workshop on corporate governance presented at the alb in-house legal summit october 14, 2004 mohit...

Workshop on Corporate Governance Workshop on Corporate Governance

Presented at thePresented at the

ALB In-House Legal SummitALB In-House Legal Summit

October 14, 2004October 14, 2004

Mohit Saraf Mohit Saraf B.D. Ushir B.D. Ushir

(Partner) (Partner) (Partner) (Partner)

Luthra & LuthraLuthra & LuthraLaw OfficesLaw Offices

FrameworkFramework

Section I Section I The Need for Corporate Governance The Need for Corporate Governance

Section II Section II Conceptualizing Corporate Governance Conceptualizing Corporate Governance

Section III Evolution of Systems of AccountabilitySection III Evolution of Systems of Accountability

Section IV Director: The FiduciarySection IV Director: The Fiduciary

Section V Auditors: The Watchful EyeSection V Auditors: The Watchful Eye

Section VI Reinventing Corporate GovernanceSection VI Reinventing Corporate Governance

Luthra & Luthra Law Offices 3

Section ISection I The Need for Corporate GovernanceThe Need for Corporate Governance

Responsibility to StakeholdersResponsibility to StakeholdersPredictabilityPredictabilityTransparencyTransparencyAccountabilityAccountability

Easier access to capital (FII, VCF)Easier access to capital (FII, VCF)

Efficiency (at the firm level) and Global Efficiency (at the firm level) and Global Competitiveness (IPRs)Competitiveness (IPRs)


Section IISection IIConceptualizing Corporate GovernanceConceptualizing Corporate Governance

Narrow DefinitionNarrow Definition- A set of - A set of relationshipsrelationships between the company and between the company and

shareholders, directors and management.shareholders, directors and management.

Broad DefinitionBroad Definition- Going beyond and looking to the implicit and explicit - Going beyond and looking to the implicit and explicit

relationships of the company with relationships of the company with employees, employees, creditors, consumers, distributors, local creditors, consumers, distributors, local communitiescommunities..


Conceptualizing Corporate Governance Conceptualizing Corporate Governance (Contd.)(Contd.)

OECD DefinitionOECD Definition– System by which corporations are System by which corporations are directed and controlleddirected and controlled. . – Spells out the rules / procedures for making decisions on Spells out the rules / procedures for making decisions on

corporate affairs. corporate affairs. – Provide the structure through which the company Provide the structure through which the company objectivesobjectives

are set, and the are set, and the means of attaining means of attaining those objectives and those objectives and monitoring performancemonitoring performance

– Specifies the distribution of rights and responsibilities Specifies the distribution of rights and responsibilities among different participants in the corporation, such as, the among different participants in the corporation, such as, the board, managers, shareholders and other stakeholdersboard, managers, shareholders and other stakeholders

World Bank DefinitionWorld Bank Definition– Corporate governance is about Corporate governance is about promoting corporate promoting corporate

fairnessfairness, transparency and accountability, transparency and accountability


Conceptualizing Corporate Governance Conceptualizing Corporate Governance (Contd.)(Contd.)

What constitutes shareholders’ interest? sustainable What constitutes shareholders’ interest? sustainable profitability versus profitabilityprofitability versus profitability

Need for external regulationNeed for external regulation– FOR:FOR:

» Conflict of interest b/w Management/Promoters and other Conflict of interest b/w Management/Promoters and other constituenciesconstituencies

» To protect small investorsTo protect small investors» To account for ExternalitiesTo account for Externalities

– AGAINST:AGAINST:» Risk of excessive policing (time & cost of compliance)Risk of excessive policing (time & cost of compliance)» Increase costsIncrease costs» Check the box approachCheck the box approach


Section IIISection III Evolution of Systems of Accountability: Evolution of Systems of Accountability:

Indian InitiativesIndian Initiatives In December In December 19951995, , CIICII set up a task force to design a set up a task force to design a

voluntary code of corporate governancevoluntary code of corporate governance In April In April 19981998, the Desirable Corporate Governance: A , the Desirable Corporate Governance: A CodeCode, ,

was releasedwas released SEBISEBI set up the set up the Kumar Mangalam BirlaKumar Mangalam Birla Committee in Committee in 19991999 to to

design a mandatory-cum-recommendatory code for listed design a mandatory-cum-recommendatory code for listed companies (companies (Clause 49Clause 49))

DCA DCA set up the set up the Naresh Chandra Naresh Chandra Committee Report in Committee Report in 20022002. . The key recommendation related to The key recommendation related to financial and non-financial disclosures and independent auditing and board oversight of management (Draft Companies Bill)

The The Narayana Murthy Narayana Murthy Committee was set up by Committee was set up by SEBI SEBI in in 2002 2002 to review clause 49 and suggest measures to improve corporate to review clause 49 and suggest measures to improve corporate governance standards (governance standards (Proposed Clause 49Proposed Clause 49))


Developments in the U.SDevelopments in the U.S ENRON

– Bankruptcy filing in 2001 (largest in US history) – Accounting techniques involving unconsolidated

partnerships and “special purpose entities” to hide losses from financial statements & conceal indebtedness.

– Issues regarding independence of auditors, provision of non audit services & conflict of interest

– Independence of directors

SARBANES OXLEY ACT, 2002 (SOX)– Signed into law July 30, 2002– Enhances reporting obligations of public companies to

prevent securities fraud & other abuses


SOXSOX

Applicable toApplicable to::– Companies listed or traded in the U.S (including non U.S Companies listed or traded in the U.S (including non U.S

Companies)Companies)

– Subsidiaries of U.S Companies in India (provided they Subsidiaries of U.S Companies in India (provided they have a business connection in the U.S)have a business connection in the U.S)

– Foreign accounting firms that prepare or furnish audit Foreign accounting firms that prepare or furnish audit report for an issuerreport for an issuer

– Sometimes compliance expected by U.S Companies Sometimes compliance expected by U.S Companies from business partners in India (implications for BPO from business partners in India (implications for BPO sector) sector)


SOX-Brief OverviewSOX-Brief Overview

CEO & CFO certificationCEO & CFO certification in SEC Reports (Ss 302 & 906) in SEC Reports (Ss 302 & 906)– Compliance with Securities Exchange Act, 1934Compliance with Securities Exchange Act, 1934– Financial statements represent the true financial condition of Financial statements represent the true financial condition of

the Company operationsthe Company operations– Financial results contain no untrue statement /Financial results contain no untrue statement /omission of omission of

material factmaterial fact– Company has complied with Disclosure normsCompany has complied with Disclosure norms– Management have disclosed significant deficiencies, changes, Management have disclosed significant deficiencies, changes,

fraud to auditors & audit committeefraud to auditors & audit committee Ban on loans to executive officers and directorsBan on loans to executive officers and directors Accelerated filings of periodic reportsAccelerated filings of periodic reports Filing of change of beneficial ownership within 2 daysFiling of change of beneficial ownership within 2 days


SOX-Brief Overview (Contd.)SOX-Brief Overview (Contd.)

Reimbursement by CEO/CFO upon restatement of financial statements due to misconduct– Bonus/other incentive based compensation– Profits from sale of securities

Independence of Board of Directors/ Committees

Enhanced Criminal Penalties (upto $5 million fine for individuals, $25 million for entities, prison terms upto 20 years)

Strict Reporting of illegal or unethical behavior


SOX-Brief Overview (Contd.)SOX-Brief Overview (Contd.) Audit Committee

– Independent– Financial Literacy of members – At least one financial expert – Responsible for appointment, compensation &

oversight of auditor & approval of audit/non audit services

– Create compliant mechanism regarding accounting and auditing

– Approve all related party transactions Implementation of a ‘Whistleblower’ policy


SOX-Brief Overview (Contd.)SOX-Brief Overview (Contd.)

Additional Disclosures – Off Balance Sheet Items & transactions that may

have material current/future effect on financial condition/results of operations

– Pro forma Information must conform to financials prepared under GAAP - No untruth/omission

– All fees billed by auditors in annual report– Audit Partner Rotation– Registration with Public Company Accounting

Oversight Board (including foreign audit firms that audit Issuers)


Major Areas of DebateMajor Areas of Debate

Directors

Independent Directors

Audit Committees

Auditors


Section IVSection IVDirector: The FiduciaryDirector: The Fiduciary

“If directors act within their powers, if they act with such care as is reasonably to be expected from them, having regard to their knowledge and experience, and if they act honestly for the benefit of the company they represent, they discharge both their equitable as well as their legal duty to the company”


WHO DO DIRECTORS OWE A DUTY WHO DO DIRECTORS OWE A DUTY TO?TO?

COMPANY

SHAREHOLDERS

EMPLOYEES

PUBLIC

CREDITORS


General Duties of DirectorsGeneral Duties of Directors

Duty of care and skill Duty of loyalty & disclosure Duty of disgorging profit in relation

to corporate opportunity


Duty of Care and SkillDuty of Care and Skill

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


Duty of Care and Skill (Contd.)Duty of Care and Skill (Contd.) Courts in UK and USA have held that directors in banks and financial institutions owe a higher degree of care

– The banking industry is involved in regular receipt of public cash and property and is thus more vulnerable than other businesses and therefore a greater care is required;

– A director of a company (a bank) that has a large amount of liquid assets carries with him higher risks and temptation to which such assets give rise;

– There are more legislative and regulatory monitoring and liability provisions pertaining to banking companies than any other company and such provisions may also extend to the director of the bank or financial institution.


Duty of Care and Skill (Contd.)Duty of Care and Skill (Contd.)

Exercise reasonable care, skill and diligence

Continuing knowledge of company’s business

Reliance on Co-directors and Power to delegate with supervision

Bona fide and good faith intention


Duty of Loyalty & DisclosureDuty of Loyalty & Disclosure

Section 299, Companies Act, 1956 principal is based on the rudiments of law that

the same person cannot act for himself/herself and at the same time, with respect to the same matter, act with another whose interests are conflicting

Effect of disclosure Disclosure to whom How extensive should the disclosure be


Duty in Relation to Corporate OpportunityDuty in Relation to Corporate Opportunity

By occupying a position of trust, a director must not make a profit which he can acquire only by use of his position and, if he does, he must account for the profit so made.


Corporate OpportunityCorporate Opportunity

Any profit made by a Director through holding the office of such director must be accounted for. Therefore, a Director would be held accountable for personal profits made from:– The sale of goods, materials or services earlier dealt with by

Company for its business– Forestalling the company’s business opportunity unless the

company has rejected such opportunity– Requesting the customer to place orders for goods, materials and

services with another company in which he has some interest– Receiving Commission from another company,

which has sold goods to the company


Liabilities of DirectorsLiabilities of Directors

Derivative ActionDerivative Action

Statutory LiabilityStatutory Liability

Contractual LiabilityContractual Liability

Tortuous LiabilityTortuous Liability


Derivative ActionDerivative Action

Resolutions by directors for transferring the controlling interest of the company wherein there is a complete changeover of the structure to the detriment of the company

Sale of land to oneself at a discounted value Directors passing an ordinary resolution where

the act in question would require a special resolution


Statutory LiabilityStatutory Liability

Companies Act, 1956: Officers in default Banking Regulation Act, 1949 Insurance Act, 1948 Pollution Laws Income Tax Act, 1961


Director:Legal ProvisionsDirector:Legal Provisions

Restrictions on loans to directors or other specified entities (s. 295)– Interest rate shall not be less than 4% above prevailing bank rate

– Quantum of loan to not exceed 25 times the gross salary

– No default on public deposit by the company

Boards sanction for contracts in which directors are interested (s. 297)– Consent by way of board resolution

– Prior to the contract or within three months

– Except contract between two public companies

– Prior approval of the central government for a contract where the company has paid up share capital of not less than Rs 1 crore


Director: Legal Provisions (Contd.)Director: Legal Provisions (Contd.) Disclosure of interest by directors (s. 299)

– Default ground for vacation under s. 283.

Interested directors not to participate or vote in board proceedings (s. 300)– Applicable only to public companies

Maintenance of records of contracts, companies, firms in which directors are interested (s. 301) – to be signed by all the directors present in the next board meeting

– kept at registered office and available for inspection Restriction on directors from holding office of profit (s. 314)

– Company can give consent by special resolution

– Does not apply to managing directors


Issues for ConsiderationIssues for Consideration

Should the directors be educated on the risk profile of the company and their duties as a director?– Narayana Murthy Committee Report

Should there be codified duties and responsibilities?

Should the liability of the non-executive directors mirror the liability of the executive directors?


Independent DirectorsIndependent Directors

No mention in the Companies Act Clause 49

- Optimum combination of executive and non-executive directors

- Not less that fifty per cent being non-executive

- If non executive chairman, at least one third of the board should

comprise of independent directors

- If executive chairman, at least half of the board should comprise of

independent directors Clause 63, Draft Companies Bill

– Every public company of prescribed paid up capital or turnover to have at least seven directors of which at least three or fifty percent, whichever is higher, to be independent directors

» Would include unlisted public companies also


Who is an Independent Director?

Independence of judgement

No material relationship

No pecuniary relationship


What is Independence?What is Independence? The Cadbury Report defines independence as:

Apart from their directors’ fees and shareholdings, they should be independent of management and free from any business or other relationship which could materially interfere with the exercise of their independent judgement.

Clause 49‘Independent’ defined as those directors who, apart from receiving director’s remuneration do not have any other material pecuniary relationship or transactions with the company, its promoters, management or subsidiaries, which in the view of the board may affect independence of judgment


What is Independence? (Contd.)What is Independence? (Contd.)

Clause 2(45), Draft Companies Bill

“Independent Director” means a non-executive director of a company who apart from receiving director’s remuneration, does not have any material pecuniary relationship or transactions of such amount as may be prescribed, with the company , its promoters, managing director, whole time director, other directors, manager or its holding company and its subsidiaries apart from possessing such attributes for being treated as Independent director as may be prescribed by the Central Government from time to time.

Excessively restrictive?


Independent DirectorsIndependent Directors

External expert

Independent director: watchdog?


Audit CommitteeAudit Committee

Clause 49, Listing Agreement– Minimum three members, all non-executive directors

– Majority independent, chairman independent

– At least one director having financial and accounting knowledge

– Must have at least three meetings per year


Audit Committee (Contd.)Audit Committee (Contd.)

Section 292A, Companies Act– public companies– minimum three directors– two thirds other than managing or whole time directors

» no other qualifications prescribed– recommendations relating to financial management binding

» reasons for not accepting any recommendation– Auditors required to attend the meetings

Clause 62, Draft Companies Bill– not less than two independent directors

» no other qualifications prescribed



Proposed Clause 49 (pursuant to N.M. Report)– At least one member having financial and accounting

expertise– All members to be financially literate– Expanded role- independent judgment– Focusing on

» Quality of accounting policies» Alternate accounting policies» Internal control deficiencies

– Implementation of ‘whistleblower’ policy



Audit committees- Efficacy?

– Chairman of Enron’s audit committee was a Stanford professor with 30 years experience in auditing and accounts

– Should the members of audit committee be financially literate?

– Should the scope of audit committee be decided by the Board of Directors?

– Is remuneration of members an issue?


Section VSection VAuditors: The Watchful EyeAuditors: The Watchful Eye

Appointment regulated by the Companies Act (s.224)– Maximum number of companies prescribed (20)

Qualifications & Disqualifications (s. 226)– Person holding any security of that company (2000

Amendment)

Requirement to report on specific matters (s. 227) ICAI Code of Conduct


Section VSection VAuditors: The Watchful EyeAuditors: The Watchful Eye

Duties of Auditor– Duty of Care (Re Kingston Cotton Mills Co.)

» Reasonable care and skill– Auditor is the servant of the shareholder and

whose duty is to examine the affairs of the company on their behalf at the end of a year and to report to them what he has found.

– The auditor is like a trustee for shareholders. – Watchdog and not a bloodhound


Auditor’s LiabilityAuditor’s Liability

Basis of Liability– Contractual and Fiduciary

» Company» Shareholders as a body

– Tortuous » “Holding out”


Auditor’s Liability (Contd.)Auditor’s Liability (Contd.) Stage I (Upto 1963)

– Candler v. Crane» Privity doctrine: a third party not in privity with the auditor cannot

recover damages for negligence

» Justice Denning gave a dissenting judgment it must be known to the advise42r that the advice would be communicated to

the plaintiff in order to induce him to adopt a particular course of action the advice must be relied upon for the purpose of the particular transaction

for which it was known to the advisers that the advice was required.

Stage II (1964-1990)– Hedley Byrne & Co. v. Heller & Partners

» Liability for a negligent misstatement made by one person to another, even in the absence of any contractual or fiduciary relationship causing financial loss


Caparo Industries Plc v. Dickman

Stage III (Post 1990)– Watered down in Caparo Industries case

» The three criteria for the imposition of a duty of care are foreseeability of damage proximity of relationship the reasonableness or otherwise of imposing a duty

» The auditor of a public company's accounts owed no duty

of care to a member of the public at large, who relied on

the accounts to buy shares in the company. An auditor owed no duty of care to an individual shareholder in

the company who wished to buy more shares in the company The purpose for which accounts are prepared and audited is to enable

the shareholders as a body to exercise informed control of the company


Caparo Industries Plc v. DickmanCaparo Industries Plc v. Dickman Cadbury Committee on Caparo Industries

– the case exposed two widely held misconceptions:» audit report is a guarantee to the accuracy of the accounts,

and perhaps even as to the soundness of the company

» that anyone (including investors and creditors) can rely on the audit, not only in a general sense but also very specifically by being able to sue the auditors if they are negligent

In light of Enron is there a need to re-examine the issue of auditor’s liability as set out in the Caparo Industries case?


Issues for ConsiderationIssues for Consideration

Should statute set out the liability?– Should ‘breach of care’ be extended to any other

group?

Whether rules for auditors liability need to be codified and made stricter?– Recommendations of Naresh Chandra Committee Report

Should Audit committees evaluate independence of auditors?


Similarities between US position & Indian Similarities between US position & Indian ProposalsProposals

SOX CEO/CFO Certification Reimbursement for

misstatement Ban on loans to directors

Code of Conduct/Ethics Independent Board/

Committee Disclosure of Off Balance

Sheet/transactions that may have future impact

Narayana Murthy Committee CEO/CFO Certification Reimbursement for

misstatement Restriction on loan to

directors Written/Public Code of

Conduct Independent Board of

Directors More limited disclosures-

but left open for consideration


Comparison between US & Indian PositionComparison between US & Indian Position

SOXAudit Partner Rotation

Audit Committee• Financial Literacy

• One financial expert

• Oversee auditor

• Approve related party transactions

• Whistleblowers policy

Narayana Murthy Committee

Audit Partner Rotation

Audit Committee• Financial Literacy

• One financial expert

• Oversee auditor

• Approve related party transactions

• Whistleblowers policy


Proposed amendments to clause 49 and Draft Companies Bill address major issues– Appointment of a Chief Accounting Officer by a

Company

– Definition of related party transactions expanded and specific approval requirements introduced

– Disclosure of all contingent liabilities

– Timely communication of Risk Management activities

– CEO/ CFO certification requirements

Proposed AmendmentsProposed Amendments


Section VISection VIReinventing Corporate Governance in Reinventing Corporate Governance in

IndiaIndia

Super regulator v. Multiple regulators?- Efficiency- Cost of Compliance

Transparency by the regulators? - Late trading and market timing investigations

Enforcement by stock exchanges?


Reinventing Corporate Governance in Reinventing Corporate Governance in India (Contd.)India (Contd.)

Disclosure of voting agreements which impact governance of companies?

Pro-active role by institutional investors?

Mandatory Corporate Governance Ratings?

- Will it lead to better corporate governance?


Reinventing Corporate Governance in Reinventing Corporate Governance in India (Contd.)India (Contd.)

How can whistle blowers be encouraged?

- Narayana Murthy Report

- Immunity for whistleblowers?

Directors & officers liability insurance?


ConclusionConclusion

Good corporate governance – means to the end of sustainable wealth creation

The positive side of adherence to most rigorous standards in governance for corporations:

- Increased importance of corporate governance as an investment criteria among large investors

- Improved Equity Price Performance

- Higher Valuations

- Access to global markets

- Increased investor goodwill & confidence

Balance between ‘enterprise’ and ‘constraints’


Our Contact DetailsOur Contact Details

Luthra & Luthra Law OfficesLuthra & Luthra Law Offices

Mumbai OfficeMumbai Office Delhi OfficeDelhi Office

704-706, 7704-706, 7thth Floor, 103, Ashoka Estate, Floor, 103, Ashoka Estate,

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workshop on corporate governance presented at the alb in-house legal summit october 14, 2004 mohit...

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