loss account at every annual general meeting. These reports are to be accompanied by a proper auditor’s report and a director’s report which is then required to be sent to every member of the company and specified number of copies are required to be sent to the SECP, the stock exchange and the Registrar. Contents and preparation of balance sheet and profit and loss statements. Section 234 of the Ordinance states that the contents of the balance sheet should give a true and fair view of the affairs of the company and the profit and loss account/income and expenditure statement should give a true and fair view of the profit and loss/income and expenditure of the company for the financial year. Detailed standard schedules (provided in the Ordinance) are required to be followed in the preparation of these financial statements. In the case of listed companies, International Accounting Standards notified by the SECP in the Official Gazette are to be followed. Furthermore, a statement of changes in the financial position or statement of sources and application of funds is to form part of the balance sheet and profit and loss account. Accounting policies must be stated and if there is any change in such policies, auditors are to report whether they agree with such a change. Further formalization of the issuance of financial statements. The Code further tightens and augments the above provisions by requiring that a listed company cannot circulate its financial statements unless the Chief Executive and the CFO present such statements, endorsed under their signatures, for consideration and approval by the board of directors and the board after such consideration and approval, authorizes their issuance and circulation. In addition to this, the Company Secretary is required to furnish a secretarial compliance certificate with the Registrar to certify that the secretarial and corporate requirements of the Ordinance have been duly complied with. Director’s Report. Section 236 of the Ordinance requires such reports for public companies or private companies which are subsidiaries of a public company, to disclose, inter alia, (while stating the company’s affairs, recommended dividends, etc.) (i) any material changes and commitments affecting the financial position of the company; (ii) any material changes that have occurred during the financial year concerning the nature of the business of the company or in the classes of business in which the company has interest; (iii) full information and explanation as regards any reservation, observation, qualification or adverse remark contained in the auditor’s report; (iv) information about the pattern of holding of shares; (v) earning per share information; (vi) reasons for incurring loss and reasonable indication of future profit prospects; and (vii) information about defaults in payment of debts, if any, and reasons thereof. The Code further bolsters the extent/categories of information to be provided under a Director’s Report under Section 236 of the Ordinance by requiring that it provide statements to the effects that (a) the financial statements of the company present a fair picture; (b) proper books of account have been maintained; (c) appropriate accounting policies have been consistently applied; (d) international accounting standards, as applicable in Pakistan, have been followed; (e) a sound internal control system has been effectively implemented and monitored; (f) the listed company can continue as a ‘going concern’, beyond significant doubt; and (g) there has been no departure from the best practices of corporate governance, as detailed in the amended listing regulations of the stock exchanges after the introduction of the Code.


The Code further requires additional disclosures, where necessary, which pertain to diverse areas such key operating and financial information and deviations, dividends, taxes, corporate plans and decisions, investments, director attendance at board meetings, pattern of shareholding and trading in shares of company by directors, chief executive, other executives and their spouses and minor children. Preparation of Half-Yearly Statements. Section 245 of the Ordinance mandates listed companies to prepare (audited or otherwise) half-yearly profit and loss accounts as well as balance sheets. Authority of SECP to require additional information from companies. Section 246 of the Ordinance gives SECP the authority to require companies to prepare and send to members, Registrar, etc.; such other periodical statements of accounts, information or other reports in such form and manner and within such time as may be specified by it. Additional requirements including submission of quarterly reports. The Code takes the disclosure requirements a huge step further by requiring, inter alia, (a) publication and circulation of quarterly unaudited financial statements along with directors’ report; (b) limited scope review of half-yearly financial statements by statutory auditors in a manner approved by the SECP; (c) immediate dissemination to SECP and stock exchanges, of all such material information relating to business and other affairs of company that will affect its market price (the Code lists potential areas of such information). The following are some other disclosure requirements under the Ordinance, which give certain specific rights to the members of a company to have access to information. All these are tools for shareholders and creditors (when applicable) to remain informed as to how the company is being run and to protect their respective rights. Copies of updated memorandum and articles of the company. Sections 35 and 36 of the Ordinance require the Company to provide the same, upon request, within fourteen days of such a request. Right to inspect copies of instruments creating mortgages and charges and the company’s register of mortgages. Section 136 of the Ordinance provides this right to members, creditors and other persons during prescribed times and a defaulting company faces penalties. Register of Members and Debenture Holders. Sections 147 and 149 of the Ordinance require a company to maintain a register of members and a register of debenture holders in the prescribed form. Section 150 of the Ordinance mandates that these registers be open to inspection at prescribed times and default entails penalties. Requirement on part of a company to file annual list of members with the Registrar. Section 156 of the Ordinance mandates this and default carries a penalty. Minutes of proceedings of general meetings and meetings of directors. Section 173 of the Ordinance mandates the maintenance of books containing this information, which are open to the inspection of members at prescribed times. Register of directors and other officers. Section 205 of the Ordinance mandates the maintenance by companies of a regularly updated register of their directors and officers, at its registered office, which is to be open to inspection of members and other persons at prescribed times. All investment made by a company on its own behalf to be held in its own name. Record to be maintained of shares and securities invested in by a Company. Permissible investments under Section 209 of the


Ordinance are required to be recorded and open to the inspection of members, debenture-holders and creditors, during prescribed times. Maintenance of Register of contracts, arrangements and appointments in which directors, etc are interested. Section 219 of the Ordinance mandates the maintenance of such a register, open to inspection of members of the company during prescribed times. Register of director’s shareholdings. Section 220 of the Ordinance requires every listed company to maintain a register as respects each director, chief executive, managing agent, chief accountant, secretary or auditor of the company and every person holding at least ten percent of the beneficial interest in the company, the number, description and amounts of any shares in or debentures of the company and other related entities, which are held by him or in trust for him etc. Such register is to be open to inspection during prescribed times. It is the duty of directors etc to make disclosures to the company under Section 221 of the Ordinance for it to comply with the requirements of Section 220 of the Ordinance. Maintenance of proper book of accounts by the Company. Section 230 of the Ordinance requires that the books give a true and fair view of the state of affairs of the Company in order to qualify as ‘proper’. These are to be open to inspection by directors during business hours. The right of every member of a company to acquire from the company, on payment of a prescribed maximum sum, copies of balance sheet, income statement, director’s and auditor’s reports. Section 243 of the Ordinance gives this right to the members and Section 247 of the Ordinance gives the same right to debenture holders. (v) The Role of Internal and External Auditors The Cadbury Report attaches great importance to the audit dimension of corporate governance. In this direction, it essentially gives recommendations for the audit function to be strengthened at three different levels, namely (i) audit committees; (ii) internal audit function; and (iii) external auditors. It would be useful to give a brief synopsis of these recommendations in order to better gauge the legal regime pertaining to auditing in Pakistan. (i) Audit Committees. The Cadbury Report regards audit committees as an important safeguard against the commission of fraud in a company. According to it, the audit committees have an important role to play in considering whether any extra work should be undertaken in addition to the normal audit procedures to investigate defenses against fraud, and in reviewing reports on the adequacy of internal control systems. The audit committee also provides a forum in which auditors can discuss at board level any concern they may have about the possibility of fraud by senior management. It is the responsibility of boards to establish what their legal duties are and to ensure that they monitor compliance with them. This would be enhanced if the auditor’s role were to check that boards had established their legal requirements and that a working system for monitoring compliance was in place. The Cadbury Report goes into great detail as to their creation and functioning. It states that (a) audit committees should be formally constituted to ensure that they have a clear relationship with the board to whom they are answerable and to whom they should report regularly. They should be given written terms of reference which deal adequately with their membership, authority and duties, and they should normally meet at least twice a year; (b) audit committees should comprise of a minimum of three members. Membership should be confined to the NEDs of the company and a majority of the non-executives serving on the committee should be independent; (c) The external auditor should normally attend audit committee meetings, as should the finance director. Because the board as a whole is responsible for the


financial statements, other board members should also have the right to attend. The audit committee should have a discussion with the external auditors, at least once a year, without executive board members present, to ensure that there are no unresolved issues of concern; (d) The audit committee should have explicit authority to investigate any matters within its terms of reference, the resources which it needs to do so, and full access to information. The audit committee should be able to obtain external professional advice and to invite outsiders with relevant experience to attend if necessary. Standard: Composition and functioning of audit committees. While the Ordinance does not contain any relevant provisions, the Code comes up with detailed requirements for listed companies in the areas of audit committees with provisions as to their composition, frequency of meetings, attendance at meetings, terms of reference and reporting procedure. These provisions are forward-looking and closely tally with the recommendations of the Cadbury Report. The following is a synopsis of these requirements under the Code. Composition of audit committee. Listed companies are required to establish such committees comprising of not less than three members (including the Chairman, and with the majority of the members coming from the NEDs of the company and the chairman of the audit committee preferably being an NED). Meetings of audit committee. The audit committee is required to meet once every quarter of a financial year and also whenever requested by the external auditor or head of internal audit. Attendance at meetings of audit committee. The CFO, head of internal audit and a representative of the external auditors are required to attend meetings of the audit committee, at which issues relating to accounts and audit are discussed. At least once a year, the audit committee is required to meet the external auditors without the CFO and head of internal audit and once a year the audit committee should meet with the head of internal audit without the CFO and external auditors. Terms of reference of audit committees. The board of directors of a listed company are required to determine the terms of reference of the audit committee and they shall, among other things, recommend the appointment of external auditors to the board of directors as well as provide direction in other related matters such as resignation/removal of external auditors, their audit fees and the provision of additional services by external auditors. The Code actually lays out several ingredients, which the terms of reference of the audit committee should contain, which include, inter alia, measures to safeguard company’s assets, review of periodic financial statements with a focus on important stated areas, facilitation of the external audit, coordination of the internal and external audit functions, review of the scope and extent of internal audit, consideration of various major findings of internal investigations, internal financial and operational controls, accounting systems, reporting structures, compliance with statutory requirements, institution of special projects/value for money studies, monitoring compliance with the code and other issues or matters assigned by board of directors. (ii) Internal audit functions. The Cadbury Report propounds it as a good practice for companies to establish internal audit functions to undertake regular monitoring of key controls and procedures. Heads of internal audit should have unrestricted access to the chairman of the audit committee in order to ensure the independence of their position. Directors should report on the effectiveness of their system of internal control, and the auditors should report on their statement. An effective internal control system is an essential part of the efficient management of a company. Standard: Provision and efficacy of the internal audit function.


The Code also requires that there be an internal audit function in every listed company whose head has access to the person chairing the audit committee. All listed companies are required to ensure that internal audit reports are provided for the review of external auditors and that auditors discuss any major findings in relation to the report with the audit committee, which shall report matters of significance to the board of directors. (iii) External auditors. The Cadbury Report emphasizes the annual external audit as one of the cornerstones of corporate governance. Given the separation of ownership from management, the directors are required to report on their stewardship by means of the annual report and financial statements sent to the shareholders. The audit provides an external and objective check on the way in which the financial statements are prepared and presented, and it is an essential part of the checks and balances required. The question is not whether there should be an audit, but how to ensure its objectivity and effectiveness. Audits are a reassurance to all who have a financial interest in companies, quite apart from their value to boards of directors. The most direct method of ensuring that companies are accountable for their actions is through open disclosure by boards and through audits carried out against strict accounting standards. One central requirement of the entire process is to ensure that an appropriate relationship exists between the auditors and the management whose financial statements they are auditing. Shareholders require auditors to work with and not against management, while always remaining professionally objective – that is to say, applying their professional skills impartially and retaining a critical detachment and a consciousness of their accountability to those who formally appoint them. Another important requirement is that there be full disclosure of fees paid to audit firms for non-audit work. The essential principle is that disclosure must enable the relative significance of the company’s audit and non-audit fees to the audit firm to be assessed. It as also a good practice for audit committees to keep under review the non-audit fees paid to the auditor both in relation to their significance to the auditor and in relation to the company’s total expenditure on consultancy. For listed companies, a periodic change of audit partners should be arranged to bring a fresh approach to the audit. The Cadbury report clarifies that the auditor’s role is to report whether the financial statements give a true and fair view. The auditor’s role is not to prepare the financial statements, nor to provide absolute assurance that the figures in the financial statements are correct, nor to provide a guarantee that the company will continue in existence. The audit is essentially designed to provide a reasonable assurance that the financial statements are free of material misstatements. The external auditors should be present at board meetings when the annual reports and accounts are approved and preferably when the half-yearly report is considered as well. Standard: Appointment, quality and independence of external auditors. The Ordinance lays out a mechanism for the appointment and functioning of external auditors. Section 252 of the Ordinance states that external auditors have to be appointed at every annual general meeting to serve till the next general meeting (in case of the appointment of the first auditors, the appointment is made by the directors) and where the company fails to appoint auditors at the stated time or there is a vacancy for any other reason, SECP can appoint a person to fill the vacancy. The remuneration of auditors is fixed by the directors or the SECP or the company in a general meeting or in such a manner as the general meeting may determine, depending on who makes the appointment. Professional qualification requirements for external auditors. Section 254 of the Ordinance mandates that the auditor for a public company or a private company which is the subsidiary of a public company or a private company having a paid up capital of three million rupees or more, has to be a Chartered Accountant within the meaning of the Chartered Accountant Ordinance of 1961. A person cannot be


appointed as an auditor if; (a) he was, at any time during the preceding three years, a director, other officer or employee of the company; (b) he/she is a partner of, or in the employment of a director, officer or employee of the company; (c) he/she is the spouse of a director of the company; (d) he/she is indebted to the company; or (e) it is a body corporate. Auditor’s right of access to company records/information. Section 255 of the Ordinance gives auditors the right of access at all times to books, papers, accounts and vouchers of the company and all information and explanation which he thinks necessary for performance of duties. Auditors are mandated to make a detailed report to members on the accounts and all related documents with their analysis and conclusions as to whether they meet the requirements of the Ordinance, and inter alia; (a) whether or not they have obtained all the information and explanations which to the best of their knowledge and belief were necessary for the audit; (b) whether proper books of accounts have been kept; (c) the balance sheet and profit and loss account have been drawn up in conformity with the Ordinance and are in agreement with the books of accounts; and (d) whether the said accounts give the information required by the Ordinance and give a true and fair view. Where the auditors answer in the negative as to any of the aforementioned matters or with a qualification, the report shall state the reasons for such an answer along with the factual position to the best of the auditor’s information. Right to attend meetings. Auditors are entitled to attend any general meeting and to be heard at such a meeting. For listed companies, the auditors are required to be present in the general meeting in which the balance sheet and profit and loss account and auditor’s report are to be considered. The Code, bolsters and supplement the above by reemphasizing and requiring, inter alia, that only those firms are appointed as external auditors; (a) which have been given a satisfactory rating by the Quality Control Review Program of Institute of Chartered Accountants of Pakistan (ICAP) and (b) which are compliant with International Federation of Accountant’s (IFAC) guidelines on Code of Ethics, as adopted by ICAP; Furthermore, the Code states that auditors will be required to only provide services in relation to audit except in accordance with the regulations and will be further required to observe applicable IFAC guidelines and it shall be ensured that they do not perform management functions or make management decisions. Additionally, listed companies are now required to change their auditors every five years and if for any reason this is impractical then as a minimum they will rotate the partner in charge of its audit engagement after obtaining the consent of the SECP. The Code further requires that no listed company shall appoint as CEO, CFO, an internal auditor or a director someone who was a partner of the firm of its external auditors (or an employee involved in the audit of the listed company) at any time during the two years preceding such appointment or someone who is a close relative, i.e. spouse, parents, dependent and non-dependent children, of such partner (or employee). The Code also requires that a partner of the firm of the external auditors shall be required to attend the Annual general Meeting at which audited accounts are placed for consideration and approval of shareholders. Auditors not to hold shares. All listed companies are required by the Code to ensure that the firm of external auditors or any partner in that firm and his spouse and minor children do not at any time, hold, purchase, sell or take any position in shares of the listed company or any of its associated companies or undertakings. (vi) Prevention of minority shareholder oppression Standard: The right to protection mechanisms for minority shareholders. Also, it is considered good practice if the minority shareholders (minority shareholders are defined as those shareholders who own 10% of share capital or less) are granted either a judicial venue to challenge the decisions of management or the right to step out of the company by requiring the company to purchase their shares when they


object to certain fundamental changes, such as mergers, asset dispositions, and changes in the articles of incorporation. The Ordinance and related laws and the Code contain several provisions, which provide special protection to minority shareholders and other special interest groups. There can be several acts of a company, which can fundamentally alter the rights of the minority shareholders. Some key protections in such areas under the Ordinance are as follows. Alteration to the Memorandum of Association. According to Section 21 of the Ordinance, a Company cannot make any alteration (which requires a ‘special’ resolution passed by three fourths of its members) to its Memorandum of Association without seeking the confirmation of the SECP. SECP’s duty to safeguard minority rights/rights of creditors. According to Section 23 of the Ordinance, while exercising its authority in terms of an alteration under Section 21 of the Ordinance, the SECP is to have regard to the rights and interests of members or any class of members of the company as well as the rights and interests of the creditors and may allow time by adjourning its proceedings to facilitate arrangements for the purchase of the interests of dissident members and may also give such orders/directions as are necessary to carry such arrangements into effect. Alteration to Articles of Association. Section 28 of the Ordinance requires a ‘special resolution’ passed by three fourths of the members of a company for it to alter any of its articles of association. However, if such alteration affects the substantive rights or liabilities of members or of a class of members then at least three fourths of such members or class of members to be affected need to vote for such alteration for it to take affect. Effect of alteration in memorandum/articles. Section 34 of the Ordinance mandates that no member of a company is bound by such an alteration which requires him to take, or subscribe for more shares than the number he holds or which increases his liability to contribute to the share capital of, or otherwise to pay money to the company unless he agrees in writing to be bound by such alteration. Judicial recourse for minority shareholders The following is an important rights protection in the form of judicial recourse to the court by the minority shareholders. Variation of rights of Shareholders of a class. Section 108 of the Ordinance provides that while the variation of the rights of shareholders of any class shall be effected only in the manner laid down in Section 28 of the Ordinance (above), 10% or more of the class of shareholders who are aggrieved by any such variation of their rights may, within thirty days of the date of the resolution varying their rights, apply to the Court for an order canceling the resolution. The Court is thus entrusted with the task of ensuring that these shareholders are not the victims of any unfair prejudice or a decision based on not all the relevant information. Petition to declare a general meeting invalid. Section 161(8) of the Ordinance allows members having at least ten percent voting power to petition to the court, within thirty days of the impugned meeting, that proceedings of a general meeting be declared invalid by reason of a material defect or omission in the notice or irregularity in the proceedings of the meeting, which prevented members from effectively using their rights. Resolution by Minority Shareholders. Section 164(2) of the Ordinance allows members with at least ten percent voting power in the company to give notice of a resolution and such resolution together with the


supporting statement, if any, which they propose to be considered at the meeting, shall be forwarded so as to reach the company and the company shall forthwith circulate such resolution to all members. Demand for polls by Minority Shareholders. Section 167(c) and (d) of the Ordinance require the Chairman to, before or on the declaration of the result of the voting on any resolution on a show of hands, order a poll upon the demand of, inter alia, any member or members present in person or by proxy having at least one-tenth of the total voting power in respect of the resolution as well any member or members present in person or by proxy and holding shares in the company conferring a right to vote on the resolution, being shares on which an aggregate sum has bee paid up which is not less than one-tenth of the total sum paid up on all the shares conferring that right. The following section contains an important protection for minority shareholders in a situation where scheme of transfer of shares is being implemented. According to Section 289 of the Ordinance, if within 120 days of such an offer by transferee company, it has been approved by holders of at least nine-tenths in value of shares whose transfer is involved (other than shares already held at the date of the offer by, or by a nominee for, the transferee company or its subsidiary) the transferee company may at any time, within 60 days after expiry of said 120 days, give notice to any dissenting shareholders of its desire to acquire his shares. After such a notice (unless dissenting shareholders make an application within 30 days of the notice and court thinks it fit to order otherwise) the transferring company will be entitled and bound to acquire these shares on the same terms as the ones on which shares of the approving share-holders are being acquired. The Code provides protection to minority shareholders in a scenario where a company is divesting its shares. Divesture of shares by sponsors/controlling interest. The Code provides a minority shareholder protection by stating that in the event of a divesture of not less than 75% of the total shareholding of a listed company (with some exceptions), at a price higher than the market value at that time, it shall be desirable and expected of the directors to allow such transfer after it has been ascertained that an offer in writing has been made to the minority shareholders for acquisition of their shares at the same price at which divesture of majority shares was contemplated (where the price is lower, such offer price will be subject to the approval of the SECP). (vii) Other Shareholder rights The International Corporate Governance Reports emphasize the accountability of boards to shareholders. The formal relationship between the shareholders and the board of directors is that the shareholders elect the directors, the directors’ report on their stewardship to the shareholders and the shareholders appoint the auditors to provide an external check on the directors’ financial statements. Thus the shareholders as owners of the company elect the directors to run the business on their behalf and hold them accountable for its progress. The issue for corporate governance is how to strengthen the accountability of boards of directors to shareholders. While we have already discussed various dimensions of this relationship, the following are some additional internationally recognized rights of shareholders. Standard: One share-one vote. Ordinary shares should carry one vote per share. It is desirable to have prohibition on the existence of both multiple-voting and nonvoting ordinary shares. Also, it is desirable if firms are not allowed to set a maximum number of votes per shareholder irrespective of the number of shares owned.


The one share-one vote standard is ensured under Pakistani law by the following provisions. These provisions underline the prohibition of the undesirable practices mentioned in the statement of the standard above. Section 160(4) of the Ordinance states that in every company having share capital, every member shall have votes proportionate to the paid-up value of the shares or other securities carrying voting rights held by him according to the entitlement of the class of such shares or securities, as the case may be. Section 160(5) of the Ordinance states that no member carrying shares or other securities carrying voting rights shall be debarred from casting his vote, nor shall anything contained in the articles have the effect of so debarring him. Section 160(6) of the Ordinance states that for companies limited by guarantee and having no share capital, every member thereof shall have one vote. Standard: Proxy by mail. It is considered good practice if shareholders are allowed to mail their proxy vote to the firm. The Ordinance and related laws as well as the Code do not allow for mailing a proxy vote. The following is a synopsis of the law relating to ordinary and proxy voting. Section 160(7) of the Ordinance says that on a poll, votes may be given either personally or by proxy. There is no provision here for proxy by mail and the proxy has to be through another person. Section 168 of the Ordinance says that any proxy appointed by a member shall have such rights as respects speaking and voting at the meeting as available to a member but a member shall not be entitled to appoint more than one proxy to attend the meeting and a proxy must also be a member unless the articles of the company permit appointment of a non-member as proxy. Standard: Shares not blocked before meeting. It is considered good practice if firms are not allowed to require that shareholders deposit their shares prior to a general shareholders meeting, thus preventing them from selling those shares for a number of days. The Ordinance and related laws as well as the Code make no provision for such a practice, neither do they disallow it. Standard: Cumulative voting or proportional representation. It is considered good practice if the shareholders are allowed to cast all their votes for one candidate standing for election to the board of directors (cumulative voting) or if a mechanism of proportional representation in the board is allowed by which minority interests may name a proportional number of directors to the board. The Ordinance and related laws as well as the Code make no provision for such practices. Standard: Preemptive rights. It is considered good practice that shareholders are granted the first opportunity to buy new issues of stock, and this right can be waived only by a shareholder’s vote. The Ordinance provides for this right of the shareholders. Further issuance of Capital. Section 86 of the Ordinance states that where directors decide to increase capital by issuance of further shares, such shares are to be issued to each existing member strictly in proportion to his present shareholding, irrespective of class, and such offer to be made by notice,


specifying the number of shares to which the member is entitled and stating the time within which the offer is to be accepted, otherwise deemed declined. However, the Federal Government may, on an application made by a public company on the basis of a special resolution passed by it, allow such a company to raise its further capital without issue of right shares. Standard: Percentage of share capital to call an extraordinary shareholders’ meeting. The minimum percentage of ownership of share capital that entitles a shareholder to call for an extraordinary shareholders’ meeting is less than or equal to 10%. This right is enshrined in the Ordinance in the following terms. Section 159 of the Ordinance requires the directors of a company to call an extraordinary general meeting of the company to consider any matter which requires the approval of a company in a general meeting and the company is to, on the requisition of members representing at least 1/10th in value of the voting power on the date of the deposit of the requisition, forthwith proceed to call an extraordinary general meeting. The requisitionists, or a majority of them in value, may themselves call a meeting, if the director’s do not proceed within twenty-one days from the date of the requisition being so deposited to cause a meeting to be called. Any default entails penalties. Standard: Mandatory dividend. It is a good practice for a company to declare a dividend once it reaches the target of a given percentage growth in net income. While the Ordinance does not mandate any such given percentage and a consequential compulsory payment of dividend, it has some other important provisions covering this area that provide protection to the shareholders. The amount and source of dividends. Section 248 of the Ordinance mandates that no dividend can exceed the amount recommended by the directors and cannot be paid out of any profits made through sale or disposal of immovable property or assets of a capital nature (unless such transactions wholly or partly form the business of the company). Section 249 of the Ordinance mandates that Dividends can only be paid out of the profits of the Company and Section 250 of the Ordinance says that such dividends can only be paid out to registered shareholders or to their order or to their bankers. Time limit within which to pay announced dividends. Section 251 of the Ordinance requires that when a dividend has been declared, it has to be paid within forty-five days of the declaration, in case of listed company, and within thirty days of declaration, for other companies (unless a listed defense can be invoked). Defaulting chief executive may be imprisoned for up to two years and fines up to a million rupees. Standard: Mandatory Annual General Meeting. Reports and accounts are presented to shareholders at the Annual General Meeting, when they have the opportunity to comment on them and to put their questions. In particular, the Annual General Meeting gives all shareholders, whatever the size of their shareholding, direct and public access to their boards. In the Committee’s view, both shareholders and boards of directors should consider how the effectiveness of general meetings could be increased and as a result the accountability of boards to all their shareholders strengthened. The Ordinance contains the following provisions relating to this area. Annual General Meetings. Section 158 of the Ordinance mandates that every company is to hold, in addition to any other meetings, a general meeting, as its annual general meeting, within eighteen months of its incorporation and thereafter once at least in every calendar year within a period of six months


following the close of its financial year and not more than fifteen months after the holding of its last preceding annual general meeting. For listed companies, the SECP, and for other companies, the Registrar may for any special reason extend the time within which any annual meeting, not being the first such meeting, shall be held by a period not exceeding ninety days. Extraordinary general meetings. Section 159 of the Ordinance, as more briefly described above, allows the directors to at any time call such a meeting to consider any matter which requires the approval of the company in a general meeting and on the on the requisition of members representing at least one-tenth of the voting power on the date of the deposit of the requisition, they are required to forthwith proceed to call an extraordinary general meeting. The requisitionists, or a majority of them in value, may themselves call a meeting, if the director’s do not proceed within twenty-one days from the date of the requisition being so deposited to cause a meeting to be called. Any default entails penalties. Power of Registrar to call meetings. Section 170 gives the Registrar the power to call, inter alia, any annual general meeting or extraordinary general meeting, if there has been a default in the holding of any such meetings, either of his own motion or on the application of any director or member of the company and there is a penalty for any default in complying with the Registrar’s directions. Institutional shareholders largely hold shares on behalf of individuals, as members of pension funds, holders of insurance policies and the like. As a result, there is an important degree of common interest between individual and institutional shareholders. In particular, both have the same stake in the standards of financial reporting and of governance in the companies in which they invest. Given the weight of their votes, the way in which institutional shareholders use their power to influence the standards of corporate governance is of fundamental importance. Institutional investors should encourage regular, systematic contact at senior executive level to exchange views and information on strategy, performance, board membership and quality of management. Institutional investors should make positive use of their voting rights, unless they have good reason for doing otherwise. They should register their votes wherever possible on a regular basis. Institutional investors should take a positive interest in the composition of boards of directors. Protection through the Regulatory Agencies Powers of Registrar and SECP under the Ordinance The Registrar and the SECP play an increasingly important regulatory role in the Pakistani corporate governance environment. The following is an overview of some of their more important powers under the Ordinance in the context of the protection of the rights of shareholders and creditors. The Registrar has important and significant powers to require companies to divulge information, if he thinks it is important for any reason for him have access to such information while looking into a matter. This serves as an important weapon against a company not coming clean with information. Power of Registrar to call for information or explanation. Section 261 of the Ordinance provides that if the Registrar thinks that any information, explanation or document is necessary, he may in writing call for it (within a specified time frame not less than 14 days). If no information furnished within specified time or inadequate information provided, the Registrar may through a written order call for production of any books or papers which he considers necessary and it will be duty of company and such persons to provide the same within the specified time frame. If still a default, then apart from financial penalty and the penalty that every defaulting officer punishable with imprisonment for up to one year, the Authority trying the offence may, on the Registrar’s application make an order, directing the Company to produce


such books or papers as in its opinion may reasonably be required by Registrar. If still no information, explanation, book or paper furnished, as required by the Registrar or such a submission shows an unsatisfactory state of affairs or does not disclose a full and fair statement of the matter, the Registrar may report in writing the circumstances to the SECP. An extension of the above power of the Registrar is the power to take even more direct attention and size documents from the company under certain scenarios. Seizure of documents by Registrar. Section 262 of the Ordinance provides that where the Registrar has reasonable grounds to believe that books or papers of or relating to any company or any chief executive or officer of such company or any associate of such person, may be destroyed, mutilated, altered, falsified or secreted, then after obtaining permission from magistrate of the first class or Court, he can search and seize such books and papers. Documents are to be returned within thirty days after seizure unless SECP gives another thirty-day grace period. The Criminal Procedure Code is to be followed during searches. The SECP has wide-ranging investigative powers into the affairs of a company, which are as follows. Investigation of affairs of company on application by members or report by Registrar. Section 263 of the Ordinance provides that SECP inspectors may investigate on: (a) in case of company with share capital, on application of members holding no less than one-tenth of total voting power; (b) in case of company with no share capital, on application of no less than one-tenth of persons on company’s register as members; and (c) in case of any company, on receipt of a report under Section 231(5) of the Ordinance (a report by an officer of SECP when inspecting accounts under this section) or the Registrar’s report under Section 261(6) of the Ordinance. SECP has further powers to initiate investigations into the affairs of a company under the following scenarios, either due to a board resolution requesting such an investigation or a court order directing one or under certain special circumstances. Investigation of company’s affairs in other cases. Section 265 of the Ordinance says that the SECP may appoint inspectors for investigation if; (a) the company, by a resolution in general meeting or, (b) the court, by order declares that the affairs of the company ought to be investigated. SECP may also investigate (after giving Company show cause notice) if in the opinion of SECP certain circumstances exist which suggest that (i) business being conducted with intent to defraud or unlawful purpose; (ii) framers of company guilty of fraud, misfeasance, breach of trust, misconduct towards company or any of its members or have been carrying unauthorized business; (iii) affairs of company so conducted so as to deprive members of reasonable return; (iv) members not given all information which they might reasonably expect; (v) any shares of company allotted for inadequate consideration; or (vi) affairs of company not being managed in accordance with sound business principles or prudent commercial practices. Inspector to be a Court for certain purposes. This declaration is provided by Section 266 of the Ordinance and applies to an inspector under Sections 263 and 265 of the Ordinance. Every proceeding before such inspector will be a judicial proceeding. Non-compliance or contravention with any orders, directions or requirement of the Inspector will have the same consequences, liabilities and penalties as provided for such in the civil and criminal procedures. Duty of officers to assist inspector. Section 268 of the Ordinance states that it is the duty of officers to assist the inspector and any default in this regard is punishable with imprisonment and fine.


Inspector’s report. Section 269 says that inspectors may, and if so directed by SECP, make interim reports and on conclusion of investigation, a final report. SECP will forward a copy to company and may, on request, give a copy to a member of the company or other body corporate or anyone interested in affairs of the company or whose interest as creditor of company or other body corporate appear to SECP to be affected. Also copies should be forwarded to the court, Registrar, and shareholders under given situations. SECP power of Prosecution. Section 270 of the Ordinance allows SECP (on the basis of a report under Section 269 of the Ordinance) to prosecute that any person whose affairs have been investigated under Section 267 of the Ordinance and who has been guilty of an offence for which he is criminally liable, and it shall be duty of all officers, employees, agents of company and body corporate (other than the accused) to give all reasonable assistance in this process. Power of SECP to initiate action against management. Section 271 says that if the SECP is of the opinion that (on the basis of a report under Section 269 of the Ordinance) that: (i) the business of the company is being conducted with intent to defraud or unlawful purpose; (ii) framers of the company are guilty of fraud, misfeasance, breach of trust, misconduct towards company or any of its members or have been carrying unauthorized business; (iii) affairs of company so conducted so as to deprive members of reasonable return; (iv) members were not given all information which they might reasonably expect; (v) any shares of company allotted for inadequate consideration; (vi) affairs of company not being managed in accordance with sound business principles or prudent commercial practices; or (vii) the financial position of the company is such as to endanger its solvency, then SECP may apply to court. The court may order (a) removal from office of director, officer, managing agent or chief executive (not unless court specifies a lower period, disqualified for five years from holding such a position), (b) that directors should carry out specified changes in management or accounting policies, (c) a meeting of members to consider specified matters and take appropriate remedial action, or (d) annulment of any existing contract which is to detriment of company or members or to benefit of any officer or director. Sections 273 and 274 of the Ordinance state that no compensation to be paid for annulment or modification of contract and no right of compensation for loss of office. SECP’s powers to initiate proceedings for recovery of damages or property Under Section 278 of the Ordinance, the SECP may, if from a report under Section 269, it appears to it that in the public interest, proceedings should be brought by company or body corporate (whose affairs are being investigated) for recovery of damages (in respect of fraud, misfeasance, breach of trust or other misconduct) or any property, which has been misapplied or wrongfully retained, bring proceedings in the name of such entity (which will indemnify SECP for any costs and expenses). SECP’s powers of Imposition of restrictions on shares and debentures and prohibition of transfer of shares and debentures in certain cases Section 279 of the Ordinance states that where it appears to SECP that in connection with any investigation, it is important for fact finding about shares to impose certain specified restrictions, but SECP may impose such restrictions for not more than a year. SECP is to provide an opportunity for showing cause before imposing any such restriction. Detailed list of restrictions are specified under the section. SECP can also block for up to year a change in directors of a company through an already completed transfer of shares or a future transfer of shares, if SECP thinks that such change is prejudicial to public interest. SECP can rescind any of its orders. Otherwise, relief against such an order lies in court (which will first hear SECP). Default is punishable with imprisonment or fine or both.


Powers of SECP under the SE Ordinance and the SECP Act SECP draws its basic powers of registering and regulating stock exchanges as well as regulating issuers under the SE Ordinance. The SE Ordinance is significant for its detailed treatment under Section 15-A of prohibited insider trading and under Section 17 of prohibited fraudulent acts, which it defines in great detail. If further provides the procedure for enquiries, the penalties and appeals pertaining to the same. Section 20 of the SE Ordinance allows the SECP to issue prohibitory orders for preventing, through any commission or omission, a contravention of any provision of the SE Ordinance or any rules made thereunder. Section 21 gives the Federal Government the power, suo moto or on an application, to appoint any person to inquire into (i) the affairs of any stock exchange, or (ii) the dealing/trading being conducted by any broker, member, director or officer of a stock exchange. The SECP Act dwells in greater detail on the structure, functioning and powers of the SECP. Some of the significant stated powers of the SECP under Section 20 of the SECP Act include, inter alia:

1. prohibiting fraudulent and unfair trade practices relating to the securities market; 2. conducting investigations in respect of matters relating to the SECP Act and the SECP ordinance

and in particular for the purpose of investigating insider trading in securities and prosecuting offenders;

3. regulating substantial acquisition of shares and the merger and take-over of companies; 4. considering and suggesting reforms of the law relating to companies and bodies corporate,

securities markets, including changes to the constitution, rules and regulations of companies and bodies corporate, Stock Exchanges or clearing houses;

5. promoting investors education and training of intermediaries of securities market; and 6. encouraging organized development of the capital market and the corporate sector in Pakistan.

Even a cursory glance at the above reveals the wide ambit of powers, which the SECP enjoys and the many hats that it wears. It acts as a developer and educator as well as a regulator with wide investigative powers. The regulatory power of the SECP, especially in the acquisition, take-over and merger area has been effectively used recently for the protection of the interest of minority shareholders and creditors. Adjudicative powers. Section 22 of the SECP Act also gives the SECP adjudicative powers to adjudicate upon the rights of any person whose application on any matter it is required to consider in the exercise of any power or function under the SECP Act and some very important case law has emerged from this process over the last couple of years which has clarified the rights and duties of various components of the corporate sector in Pakistan. Section 29 of the SECP Act empowers the SECP to conduct investigations in respect of any matter that is an offence under the SECP Act. Protection through the Courts The primary power of the courts to intervene to prevent oppression of shareholders and mismanagement of the affairs of the country is through Section 290 of the Ordinance. This has been demonstrated through recent case law. According to Section 290 of the Ordinance, if any member/members holding not less than 20% of issued share capital of a company or creditor/creditors having an interest not less than 20% of the paid up capital, complain(s), or the Registrar is of the opinion, that the affairs of the company are being conducted or are likely to be conducted in a manner, that is unlawful or fraudulent, or in a manner not provided for in its memorandum, or in a manner oppressive to the members/creditors/ or any of the members/creditors or in a manner prejudicial to the public interest, such person(s) or Registrar may make an application to the Court by petition for an order under this section. The Court, on such petition (if it is of the opinion


that any of the above is taking place and that to wind up the company would unfairly prejudice the members of creditors), may make such order as it thinks fit to bring an end to the matters complained of (whether an order for regulating the company’s conduct in future or for the purchase of shares of any members of the company by other members of the company or by the company and in case of purchase by company, for the reduction accordingly of the company’s capital or otherwise). The company cannot (unless Court allows) make an addition or further alteration to its memorandum or articles, which is inconsistent with any addition or alteration to its memorandum or articles by the Court under this section (which will be as if duly made by a company resolution). Section 291 of the Ordinance lays out further specific powers of the Court in connection with the exercise of its general powers under Section 290 of the Ordinance. The courts have been active in recent years in the development of jurisprudence in the various important areas of corporate governance. Some illustrative instances are as follows. The High Court observed that the Auditors are the ultimate watchdogs of the shareholders’ interests. According to the set practice, the Auditors are required to give a report, which is either “clean” or “qualified”. By issuing a “clean” report, the Auditors certifies that the financial statement reflects a “true and fair” view of the company’s affair and a “qualified” report subjects such opinion to some observation of irregularity or inconsistency. The High Court highlighted and denounced the practice adopted by the managements of some large companies, which are dependant on public confidence, frenziedly trying to secure a “clean” audit report from their auditors. The High Court pointed out that since the auditors are recommended (and virtually appointed) by the board of directors, some of them are made to condescend to the management’s demand and declared that it caused a devastating effect if the auditors put a seal of approval on the misleading accounts of a company. 112 The High Court has emphasized in a 2002 case, that the SECP should consider the advisability of issuing instructions for guidance of companies to ensure that shareholders attending general body meetings with the object of considering special business receive full disclosure of facts necessary for making an informed decision. Furthermore, that the SECP should also consider issuing guidelines for determining the fair value of shares by companies. 113 In the above stated case, the High Court made another very significant addition to minority shareholder rights protection by underlining the fundamental importance and duty of the courts to the protection of minority shareholder rights. It was observed by the High Court, that the court is not a bystander obliged to grant approval to all schemes of arrangements approved by special majority of shareholders specified in Section 284 of the Ordinance (dealing with a compromise of the company with its creditors and members). The court can review the proposed scheme and decline approval, even though scheme approved by requisite majority, in a situation where the majority shareholders of a company had voted in a manner coercive or oppressive to the minority or where the majority shareholders had not voted in the interest of shareholders as a class. The High Court further observed that wherever the court reaches the conclusion that a scheme is unfair and conscionable, and to which material objections have been raised by any shareholder either in a general meeting or before the court, it would become a duty of the court not to approve the scheme. The fact that the objecting shareholder constitutes a small minority in proportion to the majority will be wholly irrelevant in such circumstances. Elaborating further on the Section 284 provision, it said that Section 284 of the Ordinance which required the sanction of the Court to any scheme of arrangement is meant for the protection of the rights of powerless small minorities who can be outvoted at general meetings and cannot, therefore, adequately safeguard their interests on the strength of their voting rights alone. It is, therefore, open to these minorities to show to the Court that the proposed 112 Institute of Chartered Accountants of Pakistan v. Messers Hyderali Bhimji & Co. 2002 CLD 1207. 113 Kohinoor Raiwind Mills Limited v. Kohinoor Gujar Khan. 2002 CLD 1314.


scheme of arrangement is unfair, unreasonable and prejudicial to their interest, or to the interests of the shareholders generally. 114 The above three examples are all from the year 2002 and indicative of the growing role of the judiciary in elaborating upon and further enhancing the protections for shareholders and creditors under the law. Some concluding remarks. In conclusion, the Ordinance and related laws are perhaps not as up to date with the growing consensus on best practices, which are now being introduced globally for more effective corporate governance. However the Code and the growing role of the SECP are clear illustrations of a very progressive and modern approach to this area in Pakistan in recent years. It has to be emphasized that the Code has only just been introduced and it remains to be seen as to how much impact it will eventually have. Furthermore, it only applies to listed companies at the moment and rather than that contributing to the negative trend of companies de-listing, the ambit of the Code should be extended to all companies through statute. Another area, which may need revision, is the current level of penalties attached to a violation of the various above-discussed provisions of the Ordinance. In order to have real deterrent effect, these penalties need to be reexamined.

114 Ibid.


Corporate Governance in Sri Lanka

Fast off the Tracks:

But is the Progress Real Progress? By Ajith Nivard Cabraal FCA, FCMA, FSCMA Cabraal Consulting Group (Pvt) Ltd

Everywhere shareholders are re-examining their relationships with company bosses – what is known as their system of ‘corporate governance.’ Every country has its own, distinct brand of corporate governance, reflecting its legal, regulatory and tax regimes… The problem of how to make bosses accountable has been around ever since the public limited company was invented in the 19th century, for the first time separating the owners of firms from the managers who run them…

“Corporate Governance: Watching the Boss,” The Economist (Jan.29, 1994)

Table of Contents Preamble 265

Executive Summary 265

1. The Evolution of “Corporate Governance” in Sri Lanka 267

2. How does Sri Lanka’s CG practices compare with “best international standards”? 275

3. The Emerging International and national issues – How has Sri Lanka responded? 278

4. The Way Forward….. is good corporate governance the panacea for all business ills?

293

Abbreviations used in Report 292

Annex 1: Report of Survey of Corporate Governance Practices in Sri Lanka 293

Annex 2: Comparison of Sri Lanka’s CG Practices with OECD Principles 304


Preamble This comparative analysis is undertaken to assist South Asian countries, especially Bangladesh in understanding corporate governance practices with a view to adopting best practices and significantly improving the quality of corporate governance in the private sector. The project is designed to finally respond to the governance needs of the private sector in Bangladesh. The project aims to identify major features of the corporate governance landscape using the OECD guidelines as the major reference document in Bangladesh, India, Pakistan and Sri Lanka. The project is also expected to highlight existing strengths and weaknesses in these countries, as well as identify any disparities between theory and practice, and the arrangements which are in place for enabling better corporate governance. The ultimate goal of the project is to design strategies for intervention, after identifying areas bearing upon the climate of corporate governance in which such interventions could be made. In that context, this Report attempts to codify and set out the practices prevailing as at date rather than a detailed account of the evolution of the process. Of course, a brief history of some practices and institutions is included in the Report as background to certain issues, but the general thrust of the Report has been to identify future needs and the possible future courses of action. Stage 1 of the project consists of each country partner undertaking essentially the same exercise (although in the case of Bangladesh, there will be certain differences), which exercise is to consist of:

a. A review or survey of literature relating to CG in each country; b. Identification of major features of the CG landscape in each country, including existing

strengths and weaknesses; c. Identification of disparities between the theory-namely that to which law and institutions are

stated to aspire- and the practice or reality, and the causes of such disparities; d. Examination of arrangements in place for enabling good CG, and in particular, by way of

case studies focussing on: i. Successful arrangements, institutional or otherwise, and the incentive structures

underpinning the success of such arrangements, bearing in mind that the mere existence of the ‘right’ laws or legal or institutional environment is not enough: the greater question is why such laws are adhered to; what incentives are in place or why and how do the institutional arrangements operate to create the right incentives?

ii. Unsuccessful initiatives and the causes of continuing behaviour deviating from principles of good corporate governance.

Executive Summary The study and practice of Corporate Governance has evolved rapidly over the past decade or so to a level where the objective pursued today is a governance system which assures corporate decisions that are efficient and effective. This has resulted in a paradigm shift from the earlier “managed” corporation to the more modern model of the “governed” corporation. Over the past few years, the Organization for Economic Co-operation and Development (OECD) has set out extensive principles and practices which are today used as guidelines by many Corporate Governance regimes all over the world. In Sri Lanka the focus on Corporate Governance was led by the Institute of Chartered Accountants of Sri Lanka who developed the Code of Best Practice on Corporate Governance in 1997. The setting up of the Sri Lanka Accounting and Auditing Standards Board in 1995, the initiatives of the Securities Exchange


Commission as well as the Colombo Stock Exchange to develop the standards of financial reporting and the stock market operations help to generate interest in the subject of governance further. Developments over the past few years have given rise to many vexed and complicated issues in relation to corporate governance. The suggestion that corporate “influence” is disproportionate to “responsibility” and that society as a whole may not be best served if corporations are operated for the benefit of shareholders only, has been repeatedly raised in the recent past. In that connection, a corporate entity’s responsibility towards the environment, national and local communities, shareholders, employees, customers, suppliers and contractors, is now being stressed and attempts are being made to include these stakeholders too, in future frameworks of corporate governance practices. It is now clear that Institutional investors who exercise control over massive funds are ideally positioned to demand that corporate entities in which they invest in, act, function and behave in a certain professional and ethical manner. In that context, institutional investors have a responsibility to drive good governance practices to ensure board independence, proper board processes, effective evaluations of boards and CEOs, ensuring a proper mix of different skills within boards, etc. The new demands made on directors may appear to some as being too onerous, and some may even contend that these demands result in skilled persons being un-willing to take up appointments as Directors. In a similar manner, there are also some auditors who tend to think that audits are becoming to onerous with new rules and regulations having to be adhered to. Although such reactions may be justifiable to some extent, investors seem to be appreciative of the pressure that is mounting on directors and auditors to deliver better shareholder value through such new responsibilities. A survey of CG practices in Sri Lanka has revealed that companies do not actually do what they say they do in relation to corporate governance. This is probably true in most other countries as well. In order to address this concern, it may be necessary to increase awareness about CG practices within business communities and to institutionalize a mechanism for the independent assessment of the actual degree of physical compliance with CG practices and policies by companies. The fact that many directors are not conversant with CG practices to be implemented seems to be another serious issue that needs attention. The deficiencies of regulators; the risks run by whistle-blowers; and the greed and impatience of shareholders who are indirectly driving corrupt and/or aggressive CEOs towards attempting to maximize shareholder value through risky and dubious means, are also some of the major issues of the present day and age. The fact that CEOs are often hired on “social” connections and “supposed-to-be-independent” advisors are having serious conflicts of interest have also been matters of concern to the CG community. In addition, the many new initiatives suggested over the past few years which have raised boardroom costs considerably is yet another issue that is causing tension in the CG landscape. Global and national surveys indicate that the investors of today rely heavily on corporate governance practices in making their investment decisions. It has also led some persons to mistakenly believe that good CG is a kind of a guarantee against business risk. This feeling and attitude is likely to damage the overall credibility of the CG process in the longer term, and needs to be immediately addressed. A clear nexus exists between sound business ethics and good corporate governance practices and sound ethical behaviour can be considered an integral function of corporate governance. The ethical values and practices of market participants in the corporate scene will probably determine whether a particular corporation is a well governed one creating shareholder value or one which provides an opportunity for management to enrich themselves at the expense of other stakeholders. The fundamental challenge to the emerging science of corporate governance is to move consistently forward notwithstanding the many difficulties and issues it would face over the ensuring years. The


success or failure of the corporate world and capital markets of the future may finally depend on the manner in which this challenge is met by the market participants. 1. The Evolution of “Corporate Governance” In Sri Lanka 1.1 “Corporate Governance” – the Buzz–word

When at first Corporate Governance started becoming a buzz word in the early to mid ’90’s in Sri Lanka, it was popularly understood as “the system by which companies were to be directed and controlled.” As done in many countries, Sri Lanka too, through its corporate networks and regulatory regimes began to respond to the need to develop good governance processes in a formal manner by developing a Code of Best Practice on Corporate Governance for the guidance of their corporate sectors in 1977. As is well known, the impact of globalization shaped and forced the various issues pertaining to corporate governance in Sri Lanka to take an international flavour, and as of today the Sri Lankan corporate sector also voluntarily follows the guidelines of many worldwide and regional bodies which are actively promoting corporate governance globally, regionally and in individual countries, in addition to the various guidelines prevailing in Sri Lanka.

1.2 Sri Lanka’s interest in Corporate Governance

At this stage, it is worthy to note that The Global Corporate Governance Forum has, as its mission, the objective of helping countries improve the standards of governance for their corporations by fostering the spirit of enterprise and accountability, promoting fairness, transparency and responsibility. In that light, it would be seen that good Corporate Governance is today a desired outcome of international concern for corporations and countries all over the world, since good corporate governance would undoubtedly contribute immensely to economic development. In that context, it is perhaps no surprise that Sri Lanka is showing a keen interest in embracing the “state-of-the-art” corporate governance principles, given its commitment to a liberalized economic policy and growth through private/public sector partnerships.

1.3 Fuelling the need for good CG practices

In a globalized economy, where there is a rapid rise in the size and number of institutional investors and global funds, the focus on good corporate practices increases correspondingly, almost as a reflex action. At the same time, the number and sophistication of investment managers, intermediaries and specialists, has also been rising dramatically. All these factors have further fuelled the need for good Corporate Governance practices and hence it could now be said that the concept has really come of age and almost certainly, to stay.

1.4 The Sri Lanka Code of Best Practice on Corporate Governance

1.4.1 In Sri Lanka, the first real effort at codifying the principles of Corporate Governance in a

structured manner was in 1996 when the Council of the Institute of Chartered Accountants of Sri Lanka decided to set up a Committee to make Recommendations on matters relating to Financial Aspects of Corporate Governance.

1.4.2 This report was undertaken at a time when Sri Lanka’s own stock market was showing signs of maturity and growth, although the issues relating to Corporate Governance in Sri Lanka had by that time not progressed too far. In that context, the initiative taken by the Institute of Chartered Accountants of Sri Lanka (ICASL) to set up a Committee was a laudable effort. The Committee


comprised of eminent and senior persons who were from the many organizations and bodies which had a significant impact and influence on the development of Sri Lanka’s stock market, and they also represented a wide cross section of the interested parties in the subject of Corporate Governance.

1.4.3 The Committee categorized their final recommendations for implementation through the

following mechanisms: a) Possible amendments to the Securities and Exchange Commission Act b) Possible amendments to the rules and regulations of the Colombo Stock Exchange. c) Possible amendments to the Companies Act d) Possible amendments to the ICASL Act e) A Code of Best Practice, as applicable to all listed companies

1.4.4 In addition, the Committee Report made a useful observation that the corporate regulatory system

in Sri Lanka had many involved regulatory and semi-regulatory organizations, sometimes working in rather rigid, water-tight compartments. These authorities, e.g. the Securities and Exchange Commission of Sri Lanka, (SEC), the Colombo Stock Exchange (CSE), the Registrar of Companies (ROC), the Sri Lanka Accounting and Auditing Standards Monitoring Board (SLAASMB), the Accounting Standards Committee (ASC) of the ICASL, the Auditing Standards Committee (AuSC) of the ICASL, the Urgent Issues Task Force (UITF) of the ICASL were often seen to be performing overlapping functions and therefore an attempt to infuse an element of congruence within their respective activities seemed also to be necessary. The ICASL Committee has been hopeful that the setting out of the Code of Best Practice would lead to a greater degree of congruence and understanding within the above stated organizations as well.

1.4.5 This Code of Best Practice could, in retrospect, be considered as the key initiative which laid the

foundation for the healthy evolution of Corporate Governance principles and practices in Sri Lanka. Thereafter, many initiatives have followed, and these are described in this chapter of the Report. The empirical study made in September 2002, shows that the results are somewhat mixed, and a summary of the findings is set out in Annex 1.

1.5 The Sri Lanka Accounting and Auditing Standards Monitoring Board and Urgent Issues

Task Force of the ICASL 1.5.1 In the late ’80’s and early ’90’s, Sri Lanka witnessed many failures of Companies, especially

Finance Companies. In the light of such failures, the general public perception was that there was no one prepared to take responsibility for these debacles. Many reasons were attributed for the crashes, but whatever these were, these resulted in many investors losing faith in the regulatory and semi-regulatory frame-works, as well as the standards of financial reporting. This situation almost reached crisis proportions at a certain point in time, in the late 80’s’ and early ’90’s, but fortunately some interventions by the concerned regulatory and semi-regulatory authorities, even through somewhat late in being introduced, resulted in the storm being weathered. But the underlying causes for the failures including the weak financial reporting and auditing structures needed to be addressed on a fundamental basis, urgently and decisively.

1.5.2 As a response to this particular aspect of this wide issue, the ICASL in 1992 took the preliminary

steps to institutionalize a scheme whereby the application of Sri Lanka Accounting Standards could be monitored and enforced. To implement such scheme, the ICASL set up a Task Force to look into all aspects relating to the enforcement of the Sri Lanka Accounting Standards, and such Task Force recommended the setting up of an “Accounting Standards Monitoring Unit”. This proposal was formally forwarded to the Government in 1993, and was referred to the Financial


Sector Reform Committee, which accepted same. This finally resulted in the Government enacting the present Sri Lanka Accounting and Auditing Standards Act No. 15 of 1995. This Act empowered the ICASL to adopt Sri Lanka Accounting Standards (SLAS) and Sri Lanka Auditing Standards (SLAuS) and provided for the setting up of an independent Sri Lanka Accounting and Auditing Standards Monitoring Board (SLAASMB). The Act also required all specified business enterprises (defined in terms of criteria based on turnover, share capital, net assets, number of employees, and loans taken from the banking system), to prepare their financial statements in accordance with SLAS and have their accounts audited in accordance with SLAuS. The Sri Lanka Accounting and Auditing Standards Monitoring Board was to monitor the compliance of Sri Lanka Accounting and Auditing Standards promulgated by the ICASL for specified enterprises as set out in the Act.

1.5.3 This initiative was a significant development in the field of financial reporting and no doubt went

a long way in instilling confidence in investors and stock market intermediaries in the enhancement of the quality of financial reporting in Sri Lanka. As of today, a considerable amount of work has been done by the SLAASMB and their reports are being taken seriously by companies and the business community alike. Further, the fact that the SLAASMB is actively examining the financial statements of the specified business entities (SBEs) has placed these SBE’s on guard, and has had a useful deterrent effect on them. Consequently it could be said that the standards of financial reporting with the attendant impact on good corporate governance, has received a boost from this initiative. Another significant initiative that was taken by the ICASL was the setting up of an Urgent Issues Task Force, (UITF) in 1993 with a mandate to provide clarifications and interpretation of the Sri Lanka Accounting and Auditing Standards. Today, the UITF makes regular rulings at the request of corporates, auditors, and interested parties, and is perceived by the business and financial community as a useful body in promoting the understanding and application of the Sri Lanka Accounting and Auditing Standards. Its rulings are readily accepted as quasi-Standards, particularly where the Standard itself is not clear on a particular issue.

1.6 Ceylon Chamber of Commerce

In 2001/02, the Ceylon Chamber of Commerce (CCC) prepared and issued a booklet titled “Corporate Governance”. This effort codifies the key Corporate Governance initiatives which are considered desirable for Sri Lanka and has been useful in promoting Corporate Governance in Sri Lanka. In addition to this publication, the CCC has consistently promoted good corporate governance among its members, and has been instrumental in promoting CG principles amongst its wide membership.

1.7 Institute of Chartered Secretaries and Administrators of Sri Lanka In the year 2000/01, the Institute of Chartered Secretaries and Administrators in Sri Lanka also published a Hand book on Corporate Governance. This hand book contained detailed principles and guide lines to best practices in Sri Lanka. Although not quoted extensively, this booklet serves as a useful explanatory note to those who are involved in promoting and practising corporate governance.

1.8 National Task Force on Corporate Governance

In December 2001, a Task Force on Corporate Governance in Sri Lanka was set up under the facilitation and auspices of the Institute of Chartered Secretaries and Administrators of Sri Lanka. This Task Force which is comprised of many eminent persons in the business, professional,


banking, marketing and regulatory fields has been driving Corporate Governance forward in Sri Lanka since their formation. They have also been in close contact with the Commonwealth Association of Corporate Governance and this alliance has helped to further focus on Corporate Governance initiatives that are necessary for Sri Lanka. This group plays an important role in creating awareness as well as promoting good governance practices in the country.

1.9 Sri Lanka Institute of Directors (SLID) The formation of the Sri Lanka Institute of Directors is a recent initiative which has brought together a large number of Company Directors who have been actively focusing on administration and Governance issues. The Institute holds regular meetings at which directors discuss methods of improving Governance in their own organizations. These awareness campaigns of SLID have helped to focus attention on the subject of governance as well as keep the membership alive to the developments taking place world wide.

1.10 Provisions under the Companies Act that promote good governance The Company’s Act of Sri Lanka although having been enacted in 1982 has many provisions that encourage good governance practices. Extensive sections of the Companies Act deal with disclosures in the annual financial statements of Companies, conduct of board proceedings, conduct of shareholders meetings, particulars re. proxies, directors reports, responsibilities of directors, auditors functions, etc. etc., The Companies Act also sets out the provisions relating to the winding up of companies, consolidation procedures and certain procedures and processes connected to borrowings by Companies etc. There provisions may not be the most modern of provisions, but nevertheless they serve as a useful framework which is reasonably formal and practical.

1.11 Securities and Exchange Commission of Sri Lanka

1.11.1 The Securities and Exchange Commission of Sri Lanka was established through an Act of

Parliament No:36 of 1987. The Commission become quite active from the early 1990’s and since then, has been playing a dynamic role in financial reporting issues and the development and regulation of the capital market in Sri Lanka. The Commission was instrumental in initiating many innovations such as the setting up of the Central Depository System, the formulation of the Mergers and Takeovers Code, the implementation of laws relating to Insider Trading, etc. Today, the Securities Exchange Commission possesses a team of highly skilled professionals who have been trained in gathering and analysing market information, keeping abreast of worldwide developments and enforcing the implementation of the provisions contained in the SEC Act and Regulations.

1.11.2 While the infrastructure is in place for the SEC to play a highly dynamic role in the capital market development effort and improvement of governance practices in the country, the actual work of the Commission seems to have fallen short of expectations. This is mainly because of issues such as conflicts of interest and certain apparently biased decisions of some of the SEC members. These conflicts have rocked the corporate sector and have served to erode the level of public confidence in the capital market of Sri Lanka in general and the SEC in particular. Various attempts have been made by several governmental agencies to deal with this declining confidence levels but it appears that the process is slow and painstaking. As is seen, the SEC would have to play a very significant role in the overall enhancement of governance in the country, and any deficiency in the discharge of its duty would be reflected as a major blow to the maintenance and enhancement of the Corporate Governance levels of the country. In that context, it is imperative


that urgent steps be taken to re-infuse credibility into the SEC as soon as possible so that the SEC could play, and also be seen as playing, an impartial and professional role.

1.12 Colombo Stock Exchange The Colombo Stock Exchange is an institution which has a history of over a century and is the only “market” that is available for the trading of listed securities in Sri Lanka. Some of its key functions and services are described below:

1.12.1 Initial Public Offerings

The Colombo Stock Exchange has set out extensive procedures with regard to initial public offerings. Although in the recent past, the number of IPO’s has been few, the procedures have been tried and tested during the first part of 1990’s during which period there were many large scale IPO’s. Even during the recent past, some of the privatizations were carried out through the Colombo Stock Exchange and the public offerings connected to such privatizations evoked considerable interest in the Colombo Stock Exchange. The IPO procedures have been well structured and are contained in the CSE’s handbook of procedures as a special chapter and the provisions are carefully adhered to by all sponsoring brokers, companies issuing shares, and all other parties.

1.12.2 Listing Requirements – Initial and Continuing

The Colombo Stock Exchange has published a comprehensive booklet setting out the Continuing Listing Requirements which have to be adhered to by all Companies that are listed in the Colombo Stock Exchange. These are monitored carefully by a professional team of enforcement officers of the CSE which ensures that the integrity of the Listing procedure is maintained.

1.12.3 Disclosure Practices

The Colombo Stock Exchange has also enumerated the corporate disclosures that need to be made by the Companies that are listed in the Colombo Stock Exchange. Here again, the enforcement officers of Colombo Stock Exchange are expected to ensure the integrity of the process by constant and consistent monitoring of transactions, accuracy of disclosed information, assessment of a company’s financial and other statements, etc.

1.12.4 Mergers and Takeovers Code

For a considerable period of time, mergers and acquisitions in Sri Lanka were not regulated in any way. There was no Code to set out guidelines about the procedures to be followed if and when a merger or take over was contemplated or attempted. With the issue of the Mergers and Takeovers Code by the SEC under the Securities and Exchange Commission Act, this situation has been rectified and today there is an orderly process that governs this activity in Sri Lanka.

1.12.5 Insider Trading

The laws and regulations in relation to insider trading are contained in the Securities and Exchange Commission Act. These provisions are very stringent and are designed to reduce mal-practices that arise as a result of insider trading by market players. The processes set out in the Act however, does not seem to have had the desired effect, and the general perception in the market circles is that there are many instances of insider trading which are continuing. The


Central Depository System and the market tracking features contained in the system has helped a great deal to overcome and deter some of the mal-practices but much needs to be still done, especially in the timely implementation of the provisions of the code in the true spirit of the Code.

1.12.6 Related Parties

The transactions between related parties which affect companies have often created major controversies in the Sri Lankan corporate scenario. The Companies Act of Sri Lanka requires that disclosures be made of all transactions where the parties to the transaction are connected in certain ways. Notwithstanding such provisions there have been allegations of impropriety which have disturbed the Sri Lankan corporate world many times. As of now, the Auditors Opinion contains a special paragraph where they are expected to report upon the related party transactions and this requirement has had a useful impact on this issue. At the same time, the Sri Lanka Accounting and Auditing Standards Monitoring Board Act also deals with the manner of reporting and disclosure of transactions pertaining to related parties through the empowerment of the Accounting Standards Committee and the Auditing Standards Committee of the ICASL to promulgate Sri Lankan Accounting and Auditing Standards as quasi-laws. This initiative has helped to maintain a certain consistency in this regard and it has proved useful in the overall achievement of better governance and accountability in the corporate sector in Sri Lanka.

1.12.7 Credit Rating

Credit Rating in Sri Lanka is a comparatively recent development. Over the past few years several firms with international connections have set up credit rating firms which “rate” firms as well as various financial and debt instruments. These rating institutions fulfil a very important need since “rating” was a function that was neglected for a long time, in Sri Lanka, although it has been considered extremely useful, worldwide. Even though credit rating has been in existence for a short period only, credit rating firms of Sri Lanka today play a useful role in the stock market and debt market operations in Sri Lanka and the trend appears to be that they would continue to expand their influence and scope of operations in the country. The type of evaluation carried out by credit rating agencies and the reports issued by them naturally enhances the governance in those target companies directly and indirectly. Such outcomes are important for the overall improvement of Corporate Governance Systems in the Country and it could be positively stated that this development has helped to improve governance in general, in Sri Lanka.

1.12.8 Central Depository System

The Central Depository System was introduced into Sri Lanka in 1992/ 1993 as a joint initiative of the Securities and Exchange Commission and the Colombo Stock Exchange. Since then, it has played a very useful role in the Sri Lankan capital market. The transactions at the CSE have become accurate, faster and complete with very useful information being generated and being available which makes it possible for the convenient and speedy tracking of market activities, trends and transactions. The CDS has also made the trading process quite transparent with its obvious attendant advantages. This outcome has helped to infuse a greater degree of discipline and control into the capital market which necessarily enhances the overall governance levels in the country.

1.13 Registrar of Companies


The Registrar of Companies (ROC) in Sri Lanka has been traditionally an institution which had been perceived as a typical governmental bureaucratic institution which is almost totally unresponsive to public needs, with archaic systems and reeking with corruption and mismanagement. However, the ROC of today appears to be an institution which has undergone a considerable re-organization and is generally considered as a somewhat responsive governmental institution. Most records at the ROC have been computerized and information retrieval systems have been improved considerably, leading to a reduction in the turnaround time for the supply of information and with regard to various other activities of the institution. The procedures involved in the formation of companies, name approvals, filing of records, searches, etc., have all been organized on an interactive basis, and many of the functions of the ROC could now be carried out on-line. These developments have improved ROC’s function as a quasi-judicial institution and have had the impact of enhancing the overall governance in the corporate sector.

1.14 Central Bank of Sri Lanka and Banking Sector 1.14.1 In addition to the traditional functions of the Central Bank of Sri Lanka, the Bank also performs

many other regulatory functions. One such function is the CB role to supervise Banks and other Financial Institutions and this function has assumed an extremely important level today. This function naturally extends to assisting Banks and Financial Institutions to improve their governance systems and their credit delivery systems, as well. In that context, the Central Bank by its supervisory function helps to improve the overall Corporate Governance procedures and practices in a key and important sector which has a tremendous impact upon the economy of the nation.

1.14.2 In the late 1990’s, a spate of finance company failures led to adverse public reactions against the Central Bank, which culminated in several reforms being initiated. Some of these reforms were to tighten the doubtful debt provisioning methods and the more effective supervision and regulation of the conduct of Directors, especially in relation to related party transactions. The Central Bank also initiated the CRIB, i.e. the Credit Information Bureau, which today provides up-to-date information about customers who have defaulted to any one of the member banks. Through such pooling of vital credit information via the access to a centralized information network, the Banks in general have been able to improve their own credit delivery systems significantly.

1.14.3 Since of late, a few concerns have been expressed that the Central Bank has been somewhat lax in its supervision of the banking and finance company sectors, and this has resulted in some expressions of dissatisfaction within the corporate community. It is hoped that such situation would be temporary, and that the Central Bank would respond more positively towards enhancing the overall governance in the banking sector.

1.15 Judicial Review including function of the Commercial High Court 1.15.1 For a considerable period of time, there has been grave concern in the minds of many that the

administration of justice in general, and the judicial process in relation to corporate matters in particular, has been extremely unsatisfactory. It would be readily conceded that there are many laws in the statute books covering almost every issue, together with very elaborate procedures to implement such laws. However, there have been major bottlenecks and inordinate delays which have, almost always negated the effect and impact of these laws. Consequently, the general consensus has been that many commercial establishments have been inconvenienced tremendously without any useful redress being received in a timely manner as a result of litigation.


1.15.2 To address this issue, a Commercial High Court was set up a few years ago to deal with

commercial matters and disputes so that such issues could be dealt with expeditiously and the long suffering business community given an opportunity to obtain redress faster and more conveniently. This initiative has, to some degree served to reduce the litigation time in relation to commercial disputes, but nevertheless the problem of delayed justice has yet not been adequately or effectively addressed. The issue of training the judges on business practices and commercial transactions also need to be carefully considered since the quality of justice and the judicial orders often hinge upon the knowledge and understanding of the judges viewing and dealing with commercial issues from a sound business angle as well.

1.16 Role of Media – Business Newspapers, Business TV Shows/News, 1.16.1 Over the past decade or so, the media in Sri Lanka has been very active in highlighting business

and commercial issues. At present, it has evolved to a reasonably sophisticated level and many national newspapers of today carry separate features and sections in their daily and weekly editions which are entirely dedicated to business news.

1.16.2 Since of late, press reports have extended to vibrantly exposing matters and issues of concern and

this type of reporting has had a very useful impact on the business world. In addition to the print media, the electronic media too has kept pace and at present, almost all television channels in the country beam business programmes at least once every week and in fact the daily news bulletins of all TV networks carry a segment devoted to business news. Such developments have assisted to keep the corporate sector and the general public informed and conscious of responsibilities toward shareholders and varied groups of stakeholders, and these have contribute immensely to the improvement of governance procedures in the country.

1.17 Role of Analysts and Fund Managers

One of the major developments that have been taking place since the early 1990’s in the Sri Lankan financial sector has been the proliferation of analysts and fund managers and those functions becoming more professional. At the same time, extensive overseas expertise and experiences have been channelled into the Sri Lankan business environment and those inputs have helped to develop these services extensively. As of now, almost all the Broking firms and Banks have set up well organized research units which are providing very useful information for investors. These efforts and outputs of the analysts and fund managers have resulted in a greater demand for accountability within the corporate community, both directly and indirectly and that has led to an improvement in the governance practices in the country.

1.18 Civil Society and Investor Associations

In relation with any major law reform or development of a regulatory process, it is essential that civil society plays a dynamic role. In that context, in the development of a capital market, Sri Lanka’s civil society has been reasonably active in their reactions towards the capital market development effort. A few “watch-dog groups” have actively pursued several corporate issues which have resulted in greater awareness being created in governance. At the same time, several investor associations have also been formed, which are dedicated towards safeguarding the interests of investors, and these associations mainly consist of groups of smaller investors who are seeking greater rights for minorities as well as the promotion of good governance practices in general.


1.19 Political will and commitment of Government and State Agencies towards CG 1.19.1 In all initiatives connected to the development of capital markets, enhancement of governance

systems, a Government’s commitment and involvement towards such effort would be of special significance. The enactment of laws, framing of regulations, empowerment of regulatory authorities and establishment of the necessary key institutions would require the support and commitment of the government.

1.19.2 Fortunately for Sri Lanka, successive governments from the late 1980’s up to now have shown a

firm commitment towards this process. At the same time, a special feature in the corporate governance landscape of Sri Lanka has been that several quasi-governmental organisations have contributed their efforts towards good governance practices in Sri Lanka, sometimes even venturing much further than what could be normally expected from them as their routine functions. All these efforts have resulted in a steady improvement in corporate governance practices in Sri Lanka notwithstanding a few complications at various intervals.

2. How Do Sri Lanka’s Corporate Governance Practices Compare With “Best International

Standards”? 2.1 Today’s definition of CG 2.1.1 Today, Corporate Governance has evolved to a level where the outcome pursued internationally

appears to be “a system which assures corporate decisions that are efficient and effective”. At the same time, the foundation for the practices seem to be resting on the philosophy that corporate decisions need to be internally challenged in an effective manner in order to assure and establish its validity and long term sustainability.

2.1.2 Accordingly, present day good governance systems often provide for senior managers and boards

to collaborate amongst each other and for them to seek the input of institutional shareholders in a participatory relationship, rather than in a detached mode. Perhaps therefore, it could be said that there is almost a paradigm shift from the previous concept of “managed” corporations to the more modern model of “governed” corporations. This shift is based on the fact that “managed” corporation boards hired, monitored and fired management, while today’s “governed” corporation boards are expected to promote and foster efficient and effective decision-making. Hence, in a way, corporate governance is no longer pre-occupied only with structures and procedures such as Audit Committees, Remuneration Committees, Internal Control systems, etc; but more importantly, concerned with governance processes which attempt to decrease the possibility of corporate mistakes, and if mistakes are made, increase the speed at which corrective action is taken.

2.1.3 Since the initial initiatives in the early ’90’s, Sri Lanka has continued to progress in developing new initiatives at enhancing Corporate Governance practices in the country. In that context, the Institute of Chartered Accountants of Sri Lanka, Ceylon Chamber of Commerce, the Securities and Exchange Commission of Sri Lanka, the Colombo Stock Exchange and the Institute of Chartered Secretaries and Administrators of Sri Lanka have played, and are continuing to play significant roles and those have been described in this Report.

2.2 The Benchmark

When carrying out an overview of corporate governance practices in any particular CG regime, it would be useful to examine such provisions against governance practices which are considered to


be best international practices. Hence, it would perhaps be useful to firstly study the corporate governance practices as set out by the Organisation for Economic Co-operation and Development (OECD), which are generally considered to be the benchmark for many CG studies taking place today.

2.3 Background to international practices 2.3.1 In considering such “best international practices”, the background to such practices is also

important to be considered, and OECD’s own comments in this connection may be of relevance: 2.3.2 “The degree to which corporations observe basic principles of good corporate governance is an

increasingly important factor for investment decisions. Of particular relevance is the relation between corporate governance practices and the increasingly international character of investment. International flows of capital enable companies to access financing from a much larger pool of investors. If countries are to reap the full benefits of the global capital market, and if they are to attract long-term “patient” capital, corporate governance arrangements must be credible and well understood across borders. Even if corporations do not rely primarily on foreign sources of capital, adherence to good corporate governance practices will help improve the confidence of domestic investors, may reduce the cost of capital, and ultimately induce more stable sources of financing.”

2.3.3 “Corporate governance is affected by the relationships among participants in the governance

system. Controlling shareholders, which may be individuals, family holdings, bloc alliances, or other corporations acting through a holding company or cross shareholdings, can significantly influence corporate behaviour. As owners of equity, institutional investors are increasingly demanding a voice in corporate governance in some markets. Individual shareholders usually do not seek to exercise governance rights but may be highly concerned about obtaining fair treatment from controlling shareholders and management. Creditors play an important role in some governance systems and have the potential to serve as external monitors over corporate performance. Employees and other stakeholders play an important role in contributing to the long-term success and performance of the corporation, while governments establish the overall institutional and legal framework for corporate governance. The role of each of these participants and their interactions vary widely among OECD countries and among non - Members as well. These relationships are subject, in part, to law and regulation and, in part, to voluntary adaptation and market forces.”

2.3.4 As stated earlier, over the past 10-12 years Corporate Governance has been constantly and continuously evolving, developing, responding, reacting, and pro-acting. While several reactions and principles could be described as responses to the rapidly evolving commercial and business developments world-wide, some initiatives could be termed as proactive responses to achieve certain desired goals. The evolution has been steady and almost always the principles, local and international, have been instrumental in enhancing the manner in which corporate entities take decisions as well as ensuring that shareholders have a voice in the governance structures and systems of corporations.

2.3.5 In this regard, the Preamble to the OECD Principles of Corporate Governance comprehensively sets out what could be identified as the stage on which corporate governance is established internationally today, and such extract is set out below:

“There is no single model of good corporate governance. At the same time, work carried out in

Member countries and within the OECD has identified some common elements that underlie good


corporate governance. The principles build on these common elements and are formulated to embrace the different models that exist. The Principles are non-binding and do not aim at detailed prescriptions for national legislation. Their purpose is to serve as a reference point. They can be used by policy makers, as they examine and develop their legal and regulatory frameworks for corporate governance that reflect their own economic, social, legal and cultural circumstances, and by market participants as they develop their own practices. The Principles are evolutionary in nature and should be reviewed in the light of significant changes in circumstances. To remain competitive in a changing world, corporations must innovate and adapt their corporate governance practices so that they can meet new demands and grasp new opportunities. Similarly, governments have an important responsibility for shaping an effective regulatory framework that provides for sufficient flexibility to allow markets to function effectively and to respond to expectations of shareholders and other stakeholders. It is up to governments and market participants to decide how to apply these Principles in developing their own frameworks for corporate governance, taking into account the costs and benefits of regulation.”

2.4 The OECD Principles: These are set out below:

2.4.1 The rights of shareholders The corporate governance framework should protect shareholders’ rights.

2.4.2 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.

2.4.3 The role of stakeholders in corporate governance

The corporate governance framework should recognise the rights of stakeholders in creating wealth, jobs, and the sustainability of financially sound enterprises.

2.4.4 Disclosure and transparency 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.

2.4.5 The 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.

2.5 How does Sri Lanka’s CG practices compare with OECD Principles?

Annex 2 compares the Sri Lankan state of corporate governance with that of the OECD Principles.

2.6 The continuing conflict between “freedom” and “regulation”


2.6.1 All in all, the OECD Principles as well as the Principles followed by many countries in general, are designed to enhance confidence in the system of governance. It therefore follows that an effective enforcement of such systems requires that the relevant laws, rules, and standards are implemented effectively in the financial, legal and regulatory systems. If it is so done, the system itself would greatly benefit and thrive and consequently most countries are today moving towards such regulatory and legal regimes.

2.6.2 At the same time, there is also a growing feeling, especially among emerging economies, that a country’s business environment must be maintained and operated in a manner that is conducive for growth and sustainability. Hence, the corporate governance practices should also be regularly tested and/or analysed so as to ascertain whether those processes constitute a frame work within which businesses can prosper and grow. It is no secret that some persons view certain corporate governance practices as “irritants” to the quick growth of businesses because of the increasing requirements and minimum standards being imposed. On the other hand, there are also the others who argue, and perhaps successfully, that long term investors are more likely to invest in economies which have strong corporate governance practices that are well regulated and implemented. As the Sri Lanka Code of Best Practice on Corporate Governance sets outs: “the challenge is to strike a balance between the two propositions and to have a satisfactory mix of “freedom” and “regulation” which encourages both the steady growth of companies as well as the steady build up of confidence of investors”.

2.6.3 In summary, it may be stated that the fundamental platform on which corporate governance

practices and principles have been developed over the years has been on the basis that the practices must not stifle business, but stimulate it.

3. The Emerging International And National Issues…. How Has Sri Lanka Responded?

3.1 The Emergence of Issues

The comprehensive study of any subject, especially one that is evolving rapidly and having a significant impact continuously, will naturally produce many issues. In that sense, the subject of Corporate Governance is bound to be a prime candidate to generate many key issues. In its comparatively short history, corporate governance has had more than its fair share of issues, controversies, developments, scandals and more are emerging regularly, and more will probably emerge in the future. Over the past few years Sri Lanka too has had its share of controversies and the study of the Sri Lankan CG landscape provides some interesting insights into the manner in which SL has responded to, and tackled these issues.

3.2 Is corporate “influence” disproportionate to “responsibility”? 3.2.1 Robert Monks and Nell Minow, with perhaps a little exaggeration have claimed that:

“Corporations determine far more than any other institution, the air we breathe, the quality of the water we drink, even where we live. Yet they are not accountable to anyone,” (Power and Accountability)

This comment aptly describes the issue that the overall influence wielded by corporate entities far out-weighs the responsibility that society casts upon them. This issue has been probably raised on numerous occasions at different fora, and discussed and debated by many experts and practitioners. But yet an acceptable formula to proportionately link influence and responsibility is eluding the international business and corporate community.


3.2.2 In Sri Lanka this situation is no different and it is observed that many companies are today influencing the overall lifestyles of millions of people. Nevertheless it is noted with some concern that there are very few governance policies or practices which addresses those concerns. While many practices are designed from the point of view of safeguarding corporate stakeholders, there appears to be few which are to protect the environmental, national and local communities, employers, customers, suppliers and contractors. This wide gap is being felt by many and today several civil groups are questioning the validity of the governance practices as existing today, in that they are not wide enough to cover the host of other stakeholders as well.

3.3 Beyond Corporate Governance…. 3.3.1 This growing view is that the corporate sector should not confine themselves to corporate issues

only as stated in statements of Corporate Governance Principles, but venture beyond the obvious corporate issues. The proponents of this view suggest that the corporate sector should act in a more responsible manner and be concerned with the wider community as well. “Society as a whole may not be best served if Corporations are run for shareholders only. For many kinds of Corporations, the community, employees and other stakeholders have as much claim to being owners of the corporations as do the shareholders, and perhaps even more so.” Dr. Margaret M. Blair, Corporate Governance expert attached to The Brookings Institution, USA.

3.3.2 These new issues have given rise to new responsibilities for corporate entities being enumerated

across the world. The following concepts of social and corporate accountability and responsibility towards other stakeholders are based on the recommendations of the Investor Responsibility Research Centre of the USA which has suggested a series of Corporate Responsibility Principles.

[a] The corporate entity’s responsibility towards the environment

Generally Desired outcomes: • Careful attention must be paid to ensure that the corporate entity’s actions do not

damage the environment. Issues such as climate change, bio-diversity and pollution prevention are central to this.

• A corporate entity should adopt high environmental standards and ensure that these

are implemented universally, regardless of any legal enforcement or lack thereof, and should continually seek to improve its performance.

While there are laws to protect the environment in Sri Lanka, and these are being enforced by statutory authorities and local bodies, there are very few companies who voluntarily disclose their corporate policies vis a vis the environment. There is also a general perception that corporations are responsible for polluting the environment in many ways and in that context, a demand from the investor community that corporations should disclose their policies and practices to safeguard the environment in this connection as a part of their overall CG practices, may be a step that would be of great benefit to the community.

[b] The corporate entity’s responsibility towards the national communities

Generally desired outcomes:


• The corporate entity should strive to be a good corporate citizen in all its locations and hold it to be the responsibility of every employee to ensure that there is full compliance with all labour, health and safety standards.

• The corporate entity should strive to, in a responsible and transparent way, to contribute

to the country’s efforts to promote full human development for all its citizens.

• The corporate entity should respect the political jurisdiction of national communities.

• The corporate entity shall be committed to fully respect internationally recognized human rights standards.

• The corporate entity should not use the mobility of capital and the relative immobility of

labour as a tool against workers. Here too, there are many laws in Sri Lanka which are supposed to ensure that many of the above outcomes are achieved. However, it is common knowledge that most corporations are in breach of many of these standards and requirements. In that context, a positive statement by corporates to the effect that they voluntarily conform to such standards and practices may be a useful first step it such an outcome is to be pursued in the future. [c] The corporate entity’s responsibility towards the local communities


• A corporate entity should recognise its political and economic impact on local communities, especially where it is the principal employer. Its programmes, policies and practices should reflect this recognition.

• The employees should be encouraged to participate in local community activities and

organizations.

• The corporate entity should take account of local cultures in its decision making processes while not condoning cultural practices which denigrate human beings on the basis of gender, caste, class, culture or race.

• The corporate entity should strive to contribute to the long-term sustainability of the local

communities in which it operates.

In Sri Lanka, corporates are generally sensitive to local concerns, possibly driven by the need to maintain good relationships in its area of operations. It is also seen that some companies reach out to the local communities more than the others, and consequently are held in high esteem in their locations of business. However, as with the other areas of responsibility described above, in this regard too, there is no structured system to achieve this outcome, and it is perhaps very desirable if the corporate and investing community were to address this need.

[d] The corporate entity’s responsibility towards the shareholders:


Generally desired outcomes: • The corporate entity’s corporate governance policies should balance the interests of

managers, employees, shareholders and other stakeholders.

• The corporate entity should ensure shareholders’ participation and rights to information while protecting the interest of other stakeholders.

• The corporate entity should respect the right of shareholders to submit proposals for vote

and to ask questions at the annual meeting.

• The corporate entity should observe a code of best practice or should have its own comprehensive corporate code to cover company directors’ and employee behaviour.

These needs of course seem to be addressed through a host of laws and practices. In addition, corporates in Sri Lanka are also expected to publicly affirm their commitment to such practices, and hence it could be said that this issue is reasonably well addressed.

[e] The corporate entity’s responsibility towards the employees

Generally desired outcomes: • The corporate entity should have a set standard governing its employment practices and

industrial relations. This standard should include genuine respect for employees’ rights to freedom of association, labour organisation and free collective bargaining and should be non-discriminatory in employment.

• The corporate entity should value its employees and their contributions in every sector of

its operations.

• The corporate entity should pay sustainable community wages, which enable employees, especially women, to meet both the basic needs of themselves and their families as well as to invest in the ongoing development of sustainability in local communities through the use of discretionary income.

• The corporate entity should recognize the need for supporting and/or providing the

essential social infrastructure of child care, elder care and community services which allows workers, especially women who have traditionally done this work as unpaid labour, to participate as employees.

Very few companies in Sri Lanka follow any of the above practices in a structured way. While there is a regular lament within the corporate community about the very low productivity in the country and general labour unrest and inefficiencies, little has been done to address these issues in a positive and practical manner. It should perhaps be realized that corporations can only be as effective and efficient as its employees, and therefore steps should be taken to implement such reforms in a pro-active manner, rather than merely attempting to comply with the many labour laws that prevail in the country. This is probably one area where good governance practices could make a significant impact on the country’s business environment.

[f] The corporate entity’s responsibility towards customers, suppliers and contractors.



• The corporate entity should ensure that its products and services meet customer

requirements and product specification.

• The corporate entity should be committed to marketing practices, which protect consumers, and ensures the safety of all its products.

• The corporate entity should not market it products to consumers for whom they are not

appropriate.

• The corporate entity should have a commitment to fair trading practices.

• The corporate entity should use its purchasing power to encourage good corporate citizenship among its suppliers.

In Sri Lanka, many companies seem to operate on the basis that customers, suppliers and contractors are groups that need to be exploited to the maximum. Very few companies function on the basis that the long term health of each of those groups is vital to its own long term sustainable development and growth. It is essential that this issue be addressed fairly and openly and corporations encouraged to reconsider their relationships in a more long term manner. In that context, new initiatives regarding disclosure of policies towards customers, suppliers and customers by corporations may be the first step in achieving this outcome and new initiatives in this regard would be very welcome.

3.3.3 It appears that the above mentioned aspects of good governance is almost completely ignored in Sri Lanka and it is perhaps time that special efforts be taken to include such practices into the range of practices that should be recommended for adherence by corporate entities.

3.4 Are Institutional Investors demanding enough from corporate entities? 3.4.1 There has been a phenomenal increase in the growth of pension and retirement funds all over the

world. As of the year 2000, American workers are said to have saved and invested approximately $ 6 trillion in retirement assets such as pensions and stock plans savings funds. The growth of those funds gives rise to several issues. In a globalised economic system, it would be possible to invest such funds in corporations across the world. In such a scenario, who should control these assets, and what type of safeguards should be in place if funds are to be so invested across the globe? Who should execute voting rights?

These fundamental questions may require that such institutional investors should insist that corporations that they directly and indirectly invest in should act responsibly. Towards that end, new mechanisms of transparency and accountability will also have to be constantly developed.

3.4.2 These issues have gradually compelled passive investors of the past to become more active. In

that context, it is interesting as to what one of the largest funds in the world, the California Public Employees’ Retirement Systems (CalPERS) has to say about what they have learned.

“What have we learned during these past dozen years? We have learned that:


(a) company managers want to perform well, in both an absolute sense and as compared to their peers;

(b) company managers want to adopt long-term strategies and vision, but often do not feel that their shareowners are patient enough; and

(c) all companies – whether governed under a structure of full accountability or not – will inevitably experience both ascents and descents along the path of profitability.

We have also learned, and firmly embrace, the belief that good corporate governance – that is, accountable governance – means the difference between wallowing for long (and perhaps fatal) periods in the depths of the performance cycle, and responding quickly to correct the corporate course”.

3.4.3 In Sri Lanka too, institutional investors are today playing a significant role in capital market

activity. At the same time however, their influence over corporation activity and in implementing good corporate governance practices unfortunately, has not been correspondingly proportionate or encouraging. Other than a few institutional investors and mutual funds which have been somewhat insistent about good governance practices, many have passively watched the emerging scenario without taking a pro-active role to drive companies towards better governance practices. Surprisingly but fortunately, the initiatives towards good CG practices have been driven in Sri Lanka mainly by the regulators and quasi-regulators, (such as the ICASL), almost at the exception of the direct beneficiaries of good governance practices. It is only during the past one or two years that the investor community has been showing some interest on these issues and that is certainly a step in the right direction. Hopefully if this trend continues, the applicability and quality of CG practices in Sri Lanka is bound to improve significantly.

3.4.4 It is a well-known maxim that no one passionately calls for “accountability” and “good

governance” when the market keeps going up. And, it would be readily acknowledged that the demand for such twin virtues would increase rapidly during “bear runs” in markets. Therefore, it is perhaps time that the corporate community realises that instead of indulging in “knee-jerk” reactions to such sentiments based on market conditions, it would be wiser and more appropriate if funds, especially the indexed pension funds were to insist on some kind of active good governance programmes from corporate entities because there would then be some degree of accountability as demanded by the beneficiaries. It may also be kept in mind that if any disgruntled beneficiaries were to sue for alleged mismanagement of funds, a fund with a track record of investing in corporations with good governance programmes may be able to point out that they (the institutional investors) did whatever they could to take the necessary steps to safeguard their investors, and thereby repudiate liability, at least to some extent.

3.4.5 Perhaps to meet the above stated needs and requirements, many large and influential institutional

investors have been slowly but surely moving towards “persuading” the corporations they intend investing to embrace good CG practices and make changes in the manner in which they govern their corporations. The benchmarks that CalPERS desire have been set out in the Corporate Governance Core Principles and Guidelines of CalPERS. For purposes of comparison, this report attempts to use the CalPERS principles as a benchmark and examine the literature in Sri Lanka against such norm.

3.4.6 How can board independence and leadership be ensured?


CalPERS says:

Independence is the cornerstone of accountability. It is now widely recognised throughout the USA that Independent Boards are essential to a sound governance structure. But the emerging issue is that it has been found that independence of a majority of the board is not enough. The requirement is that the leadership of the board should embrace independence, and it must ultimately change the way in which directors interact with management.” The issue is eloquently summed up in the following quotation: “In the past, the CEO was clearly more powerful than the board. In the future, both will share influence. In a sense, directors and the CEO will act as peers. Significant change must occur in the future if boards are to be effective monitors and stimulators of strategic change. Directors and their CEOs must develop a new kind of relationship, which is more complex than has existed in the past….. Jay W. Lorsch, “The Board as a Change Agent,” THE CORPORATE BOARD (July/Aug, 1996)

In this context, a further key issue in the achievement of independence, as per CalPERS, is “a lack of conflict between the director’s personal, financial, or professional interests, and the interests of the shareholders”. This issue too is yet simmering, and quite possibly would not go away in the near future. The following comment places the issue in perspective.

A director’s greatest virtue is the independence which allows him or her to challenge management decisions and evaluate corporate performance from a completely free and objective perspective. A director should not be beholden to management in any way. If an outside director performs paid consulting work, be becomes a player in the management decisions which he oversees as a representative of the shareholder…. Robert H. Rock, Chairman NACD, DIRECTORS & BOARDS (Summer 1996)

In Sri Lanka, an Exposure Draft (ED) on Board Room Governance was issued by the Institute of Chartered Accountants of Sri Lanka in the year 2001. Although this ED has not yet been finalized and issued as a Code of Best Practice, it has several features which are designed to improve the Board’s independence as well as ensure board leadership. Needless to say, if these practices as described are followed, the outcomes as described by CalPERS would be comfortably achieved. The question however would be as to how effectively these practices could be and would be followed at some stage when those are issued as a Code and companies are encouraged to follow such practices on a voluntary basis.

3.4.7 Board processes and evaluation – is enough being done?

CalPERS says: “No board can truly perform its overriding functions of establishing a company’s strategic direction and then monitoring management’s success without a system of evaluating itself.

To achieve the above outcome of self-evaluation, there is a growing need for boards to adopt

written statements about their own governance principles; have an appropriate “mix of director characteristics”; set out performance criteria for itself together with review processes; and to establish performance criteria and compensation incentives for the CEO.


It has been generally found that self-evaluations are not too successful and the processes employed to do so, often do not foster too much credibility in the minds of those who are watching the process. However, perhaps for want of a better alternative, self-evaluation is resorted to but it is obvious that it needs to be greatly improved, if greater confidence is to be instilled in the process. A possible response to this situation is discussed in Paragraph 3.7 of this Report. The ICASL ED on Board Room Governance has provided for Board Processes and Evaluation as per the paragraphs A9-Appriasal of Boardroom Performance and A10- Appraisal of Chief Executive Officer and hence the Sri Lankan literature could be said to cover these aspects to some degree. As the survey results show however, the physical practices and application of these processes seem to be woefully inadequate.

3.4.8 Individual director characteristics – is there sufficient quality and quantity available?

In CalPERS’ view, “Each director should add something unique and valuable to the board as a whole. Each director should fit within the skill sets identified by the board. No director, however, can fulfil his or her potential as an effective board member without personal dedication of time and energy and an ability to bring new and different perspectives to the board.

The above benchmark requires a high degree of competence and commitment on the part of the

directors. In emerging economies such as Sri Lanka, corporate entities face a severe dearth of qualified and competent persons who may be able to undertake such responsibilities. In Sri Lanka, it is observed that the Code of Best Practice suggests that non-executive directors should bring expertise in the different fields to the board. It is also suggested in the Code that persons with wide knowledge on a variety of disciplines, as well as honest persons with integrity should constitute the boards of companies. Whilst these suggestions are laudable, it remains to be seen as to whether there are sufficient number of persons who could fit these characteristics in the Sri Lankan business sector. This then raises the important issue of providing intense training to those who are already in the field to meet the individual director characteristics that are necessary for the effective implementation of good CG practices.

3.5 Are non-executive directorships becoming too onerous? 3.5.1 In the past and even at present, in the case of certain companies, non-executive directors were

usually retired “eminent persons” who were either ceremoniously adorning boards, or persons who were being rewarded with directorships because of some past favour he or she had rendered to the CEO. Perhaps rather unkindly, some non-executive directors were even referred to as being “fat, dumb and comfortable.” Board meetings were usually “cakes and tea” affairs with board members usually jostling amongst themselves to endorse whatever decisions the Chairman or CEO wishes to take, as fast as possible.

3.5.2 Fortunately, events and initiatives of the recent past have changed this situation to some extent.

Today’s shareholders, especially some of the institutional shareholders and some rather vociferous minority shareholders, are more alert to the directors’ contributions to management, and they are now demanding that non-executive directors really earn their fees. The non-executive directors are not spared flak when companies decline. Many are in fact, being held liable for all of the company’s actions. Judges and regulators are also tough on them. These developments have resulted in creating a marked change in the overall functioning of non-executive directors. So much so, that some persons are now nervous about taking positions as directors and are even shying away from being directors. Some others may however say, it is a


case of “when the going gets tough, the not-so-tough running away,” and not hence contend that one should be too uncomfortable about such an outcome.

3.5.3 The general perception however, seems to be that this “attitudinal shift” has been a good one for

the corporate world, and should be sustained and further encouraged. At the same time, because of CG provisions of this nature, more persons are likely to specialise in the duties of directors as well as opt to serve as directors with their “eyes open”. Accordingly the benefits that corporations would derive in the future from non-executive directors are bound to improve.

3.6 With pressure on auditors mounting, are audits becoming too onerous? 3.6.1 Up until about the ’70’s, corporate audits were somewhat mundane exercises, and may have even

been perceived as yet another ceremonial function, which had to done just for the sake of doing it. A greater part of the attention of the auditor was very often on the arithmetical accuracy of the “books” and as to whether the principles of double entry book keeping had been adhered to. However, over the past two decades or so, there has been a growing concern building up in the minds of investors about the quality and independence of the services rendered by auditors and many auditors have been sued large sums of money for negligence, connivance, fraud, etc. These reactions have compelled auditors to take their duties and responsibilities a lot more seriously, and as a result the quality of the audits has certainly improved over the years.

3.6.2 The advent of Audit Committees also helped, at least on paper to improve the quality of the audit.

Sri Lanka’s Code of Best Practice, followed by a new Code of Best Practice on Audit Committees issued by the ICASL in May 2002 certainly were initiatives that focussed on the need to improve the quality of the audit.

3.6.3 However the issue also surfaces as to whether audits are becoming so onerous today that many

practitioners are gradually moving away from such services. If that happens, the corporate world would face a complex factor, i.e., the non-availability of competent auditors, which may be another hindrance to achieving good corporate governance. In the face of these two conflicting positions, the corporate sector may have to develop a suitable compromise or a healthy balance to deal with this complex issue.

3.6.4 At the same time, the old story that auditors are getting too cozy with their clients is also

surfacing… again and again. A survey conducted by the Investor Responsibility Research Centre revealed that 72% of the $5.7 billion in fees paid by 1,200 public companies to their auditors in 2000 was for non-audit services. Similar findings would probably surface in emerging economies as well. Everyone knows this is an old story. But somehow or another, not much seems to have been done to address this issue, all over the world. To some extent perhaps, Sri Lanka may be at least slightly different.

3.6.5 In Sri Lanka, the introduction of the Sri Lanka Accounting and Auditing Standards Monitoring

Board Act in 1995 added a new dimension to this vexed issue about ensuring compliance with Sri Lanka Accounting and Auditing Standards in the preparation and audit of financial statements by specified business entities. As would be seen, the Act requires SBEs to prepare their financial statements in accordance with Sri Lanka Accounting Standards. In a way, such a provision facilitates the work of the auditor in a certain manner and degree. At the same time however, the work of the auditor too may have become more onerous as a result of the added requirement that the audit too should be conducted in accordance with Sri Lanka Auditing Standards. The Act empowers the Monitoring Board to take various measures to ensure compliance and penalties specified for defaulters include heavy fines and even imprisonment. These rather stringent


provisions have certainly had an effect and impact on the financial reporting standards and audit quality, and this initiative of the SLAASMB could perhaps be described as one of the high points in the Sri Lankan CG landscape

3.7 In relation to Corporate Governance, do companies actually do what they say they do? 3.7.1 Over the past three or four years, it would have been observed by the Sri Lankan business

community that many corporate entities proudly state in their annual reports that they are complying with a wide variety of corporate governance practices. They also state very diligently that, as good corporate citizens, they adhere to some Code of Best Practice or another. These statements are obviously very comforting to the shareholders and the community of investors, who are naturally interested as to how efficiently and effectively their companies are being managed, operated and governed.

3.7.2 Notwithstanding such “good” feelings, there is today a growing and nagging concern among

many investors who have some insight into the manner in which many Sri Lankan companies actually operate, that companies do not, in actual fact, follow the Corporate Governance practices in spirit and form, although they say they do so.

3.7.3 In the course of the empirical study on Corporate Governance (CG) Practices in Sri Lanka carried

out in September 2002, one of the stunning findings was that sufficient evidence was not available to even weakly confirm that many of the corporate governance practices that corporate entities said publicly that they were following, were in fact being practiced professionally and diligently. Nevertheless, probably in order to show a good picture in their Annual Reports and to appear as a “good corporate citizens”, practicing “state of the art” corporate practices, such claims seemed to have been made quite nonchalantly or perhaps even casually. Maybe, in many instances, these statements were not entirely or totally untrue or inaccurate. But in general, it seemed that the statements were grossly exaggerated and/or largely unsubstantiated.

3.7.4 But, as practices prevail today, whatever may be the actual ground position, how is anyone to

know? As per the current practices that prevail in Sri Lanka, the corporate community is only able to know what companies do as far as corporate governance practices are concerned, is from what the companies say they do. There is no suggestion or requirement, legal or otherwise, that such “self claims” of good behaviour by companies should be independently verified and reported upon. In the absence of such an independent and professional review of the company claims, no disbeliever could state with any certainty or conviction, that some practice or another was not carried out or that the adherence to some other practice was overstated or exaggerated. This outcome therefore, raises a very significant issue. When corporate entities are technically given the opportunity, or even coaxed and encouraged into making “price sensitive” statements, (there is enough evidence to show that corporate governance compliance statements are “price sensitive”) and such claims are not subjected to any review as to its veracity, is the corporate community inadvertently exposing itself to a dangerous abuse of the system? Could it be said that they may even be tacitly encouraging and/or promoting such abuse? In that context, an extract from the Annual Report (2000) of Enron Corporation which was responsible for one of the largest bankruptcies in US history and caused a highly publicised financial scandal, is worthy of note. “The adequacy of Enron’s financial controls and accounting principles employed in financial reporting are under the general oversight of the Audit Committee of Enron Corporation’s Board of Directors. No member of this Committee is an officer or employee of Enron”. Technically true? Ethically false?


3.7.5 During the Sri Lankan survey, it was quite patent that a number of Sri Lankan companies assessed during the survey were merely setting out certain selected extracts from the Institute of Chartered Accountants of Sri Lanka (ICASL) Code of Best Practice or the Cadbury Guidelines without a clear link or reference to the rest of those Reports. There was no clear disclosure as to how those guidelines were actually being followed. A number of relatively smaller companies also seemed to have reported on certain aspects of CG within their CG reports or Directors' reports on an ad hoc basis, and it seemed that they were merely mimicking the reports of others. Some of the larger companies which appeared to be getting conceptual inputs from specialized Annual Report production firms seemed to be following a set template with a pre-configured checklist of reporting topics. All in all, it looked as if it was a case of many companies blindly following a Framework or Code on CG without clearly comprehending the spirit in which it had been established. It followed therefore that it is very unlikely that those companies would actually be reaping the benefits for which the CG practices were recommended to be followed, in the first instance.

3.7.6 This unsatisfactory situation is further compounded by the fact that an established mechanism of

independently verifying the actual degree of compliance by different companies with the various Best Practice recommendations, is not in place in Sri Lanka, or for that matter in other CG regimes as well. For example, a company that has an Audit Committee that meets once a year for 15 minutes (perhaps just for the sake of meeting), and a company that has an Audit Committee with a number of non-executive directors, meeting once a month for a comprehensive review, would both be able to technically and truthfully, disclose as having working Audit Committees. It is even possible that this wide latitude available in describing its practices has led some companies to even have a somewhat lacklustre attitude towards CG disclosures, and maybe even consider it as a bit of a farce. As one company quite casually remarked in their annual report, “it is not mandatory to disclose corporate governance practices. However…” This kind of feeling is obviously not surprising because in actual practice, there is no real onus on the companies to disclose their CG practices in a credible environment, and even it they were to do so, they know it could be done by using a varied number of measures which results in it being difficult or even impossible for any one to make useful inferences and comparisons.

3.7.7 Although not sufficiently highlighted in the past, this issue is a very serious one and needs a

response from the world-wide corporate community soon. It could perhaps be identified as an issue which is deeply rooted in an “information-expectation-awareness-understanding gap” between corporations and investors/other stakeholders, coupled with an acute misunderstanding on the part of many company directors and investors about the true nature of CG. In that context, the appropriate response to deal with this issue could possibly be through a two-pronged strategy which addresses the underlying and fundamental reasons for this problem.

3.7.8 The first part of such strategy would be to create awareness in the business community of the

need to ensure that companies actually do what companies say they do. For this to happen, there should be an active and concerted drive towards enhancing awareness about this issue among all companies and investors and make them appreciate the vast benefits and opportunities that could be derived from the adherence to good CG practices. The second part of the strategy would be to set up an institutionalized mechanism for Independent Assessments to be done on the actual degree of physical compliance with CG practices and policies by companies. It is obvious that all aspects of a company’s CG practices including the activities of various board committees, disclosures of information, composition of non-executive directors, implementation of Board/CEO evaluation criteria and evaluation of performance etc. should be scrutinised, evaluated and reported upon, if it is to be credible. In that background, the investment community should essentially drive the demand for such independent monitoring, since their


investment decisions are to some extent, based on such claims. Just as investors require credit ratings of corporates from independent “credit rating” firms before making decisions on certain investments and debt instruments, investors should also require independent reviews and evaluation of corporates’ CG practices from “CG rating” firms, if they are to confidently rely upon such claims.

3.7.9 Many surveys across the world have shown that investors pay more for shares of companies who

have good CG practices. The Global Investor Opinion Survey, 2002 released by McKinsey & Company clearly showed the importance today’s investors place on good corporate governance. 63% of investors said they would avoid certain companies with unreliable CG, while 57% stated that they would increase or decrease their holdings based on the company’s CG practices. Over 80% of Asian investors ranked good CG as equally or more important, relative to financial issues. A significant percentage of investors (78%) said they would be willing to pay a premium for a well-governed company. A new stock market, the STAR exchange, launched in April 2001 by Italy’s Borsa Italiana for companies that follow a strict set of governance requirements also provides more evidence. Listed companies in the STAR exchange must have a minimum number of independent, non-executive directors; ensure that the compensation of managers and directors reflects their performance; and adhere to rigorous disclosure requirements. Studies have revealed that Companies on the STAR exchange out-performed those on the main boards by 16.5% and had a weighted average market-to-book ratio of 3.8, compared with 2.1 on the main exchange. (The McKinsey Quarterly, 2002 Number 3). These findings confirm the “price-sensitive” nature of perceived adherence to corporate governance practices. Sri Lanka is no different. The September/October 2002 survey findings clearly revealed that several companies which ranked higher with regard to their stated adherence to CG practices, displayed higher PE ratios than their counterparts whose stated CG practices ranked lower. It could therefore be said with some authority that investors of today are prepared to pay a premium for companies with good CG practices. In that background it would not be too difficult to implement an independent review scheme as suggested, since it would greatly enhance the credibility of the process. Further, it is very likely that when such a scheme is set in motion, the companies themselves would opt for independent assessment of their CG practices in order to show themselves off to the investor community as model corporate citizens. In this context, CG champions should in the very near future, identify the key assessment criteria along with the skills required by Independent Assessors, and such initiatives should be translated into a comprehensive strategic framework with an implementation arm as well. It is indeed surprising that this issue has not received sufficient attention from the global CG community as yet, but it is now certainly time that it be viewed with serious concern, and responses implemented before some horrendous scandal surfaces to direct the public and media searchlight towards it.

3.8 How can CG practices be implemented when many directors do not even know how to do

so? 3.8.1 It may also be opportune to acknowledge another ground reality in that many company directors

do not know how to effectively implement good governance practices in their companies. It is no secret among many in the investing community that the knowledge and appreciation of governance practices is very limited amongst many directors. Unfortunately, there are very few who could train such directors either! For example, in the case of the implementation of practices such as Independent Board appraisals, CEO appraisals, CEO succession, Nominating Committee processes, Remuneration Committee processes, etc., many directors are not sure as to how those processes could be worked or even how they should work!


3.8.2 It is therefore very necessary that experts in these fields start to offer specialized services to assist boards to carry out such appraisals as well as to develop functional and practical methods and models for the successful implementation of various governance procedures, processes, etc. While it is noted that there are some ad hoc type of initiatives in the form of director training courses carried out in this regard, many of these do not address the real needs as set out above. It is therefore important that a sufficient number of structured courses are organised to impart these special knowledge and skills to Directors and Chairmen. If this does not happen soon, the well-spelled out governance processes will remain processes on paper only.

3.9 What about Whistleblowers?

A study by the National Whistleblowers Centre in the USA has revealed that about a half of the whistle-blowers who exposed workplace wrongdoing, have been fired, harassed, or been unfairly disciplined. The question then may be posed as to in that if this situation continues, who will tell? Who is to safeguard the whistle-blowers?

In emerging economies, especially in South Asia, whistle-blowing could be a somewhat risky enterprise, and it is quite likely that if members of the staff or top executives were to expose wrong-doing, they would almost certainly be subjected to harassment and/or penalized in some way. In Sri Lanka, there have been very few cases where whistleblowers have been successful in exposing instances of wrong doing, but more often than not, the reverse would be true; and it is unlikely that any material change would take place in this regard in the near future. This is perhaps an issue that needs careful attention soon.

3.10 Are regulators really independent? 3.10.1 An issue that it is also quite pertinent is the quality, integrity and independence of regulators.

Especially in smaller economies, “old boys clubs” have taken root where persons with obvious conflicts of interest sit on judgement on many corporate issues, as Members of Commissions, Members of Supervisory Bodies and other Regulatory authorities. Such blatant disregard of good governance principles hardly promotes confidence, and should be exposed and discouraged at every turn.

3.10.2 In Sri Lanka there is a plethora of regulators in many forms. These institutions and the work

done by them are described in Paragraph 1 of this Report. Any person looking at these institutions from outside is bound to convince themselves that these organizations are all working satisfactorily, supporting each other effectively and are all part of a framework which results in promoting and ensuring a very high quality of governance in the country. Unfortunately however, although all these institutions have been established to fulfil some major need, it is sad that not all are playing such dynamic and/or useful roles. There are many instances which are surfacing again and again with regard to conflict of interest, arrogant or arbitrary behaviour, poor understanding of issues, obvious bias, painful bureaucratic procedures, etc. These shortcomings very often make those institutions less credible and effective. Therefore not only is it necessary to head-hunt outstanding persons to fill regulatory roles and invite them to carry out the tasks ahead with integrity and efficiency, but also restore confidence in the regulatory system by ensuring that there is consistency in the decision making processes.

3.11 CG is a vibrant and dynamic process The above mentioned emerging issues as well as many others contribute to the vibrancy and

dynamism of the subject of corporate governance. While obvious benefits would follow if the


above mentioned issues are satisfactorily resolved, or managed, it must be kept in mind that fresh issues would also emerge as time goes on. The necessity therefore would be to strike the optimum balance when faced with “contradictory” issues, as well as develop a global community of CG professionals who will “watch over” this new science. That then would probably be one of the main challenges that are facing the business and corporate sector today.

4. The Way Forward…Is Good Corporate Governance, The Panacea For All Business Ills? 4.1 CG at the centre of investment decisions

It is very clear that Corporate Governance is of great concern and interest for institutional investors, according to the July 2002 Global Investor Opinion Survey released by McKinsey & Company. The survey has also revealed that the strengthening of the quality of accounting disclosure has also been identified as a top priority by the investing community. From all accounts, therefore it could be safely stated that Corporate Governance is obviously at the centre of all investment decisions. In fact, as per the McKinsey findings:

• Investors state that they place corporate governance on par with financial indicators when

evaluating investment decisions. • An overwhelming majority of investors have stated that they are prepared to pay a premium

for companies exhibiting high governance standards. [Premiums averaged 12-14% in North America and Western Europe; 20-25% in Asia and Latin America; and over 30% in Eastern Europe and Africa].

• The relative significance of “governance” seems to have decreased slightly since 2000. This

is probably due to the fact that: (a) many countries have implemented governance-related reforms in their corporate sectors, and that has been welcomed by investors, and (b) more than 60% of institutional investors have been guided by policies that make them to avoid individual companies with poor governance, as well as avoid countries with poor governance.

4.2 Is CG the new miracle drug?

Does all this mean therefore that Corporate Governance is the new miracle drug that could be prescribed to treat all corporate ills?

Over the past few years the awareness about corporate governance principles has been growing worldwide. Together with such awareness, the expectations of corporate entities and investors about its validity and usefulness have also been growing. Investors have begun to have more faith in corporate entities that practice good corporate governance processes rather than those which do not do so.

4.3 Will good CG eliminate business risk? 4.3.1 On the downside however, this situation has also perhaps in an indirect manner, led to many

investors tending to perceive and believe that corporations which follow good corporate governance practices are risk free and that the good governance practices offer some kind of a guarantee against business risk and the uncertainty of business as well. The disappointments being expressed about CG practices when corporate failures take place is probably a


manifestation of this growing, genuine belief. This is a dangerous and misleading trend and can quite effectively damage the positive build-up about the concept that is prevailing today.

4.3.2 It is therefore vital for these who are involved in promoting good corporate governance practices

to also publicise the limitations of corporate governance and address this growing expectation gap. Good corporate governance practices however soundly applied, does not eliminate business risk. The fact that such practices could certainly help to manage and control risk and to bring a corporate entity back to profitability and stability faster, should not be mistaken for the elimination of business risk. Emerging economies such as Sri Lanka are greatly susceptible to expectations of this nature and hence it is vital that good CG is shown in its true light with all its strengths and weaknesses.

“We wanted a system which stops reasonable men being fooled, not to protect fools from their own folly.” White Paper on Investor Protection, January 1985 – in England

Abbreviations used in this Report CBSL - Central Bank of Sri Lanka CCC - Ceylon Chamber of Commerce CDS - Central Depository System CEO - Chief Executive Officer CSE - Colombo Stock Exchange ED - Exposure Draft ICASL - Institute of Chartered Accountants of Sri Lanka IPO - Initial Public Offering OECD - Organisation for Economic Co-operation and Development ROC - Registrar of Companies SBE - Specified Business Enterprise SEC - Securities and Exchange Commission of Sri Lanka SLAASMB - Sri Lanka Accounting and Auditing Standards Monitoring Board SLAS - Sri Lanka Accounting Standards SLAuS - Sri Lanka Auditing Standards SLID - Sri Lanka Institute of Directors TOR - Terms of Reference UITF - Urgent Issues Task Forces


Annex 1 Survey of Corporate Governance Practices in Sri Lanka 1.0 Introduction Good Corporate Governance (CG) is an extremely complex issue. The issues and complexities involved are shared alike in developing countries, transition economies and the developed world. Therefore, it is necessary to gain a clear understanding of these issues at a grass-roots level in order to devise practical frameworks and processes to contribute to good CG and economic expansion. 2.0 CG Survey The survey was conducted on a random sample of 50 Public Listed Limited Liability companies representing 21% of all listed companies in the Colombo Stock Exchange (CSE). The sample covered most of the major sectors in the CSE. The sample companies recorded a combined turnover of LKR 141.2 billion (US$ 1.5 billion) within the period of review. The latest available Annual Reports of the sample companies were analysed based the following criteria: Statement of Compliance to ICASL guidelines Separation of the Chairman and the CEO Composition of the Board of Directors with respect to Non-Executive Directors Provision of training to directors Disclosure of a Nomination Committee Disclosure of an Audit Committee Disclosure of a Remuneration Committee Having a Director in charge of finance Statement of internal control Disclosure of audit fees as a separate item Directors’ responsibility statement Statement of going concern Payment of all Statutory Payments Qualified Company Secretary Statement of a Code of Ethics in business practices Chairman’s review addressing future prospects Method for CEO succession Method for CEO evaluation Method for Board evaluation

Each Company was given 1 point for fulfilling each of the above criteria (apart from the percentage composition of the Board) for a maximum of 18 points. 3.0 Analysis The Sample obtained an average of 8 points or 45% of the total achievable score with a median of 9. Notable high-scorers include National Development Bank (72%), Commercial Bank (67%), John Keells Holdings (67%), Ceylon Tobacco Company (67%) and Hayleys (61%).


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44% of the Sample Companies disclosed a Statement of Compliance with the ICASL Best Practices Guidelines. However, non-of the companies stated the degree of compliance. There was a significant number of companies that extracted verbatim the definition of Corporate Governance from the ICASL guidelines or from the Cadbury Report on Corporate Governance without any clear linkage to the remainder of their CG report. The purpose of this exercise is unclear apart from giving the reader a definition of CG. There were also a number of companies that stated that they agreed fully with the guidelines set by the ICASL, but did not state whether they were complying with the guidelines. Over two thirds of the Sample Companies issued a Statement of Internal Control. Most of the larger companies had a specific report on the subject while some smaller companies included it within the Directors’ Report. Just over half of the Sample Companies reported an Audit Committee. Some of the larger companies accompanied the disclosure with a separate Audit Committee Report. The smaller companies usually disclosed the presence of an Audit Committee within its CG report, but did not disclose the functions and responsibilities of the Committee or its activities within the reporting period. The Remuneration Committee was generally reported only by the larger and more established companies. It has to be noted that all the companies within the Diversified Holdings sector reported a Remuneration Committee.

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A significant majority (78%) of the Sample Companies reported a Directors’ Responsibility Statement. The Statements generally conformed to the ICASL guidelines identified that the Directors’ responsibility is different from the responsibilities of the Auditor’s. They also referred to the relevant sections of the Companies Act and Sri Lanka Accounting Standards (SLAS). 64% of the Sample Companies reported a Statement of Going Concern while half of the Sample Companies disclosed that their statutory payments were up-to-date. It was notable that a leading bank that had omitted to report a going concern statement in the preceding reporting period had disclosed such a statement within the current period. However, a very dismal 14% reported any kind of training programs for their Directors. Moreover, none disclosed the type of training and skills development available. Nearly two thirds of the Sample Companies reported a separation of duties between the Chairman and the Chief Executive Officer. Many companies referred to the ICASL guidelines as a prime motivator for this separation. A few of the larger companies also referred to the OECD guidelines115. However, there were a nominal number of companies, including a large Bank and Diversified Holdings Company, which had an executive Chairman and a CEO. While these companies reported faithfully following Guidelines, they do not necessarily adhere to the spirit of such Guidelines. The OECD Guidelines for the separation of the roles between Chairman and CEO is to ensure an "appropriate balance of power, increasing accountability and increasing the capacity of the board for independent decision making”116. However, it is unclear how this can be achieved by having an executive Chairman and a CEO.

115 OECD Principles of Corporate Governance (1999), OECD 116 OECD Principles of Corporate Governance (1999), OECD, pp. 24

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It was only 18% of the Sample Companies that had a Director in-charge of finance in their Boards. Considering that it is the responsibility of the Directors to “ensure (sic) the integrity of the corporation’s accounting and financial reporting” and “reviewing…annual budgets…and setting performance objectives and monitoring…performance”117 it is essential to have representation of a financially qualified person within the Board. 80% of the Sample Companies referred to their future prospects and strategies in their respective Chairman’s Reviews. A few companies reported their future plans within the Directors Review or Management Discussion. Only one fifth of the Sample Companies referred to any code of ethical practices. Some companies stated that they expect their employees to act in the “highest ethical standards”, but failed to refer to any standard or code. One fourth of the Sample Companies had a composition of over 80% non-executive directors within their Boards. Nearly 75% of the Sample Companies had a composition of over 41% non-executive directors within their Boards. Many companies referred to the ICASL Code and the OECD Code as a motivating factor in deciding Board Compositions. A number of Companies stated that the experience and calibre of non-executive directors will contribute significantly to the performance of their companies and will look after the interests of external stakeholders. All the Sample Companies showed audit fees as a separate cost item in their notes to accounts.

117 OECD Principles of Corporate Governance (1999), OECD, pp. 9

Fig. 3.0


48 of the Sample Companies reported qualified Company Secretaries. While most companies used a corporate services firm to provide secretarial services few companies used in-house corporate secretaries. Their qualifications were disclosed. Only one company-a bank- reported procedures for CEO succession and CEO evaluation. Two other companies had procedures for Board Evaluation. 4.0 Case Study

There were a few companies that were way ahead of the others with respect to disclosure. Therefore, we sought to establish whether there was any distinct advantage with respect to the company by a high rate of disclosure. A test was undertaken to measure the performance of the Company against the performance of the overall market during the reporting period. The Company Price Earnings Ration (PER) was plotted against the Colombo Stock Exchange Market PER. While there may be a number of

factors influencing the performance of a company, we believe that corporate governance disclosure and good CG practices are a significant contributory factor. 4.1 John Keells Holdings Ltd.

Fig. 4.0: Non Executive Director Composition

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JKH Market

John Keels Holdings Ltd. (JKH) is a Diversified Holdings company involved in Leisure, Food & Beverage, IT, Infrastructure Development, Plantations and Financial Services Sectors. JKH had a 67% disclosure rate in the CG survey. Moreover, the Company was one of the first corporates to adopt the ICASL guidelines and have consistently made a high degree of disclosure. The Company has constantly over performed the market during the reporting period. 4.2 Commercial Bank Commercial Bank (CB) is one of the largest private sector banks in Sri Lanka. It was the first bank to reach the LKR 1 billion mark in its profit.

Fig. 4.0: JKH PER performance


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The Bank has won the prestigious “Best Bank in Sri Lanka” award from the Global Finance Magazine for three consecutive years from 1999-2001. Moreover, CB has won the “Bank of the Year 2001 Sri Lanka” award from the Banker Magazine. CB was the only company to disclose procedures for CEO succession and evaluation. CB has over performed or performed at par with the Market in what was essentially a depressed year for financial services. 4.3 Richard Pieris & Co. Ltd

Fig. 5.0: CB PER performance based on EPS of voting shares


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Richard Pieris & Co. Ltd. (RPC) is a large manufacturing company with interests in real estate development and retail services. The Company has shown a significant year on year growth in its CG reporting. RPC has incrementally disclosed the addition of a Director of Finance, Audit Committee and a Statement of Statutory Payments within the review period applicable to the Survey. RPC has consistently over performed the market within the same period. 4.4 Hayleys Ltd. Hayleys Ltd. (HL) is a large Diversified Holdings company involved in Manufacturing, Agriculture, Plantations, Transportation, Leisure and Textiles. HL had a disclosure rate of 61%. The Company was one of the few in the Survey that disclosed training for Directors.

Fig. 6.0: RPC PER performance


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The Company has been winning the ICASL Annual Report Competition consistently for the last 2 years in the Diversified Holdings Sector. The measure of disclosure is a key criterion for winning the Annual Report Competition. The Company has performed generally at par with the market in a depressed year for a number of its core sectors. 5.0 On the Ground The Global Investor Opinion Survey, 2002118 released by McKinsey & Company clearly shows the importance today’s investors place on good corporate governance. 63% of investors said they would avoid certain companies with unreliable CG, while 57% stated that they would increase or decrease their holdings based on the companys’ CG practices. Over 80% of Asian investors ranked good CG as equally or more important relative to financial issues. A significant percentage of investors (78%) said they would be willing to pay a premium for a well-governed company. 5.1 The Sri Lankan Case Our survey on the Sri Lankan CG practices show that most companies are following a framework based on theoretical principles. However, there is no clear indication as to how these principles are really put into practice. We came across a number of companies during the Survey that merely printed extracts from the ICASL guidelines or the Cadbury Guidelines without any clear link or relevance to the rest of the report. These

118 Global Investor Opinion Survey on Corporate Governance (2002), McKinsey & Company

Fig. 6.0: RPC PER performance


extracts were used more as a definition of CG while there was no disclosure as to whether these guidelines were being actually followed. 5.2 The Pied Piper Effect A number of smaller companies reported on certain aspects of CG within their CG reports or Directors' report on an ad hoc basis. There was no clear indication as to whether these companies were aware of the ICASL guidelines or whether they were merely mimicking reports of others. Some of the larger companies were getting conceptual inputs from specialised Annual Report Production firms. Most of these firms follow a set template with a pre-configured checklist of reporting topics. Therefore, there seems to be a blind following of the Framework without clearly comprehending the spirit of which it was established. Just as the mice of Hamelin blindly followed the Pied Piper and his flute, many companies seem to be following the Framework without actually reaping or passing on its benefits for which it was devised. Such a reality might lead some companies over the cliff of investor confidence- just like the mice of Hamelin- to their eventual demise. This situation is further compounded by the fact that there is no way of independently verifying the actual degrees of compliance of the various Best Practice recommendations of different companies. For example, a company that has an Audit Committee that meets once a year for 15 minutes and a company that has an Audit Committee with a number of non-executive directors and meet once a month for a comprehensive review would both be able to disclose as having a working Audit Committee within their respective Annual Reports. Some companies have a lacklustre attitude towards CG disclosure. As one company put it “it is not mandatory to disclose corporate governance. However…” This shows that there is no real onus on the Companies to disclose their CG practices and even when they do it is done by using a varied number of base measures that no useful inferences can be made. Another case to point: An extract from the Annual Report (2000) of Enron Corporation- which was responsible for one of the largest bankruptcies in US history and caused a highly publicised financial scandal. “The adequacy of Enron’s financial controls and accounting principles employed in financial reporting are under the general oversight of the Audit Committee of Enron Corp.’s Board of Directors. No member of this committee is an officer or employee of Enron”. 119 This clearly shows that having the tools for good CG is by itself not enough. They have to be used knowledgably and with a clear idea of what needs to be achieved. 6.0 A Solution We believe that any solution to this information gap between the corporation and investor (and other stakeholders) along with the attitude deficit of the corporation needs to be addressed through a two-pronged strategy. 6.1 Awareness 119 Annual Report (2000), Enron Corporation


It should be the responsibility of the persons who are championing good Corporate Governance to ensure that companies are actually doing what they say they are doing within the true spirit of the frameworks and concepts. There should be an active drive towards enhancing awareness among the smaller companies and to make them realise the opportunities that can be derived from good CG. 6.2 Independent Assessment Although Latham (1999)120 calls for independent Corporate Monitoring Firms to nominate director candidates for a company’s Board, we believe independent assessment of a company’s CG practices should be much more far reaching. All aspects of a company’s CG practices including the activities of various Board committees, disclosure of information, composition of non-executive directors, Board/CEO evaluation criteria and evaluation performance etc. should be scrutinised and reported. The investment community should essentially drive the demand for independent monitoring. Just as investors require credit ratings of corporates from independent credit rating firms before making any decisions on an investment instrument, investors should require an independent “audit” of a corporate’s CG practices. With many investors prepared to pay a premium for companies with good CG121 it should also be the responsibility of the corporates themselves to opt for independent assessment. CG champions such as the ICASL and the international CG institutions should identify the key assessment criteria along with the skill set required by the Independent Assessors, which should be translated into a comprehensive strategic framework. 7.0 Conclusion While the Sri Lankan CG landscape is yet a long way off from ideal there has been significant improvements year on year. As the case studies show some companies are already reaping dividends from their CG practices. One of the principal problems in Sri Lanka and indeed the rest of the world is that there is no reliable way of assessing the CG practices of individual companies. Therefore, independent assessment backed by a strategic framework from CG champions and driven by the investment community would be a step in the right direction to enhance the utility of CG in the investment environment.

120 Latham, M.(1999) The Corporate Monitoring Firm, Corporate Governance- An International Review, Vol. 7, No. 1 121 Global Investor Opinion Survey on Corporate Governance (2002), McKinsey & Company


Annex 2 Comparison of Sri Lanka’s CG Practices with OECD Principles

Responsibilities of the Board Act fully informed, due diligence, best interests of the Company and the Monitoring and managing potential conflicts of interest shareholders Appointment of Audit Committee Seeking legal and financial advice with the Company to bear the cost Internal Control Statement Formal and basic training for Directors Draw up a Code of Ethics and Statements of Business Practices Short "in-house" courses organised by Institutions Draft: Declaration of all material contracts involving the Company and refrain for voting in materially interested matters Treat shareholders fairly Draft: Statement of equitable treatment of shareholders Ensuring the integrity of the corporation's accounting and financial reporting systems Ensure compliance with applicable laws and take into account the Finance function should be the responsibility of a specific interests of the shareholders board director Issue compliance report setting out the extent statutory payments have been Statement of Directors' Responsibility for Financial Statements made. Fees paid for audit and non audit work to be shown separately I: Responsibility of Board to look after interests of stakeholders Periodical rotation of audit partners and staff Statement of Going Concern Reviewing and guiding corporate strategy, plans, annual budgets, I: Business Risks undertaken after due consideration by both performance objectives, implementation, cap ex, acquisitions and management and board divestitures Draft: Board should meet regularly with board meetings at least once every Monitoring the effectiveness of governance practices quarter Draft: CG Report Draft: Board should have a formal schedule of matters for decision Selecting, compensating, monitoring, replacing key executives and overseeing succession planning Appointment of Remuneration Committee Key: Appointment of Non-Ex Directors should be a matter for the Board as a Supporting recommendations of the OECD Principles whole Supporting recommendations of ICASL and other documents Draft: Nomination Committee for Board Appointments I: Supporting recommendations of ICSA I: Reviewing and appraising the performance of the Board annually Draft: Supporting recommendations of Exposure Draft ICASL Draft: Appraisal of CEO


Responsibilities of the Board (cont.)

Overseeing the process of disclosure and Key: communications Supporting recommendations of the OECD Principles I: Annual Report of the Board should give concise Supporting recommendations of ICASL and other documents and informative statements that give insight to the company's I: Supporting recommendations of ICSA underlying governance approach Draft: Supporting recommendations of Exposure Draft ICASL Exercise objective judgement of corporate affairs independent of management Separation of Chairman and CEO Appointment of independent non- ex board members Have access to accurate, relevant and timely information I: Company secretary to provide information to the Board Draft: Board must be supplied information in a timely manner in sufficient quality to discharge its duties


Disclosure and Transparency

Disclosure should include, but not limited to: Information should be prepared, audited and disclosed The financial and operating results of the company in accordance with high quality standards of I: Annual Report- financial statements of the company prepared accounting and audit in terms of the Companies Act No. 17, 1982 and SLAS Confirmation that applicable Sri Lanka Accounting Standards have been followed. Company objectives I: Concise statements should be provided for company plans and strategies Annual audit should be conducted by an independent auditor External Audit…according to SLAS would lead to expression Major Share ownership and voting rights of objective, independent and effective opinion on the Financial Statement Members of the board and key executives, and their remuneration Channels for disseminating information should Draft: The company's Annual Report should contain statement of provide for fair, timely and cost efficient access to remuneration policy relevant information by users Draft: Disclose all elements of remuneration…of the board as a whole I: Identification of chairman and CEO and also non-ex and independent directors Material foreseeable risk factors I: Concise statements should be provided for company risk management Material issues regarding employees and other Key: stakeholders Supporting recommendations of the OECD Principles Supporting recommendations of ICASL and other documents Governance structures and policies I: Supporting recommendations of ICSA Directors should state the extent of compliance with the Draft: Supporting recommendations of Exposure Draft ICASL Code of Best Practice


Role of Stakeholders in CG Equitable Treatment of Shareholders

CG framework should assure the rights of All shareholders of the same class should be stakeholders that are protected by law are respected treated equally Within the same class, all shareholders should have Where stakeholder interests are protected by law, the same voting rights stakeholders should have the opportunity to obtain effective redress for violation of their rights Votes should be cast by custodians and nominees in a manner agreed upon with the beneficial owner of the shares CG framework should permit performance-enhancing Draft: Companies should count all proxy votes mechanisms for stakeholder participation Processes and procedures for general shareholder Where stakeholders participate in CG they should meetings should allow for equitable treatment of have access to relevant information shareholders Key: Supporting recommendations of the OECD Principles Supporting recommendations of ICASL and other documents I: Supporting recommendations of ICSA Draft: Supporting recommendations of Exposure Draft ICASL


The Rights of Shareholders

Basic shareholder rights: Opportunity for shareholders to ask questions of the board and Secure method of ownership registration place items on the agenda Convey or transfer shares Obtain relevant information Able to vote in person or absentia Participate and vote in general shareholder meetings The Company should use its AGM to communicate effectively with its shareholders Capital structures and arrangements that enable certain Elect members of the Board shareholders to obtain a degree of control disproportionate to The Directors should stand for re-election at an AGM at their equity ownership should be disclosed regular intervals Share in the profits of the corporation Markets for corporate control should be allowed to function in an efficient and transparent manner Right to participate in and sufficiently informed on Amendments to statutes, AA or similar governing documents of the company Should consider the costs and benefits of exercising their voting Authorisation of additional shares rights Extraordinary Transaction Draft: Directors should disclose to shareholders all proposed corporate transactions, which if entered into, would materially alter/vary the company’s net asset base

Should be furnished with sufficient and timely information concerning the date, location and agenda of general meetings Key: as well as full and timely information Supporting recommendations of the OECD Principles I: Send notice of AGM and all connected documents at least Supporting recommendations of ICASL and other documents 28 calendar days before the day of the meeting I: Supporting recommendations of ICSA Draft: Supporting recommendations of Exposure Draft ICASL