Executive Summary

The initial stimulus for corporate governance reforms came after the South-East and East Asian crisis of 1997-98. Governments, multilateral institutions, banks and companies recalled that the devil lay in the details — the nitty-gritty of transactions among companies, banks, financial institutions and capital markets; corporate laws, bankruptcy procedures and practices; the structure of ownership and crony capitalism; stock market practices; poor boards of directors with scant fiduciary responsibility; poor disclosures and transparency; and inadequate accounting and auditing standards.

2. India has not been in the middle of this global and Asian reform movement, as a reaction to corporate and financial crises. First, unlike South-East and East Asia, this movement did not start because of a national or region-wide macroeconomic and financial collapse. Indeed, the Asian crisis barely touched India. Secondly, unlike other Asian countries, the initial drive for better corporate governance and disclosure, perhaps as a result of the 1992 stock market ‘scam’, and the onset of international competition consequent on the liberalisation of economy that began in 1990, came from all-India industry and business associations, and in the Department of Company Affairs. Thirdly, from April 2001, listed companies in India need to follow very stringent guidelines on corporate governance, which rank among some of the best in the world. Sadly, there is a wide gap between prescription and practice. Worse, adverse legal consequences, for the defaulters, almost always get caught in the web of inefficiency, corruption and the intricate, dilatory legal system. Thus, while corporate governance reforms in India far outstrips that of many other countries, the performance in either lags very much behind.

3. After the Enron debacle of 2001, came other scandals involving large US companies such as WorldCom, Qwest, Global Crossing, and the auditing lacunae that eventually led to the collapse of Andersen. These scandals triggered another phase of reforms in corporate governance, accounting practices and disclosures — this time more comprehensive than ever before. In July 2002, less than a year from the date when Enron filed for bankruptcy, the Sarbanes-Oxley Bill (popularly called SOX) was enacted. The Act brought with it fundamental changes in virtually every area of corporate governance — and particularly in auditor independence, conflicts of interest, corporate responsibility, enhanced financial disclosures, and severe penalties, both fines and imprisonment, for wilful default by managers and auditors. It is fair to predict that the SOX Act will do more to change the contours of board structure, auditing, financial reporting and corporate disclosure than any other previous law in US history.

4. On 21 August 2002, the Department of Company Affairs (DCA) under the Ministry of Finance and Company Affairs appointed this High Level Committee to examine various corporate governance issues. Among others, this Committee has been entrusted to analyse and recommend changes, if necessary, in diverse areas such as:

- the statutory auditor-company relationship, so as to further strengthen the professional nature of this interface;

- the need, if any, for rotation of statutory audit firms or partners;

- the procedure for appointment of auditors and determination of audit fees;

- restrictions, if necessary, on non-audit fees;

- independence of auditing functions;

- measures required to ensure that the management and companies actually present ‘true and fair’ statement of the financial affairs of companies;

- the need to consider measures such as certification of accounts and financial statements by the management and directors;

- the necessity of having a transparent system of random scrutiny of audited accounts;

- adequacy of regulation of chartered accountants, company secretaries and other similar statutory oversight functionaries;

- advantages, if any, of setting up an independent regulator similar to the Public Company Accounting Oversight Board in the SOX Act, and if so, its constitution; and

- the role of independent directors, and how their independence and effectiveness can be ensured

5. As is evident, the terms of reference to this Committee (Appendix 1) lie at the heart of corporate governance. Given below are the recommendations of the Committee.

Recommendations in Chapter 2: The Auditor — Company Relationship

6. The Committee believes that the propriety of auditors rendering non-audit services is a complex area which needs to be carefully dealt with, keeping in view the twin objectives of maintaining auditor’s independence and ensuring that clients get the benefit of efficient, high quality services

7. Having said this, the Committee believes that certain types of non-audit services could impair independence of the auditor and possibly affect the quality of audit. It also believes that, given the times and the well-publicised failure of an auditing firm as large as Andersen, some judicious prohibitions are in order.

8. An auditor who depends upon a single audit client for a sizeable portion of annual revenues, risks compromising his independence. The Committee, therefore, concluded that certain recommendations in this regard were also in order.

Recommendation 2.1: Disqualifications for audit assignments

In line with international best practices, the Committee recommends an abbreviated list of disqualifications for auditing assignments, which includes:

- Prohibition of any direct financial interest in the audit client

by the audit firm, its partners or members of the engagement team as well as their ‘direct relatives’. This prohibition would also apply if any ‘relative’ of the partners of the audit firm or member of the engagement team has an interest of more than 2 per cent of the share of profit or equity capital of the audit client.

- Prohibition of receiving any loans and/or guarantees

from or on behalf of the audit client by the audit firm, its partners or any member of the engagement team and their ‘direct relatives’.

- Prohibition of any business relationship

with the audit client by the auditing firm, its partners or any member of the engagement team and their ‘direct relatives’.

- Prohibition of personal relationships

which would exclude any partner of the audit firm or member of the engagement team being a ‘relative’ of any of key officers of the client company, i.e. any whole-time director, CEO, CFO, Company Secretary, senior manager belonging to the top two managerial levels of the company, and the officer who is in default (as defined by section 5 of the Companies Act). In case of any doubt, it would be the task of the Audit Committee of the concerned company to determine whether the individual concerned is a key officer.

- Prohibition of service or cooling off period


under which any partner or member of the engagement team of an audit firm who wants to join an audit client, or any key officer of the client company wanting to join the audit firm, would only be allowed to do so after two years from the time they were involved in the preparation of accounts and audit of that client

-Prohibition of undue dependence on an audit client.

So that no audit firm is unduly dependent on an audit client, the fees received from any one client and its subsidiaries and affiliates, all together, should not exceed 25 per cent of the total revenues of the audit firm. However, to help newer and smaller audit firms, this requirement will not be applicable to audit firms for the first five years from the date of commencement of their activities, and for those whose total revenues are less than Rs.15 lakhs per year.

- This recommendation has to be read with Recommendation 2.3 below.

>Note: A ‘direct relative’ is defined as the individual concerned, his or her spouse, dependent parents, children or dependent siblings. For the present, the term ‘relative’ is as defined under Schedule IA of the Companies Act. However, the Committee believes that the Schedule IA definition is too wide, and needs to be rationalised for effective compliance.

9. Section 201 of the SOX Act has disallowed eight types of non-audit services, with the provision to disallow more as may be determined by the newly legislated Public Company Accounting Oversight Board. Most of these restrictions exist in India. For example, the ICAI prohibits its members as auditing firms from offering services such as bookkeeping, maintaining accounts, internal audit, designing any information system which is a subject of audit or internal audit, brokering, investment advisory and investment banking services. Even so, the Committee believes that it is necessary to provide an explicit list of prohibited non-audit services

Recommendation 2.2: List of prohibited non-audit services

The Committee recommends that the following services should not be provided by an audit firm to any audit client:

- Accounting and bookkeeping services, related to the accounting records or financial statements of the audit client.

- Internal audit services.

- Financial information systems design and implementation, including services related to IT systems for preparing financial or management accounts and information flows of a company.

- Actuarial services.

- Broker, dealer, investment adviser or investment banking services.

- Outsourced financial services.

- Management functions, including the provision of temporary staff to audit clients.

- Any form of staff recruitment, and particularly hiring of senior management staff for the audit client.

- Valuation services and fairness opinion

Further in case the firm undertakes any service other than audit, or the prohibited services listed above, it should be done only with the approval of the audit committee.

10. The Committee has no qualms per se about audit firms having subsidiaries or associate companies engaged in consulting or other specialised business services. It makes a great deal of sense for good auditors to widen their horizons by occasionally engaging in business consulting, just as it does for business consultants to occasionally get involved in the nitty-gritty of auditing. However, it is also a fact that such affiliations could cause potential threats to auditor independence and, therefore, it would be prudent to create realistic safeguards against such contingencies. Hence, the following recommendation.

Recommendation 2.3: Independence Standards for Consulting and Other Entities that are Affiliated to Audit Firms

- Prohibition of undue dependence.

Where an audit firm has subsidiary, associate or affiliated entities, yardstick of no more than 25 per cent of revenues coming from a single audit client stated in Recommendation 2.1 should be widened to accommodate the consolidated entity. Thus, no more than 25 per cent of the revenues of the consolidated entity should come from a single corporate client with whom there is also an audit engagement.

- The other prohibitions listed in Recommendation 2.1 should also apply in full to all affiliated consulting and specialised service entities of any audit firm that are either subsidiaries of the audit firm, or have common ownership of over 50 per cent with the audit firm. And all the tests of independence outlined in Recommendation 2.1 should be carried over to the consolidated entity.

- Therefore, this recommendation has to be read with Recommendation 2.1.

Consolidation tests should test fully, line-by-line, for all subsidiaries, whether the audit firm, or its partners, own over 50 per cent of equity, or share of profit.

11. The Committee deliberated, at length, the issue of rotation of auditors. It heard the views of two distinct schools of thought: the minority, which believed in the compulsory rotation of audit firms (a notable proponent being the office of CAG); and the majority, which was against it. Given international practice, and the fact that there is no conclusive proof of the gains while there is sufficient evidence of the risks, the Committee decided not to recommend any statutory rotation of audit firms. However, in line with the SOX Act, the Committee is in favour of compulsory rotation of audit partners.

Recommendation 2.4: Compulsory Audit Partner Rotation

- There is no need to legislate in favour of compulsory rotation of audit firms.

- However, the partners and at least 50 per cent of the engagement team (excluding article clerks and trainees) responsible for the audit of either a listed company, or companies whose paid-up capital and free reserves exceeds Rs.10 crore, or companies whose turnover exceeds Rs.50 crore, should be rotated every five years.

Also, in line with the provisions of the European Union and the IFAC, persons who are compulsorily rotated could, if need be, allowed to return after a break of three years.

12. In ensuring rectitude, nothing works like disclosures. The guidance, “When in doubt, disclose” is probably the simplest and best yardstick for evaluating good corporate governance. Hence the following recommendation.

Recommendation 2.5: Auditor’s disclosure of contingent liabilities

It is important for investors and shareholders to get a clear idea of a company’s contingent liabilities because these may be significant risk factors that could adversely affect the corporation’s future health. The Committee recommends that management should provide a clear description in plain English of each material liability and its risks, which should be followed by the auditor’s clearly worded comments on the management’s view. This section should be highlighted in the significant accounting policies and notes on accounts, as well as, in the auditor’s report, where necessary.

13. A qualification can be a serious indictment of the financial affairs and management of a company. Yet, far too few shareholders really understand what a qualification means, and companies are hardly ever questioned by regulators such as the SEBI and the DCA regarding such qualifications. The Committee believes that this must change — and the only way of doing so is by mandating disclosures to a greater degree.

Recommendation 2.6: Auditor’s disclosure of qualifications and consequent action

- Qualifications to accounts, if any, must form a distinct, and adequately highlighted, section of the auditor’s report to the shareholders.

- These must be listed in full in plain English — what they are(including quantification thereof), why these were arrived at, including qualification thereof, etc.

- In case of a qualified auditor’s report, the audit firm may read out the qualifications, with explanations, to shareholders in the company’s annual general meeting.

- It should also be mandatory for the audit firm to separately send a copy of the qualified report to the ROC, the SEBI and the principal stock exchange (for listed companies), about the qualifications, with a copy of this letter being sent to the management of the company. This may require suitable amendments to the Companies Act, and corresponding changes in The Chartered Accountants Act.

14. The Companies Act makes it more difficult to replace an auditor than to reappoint one. While this is as it should be, the Committee felt that corporate governance would benefit from disclosing the reasons for replacement. The Committee felt that if the management were to be more accountable to the shareholders and the audit committee, in the matter of replacing auditors, this is likely to make the auditors more fearless.

Recommendation 2.7: Management’s certification in the event of auditor’s replacement

- Section 225 of the Companies Act needs to be amended to require a special resolution of shareholders, in case an auditor, while being eligible to re-appointment, is sought to be replaced.

- The explanatory statement accompanying such a special resolution must disclose the management’s reasons for such a replacement, on which the outgoing auditor shall have the right to comment. The Audit Committee will have to verify that this explanatory statement is ‘true and fair’

15. The Committee felt that it will be good practice for the audit firm to annually file a certificate of independence to the Audit Committee and/or the board of directors of the client company. This will help in ensuring that the auditors have retained their independence throughout their period of engagement.

Recommendation 2.8: Auditor’s annual certification of independence

- Before agreeing to be appointed (along with 224(1)(b)), the audit firm must submit a certificate of independence to the Audit Committee or to the board of directors of the client company certifying that the firm, together with its consulting and specialised services affiliates, subsidiaries and associated companies:

1. are independent and have arm’s length relationship with the client company;

2. have not engaged in any non-audit services listed and prohibited in Recommendation 2.2 above; and

3. are not disqualified from audit assignments by virtue of breaching any of the limits, restrictions and prohibitions listed in Recommendations 2.1 and 2.3.

In the event of any inadvertent violations relating to Recommendations 2.1, 2.2 and 2.3, the audit firm will immediately bring these to the notice of the Audit Committee or the board of directors of the client company, which is expected to take prompt action to address the cause so as to restore independence at the earliest, and minimise any potential risk that might have been caused.

16. The Committee felt that audit committees should be allowed to be true to their name by ensuring that they have a larger role with regard to audit. In fact, this should be the starting point in empowering audit committees. Therefore, it recommends

Recommendation 2.9: Appointment of auditors

The Audit Committee of the board of directors shall be the first point of reference regarding the appointment of auditors. To discharge this fiduciary responsibility, the Audit Committee shall:

- discuss the annual work programme with the auditor;

- review the independence of the audit firm in line with Recommendations 2.1, 2.2 and 2.3 above; and

- recommend to the board, with reasons, either the appointment/re-appointment or removal of the external auditor, along with the annual audit remuneration.

Exceptions to this rule may cover government companies (which follow section 619 of the Companies Act) and scheduled commercial banks (where the RBI has a role to play).

17. Section 302 of the SOX Act specifies that the CEO and CFO of all listed companies must certify to the SEC regarding the veracity of each annual and quarterly financial report. The Committee examined the management certification issue in detail, and concluded that it constitutes a good corporate governance practice. However, it is not in favour of instituting criminal proceedings in the event of a misstatement. Instead, it felt that there should be significantly enhanced penalties — ones that should act as credible deterrents.

Recommendation 2.10: CEO and CFO certification of annual audited accounts

For all listed companies as well as public limited companies whose paid-up capital and free reserves exceeds Rs.10 crore, or turnover exceeds Rs.50 crore, there should be a certification by the CEO (either the Executive Chairman or the Managing Director) and the CFO (whole-time Finance Director or otherwise) which should state that, to the best of their knowledge and belief:

- They, the signing officers, have reviewed the balance sheet and profit and loss account and all its schedules and notes on accounts, as well as the cash flow statements and the Directors’ Report.

- These statements do not contain any material untrue statement or omit any material fact nor do they contain statements that might be misleading.

- These statements together represent a true and fair picture of the financial and operational state of the company, and are in compliance with the existing accounting standards and/or applicable laws/regulations.

- They, the signing officers, are responsible for establishing and maintaining internal controls which have been designed to ensure that all material information is periodically made known to them; and have evaluated the effectiveness of internal control systems of the company.

- They, the signing officers, have disclosed to the auditors as well as the Audit Committee deficiencies in the design or operation of internal controls, if any, and what they have done or propose to do to rectify these deficiencies.

- They, the signing officers, have also disclosed to the auditors as well as the Audit Committee instances of significant fraud, if any, that involves management or employees having a significant role in the company’s internal control systems.

- They, the signing officers, have indicated to the auditors, the Audit Committee and in the notes on accounts, whether or not there were significant changes in internal control and/or of accounting policies during the year under review.

- In the event of any materially significant misstatements or omissions, the signing officers will return to the company that part of any bonus or incentive- or equity-based compensation which was inflated on account of such errors, as decided by the Audit Committee.

Recommendations from Chapter 3: Auditing the Auditors

18. The Committee deliberated long and hard on the issue of whether it was necessary to establish a new, independent Public Oversight Board (POB) for supervising the work of auditors — such as the one proposed in the SOX Act. On balance, the Committee felt that there is no need at this point of time to set up yet another new regulatory oversight body. However, the Committee felt that there is a need to establish an efficient and professional body which can be entrusted to provide transparent and expeditious auditing quality oversight. This will be in the interest of investors, the general public and the professionals themselves. With these considerations in mind, the Committee has recommended the setting up of independent Quality Review Boards.

Recommendation 3.1: Setting up of independent Quality Review Board

- There should be established, with appropriate legislative support, three independent Quality Review Boards (QRB), one each for the ICAI, the ICSI and ICWAI, to periodically examine and review the quality of audit, secretarial and cost accounting firms, and pass judgement and comments on the quality and sufficiency of systems, infrastructure and practices.

- In the interest of realism, the QRBs should, for the initial five years, focus their audit quality reviews to the audit firms, which have conducted the audit for the top 150 listed companies, ranked according to market capitalisation as on 31 March. Depending upon the record of success of such reviews, the DCA may subsequently consider altering the sample size or criterion.

- Composition of ICAI’s QRB:

The board shall consist of 11 members, including the chairman. The chairman shall be nominated by the DCA, in consultation with, but not necessarily from, the ICAI. Five members of the board, excluding the chairman, shall be nominated by the DCA who will be people of eminence, professional reputation and integrity including, but not limited to, nominees of the Comptroller and Auditor-General of India, RBI, SEBI, members or office-bearers of the Bombay Stock Exchange or the National Stock Exchange, the three apex trade and industry associations (CII, FICCI and ASSOCHAM), reputed educational and research institutions, bankers, economists, former public officials and business executives. The remaining five members of the Board will be nominated by the Council of the ICAI.

Composition of ICSI’s QRB:

A five-member board, including the chairman. The chairman shall be nominated by the DCA, in consultation with, but not necessarily from, the ICSI. Two members, excluding the chairman, shall be nominated by the DCA, who will have the same

attributes suggested for ICAI’s QRB above. The remaining two members will be nominated by the Council of the ICSI.

- Composition of ICWAI’s QRB:

A five-member board, including the chairman. The chairman shall be nominated by the DCA, in consultation with, but not necessarily from, the ICWAI. Two members, excluding the chairman, shall be nominated by the DCA, who will have the same attributes suggested for ICAI’s QRB above. The remaining two members will be nominated by the Council of the ICWAI.

- Funding:

Each of these QRBs will be funded by their respective institutes in a manner that will enable it to discharge its functions adequately.

- Appellate forum:

In the instance of a dispute between the findings of the QRBs and reviewees, the matter should be referred to an appropriate appellate forum. This appellate forum should be the same as that suggested for disciplinary matters, which is discussed in Recommendation 3.2 below.

19. The area of disciplinary mechanism of the audit profession requires careful consideration. According to many who interacted with the Committee, the ICAI, despite best intentions, seems to have been unable to adjudicate disciplinary cases within reasonable time. Similar concerns were expressed about the other two institutions, though the number of cases is fewer in their case.

20. The problems, according to the Committee, are not those of the law, but of law’s delays. Procedures framed under the Chartered Accountants Act have not been able to cope with the changed scenario that must deal with complex businesses and over 70,000 practicing members. The confidence of the investing public and other stakeholders cannot be nurtured unless disciplinary cases are dealt with much more expeditiously and with greater transparency. Accordingly, the Committee recommends an entirely new disciplinary procedure which, while keeping the process within the framework of the existing Acts, will bring about greater independence and speed.

Recommendation 3.2: Proposed disciplinary mechanism for auditors

- Classification of offences and merging of schedules:

At present there are two schedules of offences and misconduct — with the second schedule requiring action by High Courts. These two schedules need to be merged, so that the Council is empowered to award all types of punishment for all types of offences. Further, offences need to be categorised according to the severity of misconduct, so that processes can be designed, and punishments awarded, according to the severity of the offence.

Prosecution Directorate:

An independent permanent directorate within the structure of ICAI shall be created, which shall act as the Prosecution Directorate. This office will exclusively deal

with all disciplinary cases and, hence, expedite the process of enquiry and decision-making by fully devoting its time and energy towards processing these cases. The office should be headed by a person of the level of Director, and should be one with a legal background and conversant with the provisions of The Chartered Accountants Act and its regulations. He and his office shall be independent of the electoral process of ICAI. Suitable regulations need to be framed to uphold the independence of this office. The Prosecution Directorate shall have the same powers as are vested in a civil court under the Code of Civil Procedure, 1908, regarding (i) the discovery and production of any document; and (ii) receiving evidence on affidavit.

Procedure for dealing with complaint cases

1. The complaints received in the appropriate form, manner, and complete in all respects, shall be registered by the Prosecution Directorate, and sent to the member or firm within 15 days of registration of such a complaint.

2. Depending on the category of the complaint, the Prosecution Directorate shall ask for and obtain necessary documents such as written statements, rejoinders, comments, and other evidence from the complainant as well as the respondent. The time frame for this should be, under normal circumstances, no more than 60 days. Not submitting such documents within the prescribed time shall be treated as an offence, risking the initiation of additional obstruction of justice proceedings.

3. On receipt of the relevant documents, the complaint, along with the views, if any, of the Prosecution Directorate, will be placed before the Disciplinary Committee. This has to be done within 20 days of receiving all relevant accompanying documents.

Procedure for dealing with information cases

1. Information received shall be examined by the Prosecution Directorate. After forming his views, the Director of the Prosecution Directorate will place the matter before the Secretary of ICAI. 2. If the Secretary agrees with the view expressed by the Director, then the information case will be placed before the Disciplinary Committee. 3. In the event of the Secretary differing with the views of the Director, the matter would be placed before the President of ICAI and, thereafter, it would be discussed at a meeting between the President, Secretary and the Director. If in this meeting, it is decided to refer the matter to the Disciplinary Committee, then reference be made accordingly. Upon such referral, the Prosecution Directorate shall argue the case before the Disciplinary Committee. If, however, the Secretary and President of ICAI decide that the information should be filed and closed, then the Director of the Prosecution Directorate will have the choice to either follow the majority opinion, or dissent and refer such a case to the Disciplinary Committee, with his as well as the Secretary’s and President’s opinion. In such instances, however, the President shall not function as the Presiding Officer of the Disciplinary Committee. Further, if the Director Prosecution does not feel that a reference to the Disciplinary Committee is warranted, the Institute would still be free to take such cases to the Committee if it feels there is a need to do so. 4. After registering the ‘information’ case, the procedure outlined for the complaint case may be followed mutatis mutandis.

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Disciplinary Committee

Ÿ Enquiries in relation to misconduct of members shall be held by the Disciplinary Committee. To expedite decision-making, the Council of ICAI shall be empowered to constitute one or more bench of the Disciplinary Committees in cities where there are regional headquarters of ICAI.

Ÿ Composition: Each bench should consist of five members. The President or the Vice-President of ICAI will be the Presiding Officer. However, in ’information’ cases put before the Committee by the Prosecution Director after disagreeing with the views of the President and the Secretary, the President shall not act as the Presiding Officer. In such cases, the Vice-President will perform this role. Two of the other four members will be nominees of ICAI’s Council, while the remaining two will be nominees of the DCA viz. people of eminence, professional reputation and integrity such as, retired judges, bankers, professionals, educationists, economists, business executives, former members of regulatory authorities and former public officials. As far as practicable, members of the Disciplinary Committee should be from the regions other than the one in which it is being constituted.

It needs to be stated that in terms of the existing requirement, a nominee of the Central Government is required to be nominated to the Disciplinary Committee. Until very recently, such a nominee was an official of the DCA. However, DCA officials have rarely had the time to attend the meetings of the Disciplinary Committee. Hence, the Committee recommends that, given their pre-occupation in the department, a sitting government official should not be nominated to the Disciplinary Committee. It is pointed out that for each stage in the process, strict time lines should be prescribed. This is especially important in respect of scrutiny of ’information cases’.

Ÿ Quorum:

Three of the five members

Ÿ Tenure:

Co-terminus with the duration of the ICAI Council.

Ÿ Functions:

The Disciplinary Committees shall hear the complaint and information cases referred by the Prosecution Directorate and record their decisions and conclusions in a report. This report shall also record the punishment to be awarded, if any, to the member, which can constitute (i) reprimand, (ii) removing the name of the member either permanently or for such a period as thought fit, (iii) monetary penalty, and/or (iv) a combination of any two.


Ÿ Any report submitted by the Disciplinary Committee should normally be considered by the Council within 45 days from the date of the report. It shall be the duty of the Council of ICAI to act upon the decisions of the Disciplinary Committee. While performing such a duty, the Council can: 1. Endorse the decisions of the Disciplinary Committee, and implement them. 2. Refer any case back to the Disciplinary Committee for further enquiry, when it finds that certain issues need further enquiry. However, in doing so, the Council will have to frame the specific issues. 3. Direct the Prosecution Directorate to place the case before the Appellate Body, in the event of the Council deciding to appeal against the decisions of the Disciplinary Committee.

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Appellate Body

Ÿ Headquartered in New Delhi, the Appellate Body shall consist of a Presiding Officer and four other members. The Presiding Officer shall be a retired judge of the Supreme Court or a retired Chief Justice of a High Court. Two members shall be Past Presidents of ICAI, nominated by the Council. The remaining two shall be persons of eminence nominated by the DCA (but excluding any officer of the Department or member of the Council). The quorum shall be three.

Publication of decisions of the Disciplinary Committee

- Due publicity shall be given by the Prosecution Directorate about the punishment ultimately awarded, through periodicals, newsletters, website and any other means considered appropriate. However, no decision taken by the Disciplinary Committee be published unless and until the punishment is endorsed and implemented by the Council.


1. Appellate Body: Required funding arrangements should be made by the Central Government. This is essential for ensuring independence, and on the ground that the High Court stage can be said to have been always funded by the Government. 2. Disciplinary Committee: The expenses shall be borne by ICAI’s Council, which shall also fix the emoluments, sitting fees, allowances, and other expenses of the members. 3. Prosecution Directorate: All expenses will be borne by the Council of ICAI. 4. Every complaint, other than a complaint made by or on behalf of the Central or any State Government shall be accompanied by a fee Rs.5,000, which will be returned as soon as the Disciplinary Committee recommends that case is not frivolous. Fees not refunded for frivolous cases will be used to partly defray the cost of investigation. 21. Independent disciplinary mechanisms may be designed along similar lines for the other two Institutes, namely, the Institute of Company Secretaries of India, and the Institute of Cost and Works Accountants of India.

Recommendations from Chapter 4: Independent Directors

22. At the core of corporate governance is the board of directors. A joint-stock company is owned by the shareholders, who appoint a board of directors to supervise management and ensure that it does all that is necessary by legal and ethical means to expand the business and maximise long-term corporate value. 23. The first point to note is the one that is frequently forgotten: the board is appointed by the shareholders and other key stakeholders. Simply put, directors are fiduciaries of shareholders, not of the management. This does not imply that the board must have an adversarial relationship with the management. However, in instances where the objectives of management differ from those of the wide body of shareholders, the non-executive directors on the board must be able to speak in the interest of the ultimate owners, discharge their fiduciary oversight functions; in short, they should stand up and be counted. This is why ‘independence’ has become such a critical issue in determining the composition of any board. Clearly, a board packed by executive directors, or friends of the promoter or CEO, can hardly be expected to exercise independent oversight judgement. 24. After going through various international best-in-class definitions of independence, and keeping in mind pragmatic factors, the Committee came to the conclusion that the definition can be made more precise than what is contained in Clause 49 of the Listing Agreement without compromising the spirit or constraining the supply of independent directors.

Recommendation 4.1: Defining an independent director

- An independent director of a company is a non-executive director who:

1. Apart from receiving director’s remuneration, does not have any material pecuniary relationships or transactions with the company, its promoters, its senior management or its holding company, its subsidiaries and associated companies; 2. Is not related to promoters or management at the board level, or one level below the board (spouse and dependent, parents, children or siblings); 3. Has not been an executive of the company in the last three years; 4. Is not a partner or an executive of the statutory auditing firm, the internal audit firm that are associated with the company, and has not been a partner or an executive of any such firm for the last three years. This will also apply to legal firm(s) and consulting firm(s) that have a material association with the entity. 5. Is not a significant supplier, vendor or customer of the company; 6. Is not a substantial shareholder of the company, i.e. owning 2 per cent or more of the block of voting shares; 7. Has not been a director, independent or otherwise, of the company for more than three terms of three years each (not exceeding nine years in any case); · An employee, executive director or nominee of any bank, financial institution, corporations or trustees of debenture and bond holders, who is normally called a ‘nominee director’ will be excluded from the pool of directors in the determination of the number of independent directors. In other words, such a director will not feature either in the numerator or the denominator. · Moreover, if an executive in, say, Company X becomes an non-executive director in another Company Y, while another executive of Company Y becomes a non-executive director in Company X, then neither will be treated as an independent director. · The Committee recommends that the above criteria be made applicable for all listed companies, as well as unlisted public limited companies with a paid-up share capital and free reserves of Rs.10 crore and above or turnover of Rs.50 crore and above with effect from the financial year beginning 2003. 25. The Committee felt that to be really effective, independent directors need to have a substantial voice, by being in a majority. It was felt that rather than the management or the promoters, the Committee should put its weight behind minority shareholders and other stakeholders such as consumer or creditors. The committee, therefore recommends that independent directors have adequate presence and strength on the Board, especially of the companies that are listed or, being public companies above a specific size.

Recommendation 4.2: Percentage of independent directors

No less than 50 per cent of the board of directors of any listed company, as well as unlisted public limited companies with a paid-up share capital and free reserves of Rs.10 crore and above, or turnover of Rs.50 crore and above, should consist of independent directors — independence being defined in Recommendation 4.1 above. However, this will not apply to: (1) unlisted public companies, which have no more than 50 shareholders and which are without debt of any kind from the public, banks, or financial institutions, as long as they do not change their character, (2) unlisted subsidiaries of listed companies. Nominee directors will be excluded both from the numerator and the denominator. 26. Corporate governance norms require companies to have a number of committees. Boards of listed and large unlisted public limited companies also have greater fiduciary responsibilities. For these reasons, the committee felt that the law should prescribe a minimum board size as well.

Recommendation 4.3: Minimum board size of listed companies

The minimum board size of all listed companies, as well as unlisted public limited companies with a paid-up share capital and free reserves of Rs.10 crore and above, or turnover of Rs.50 crore and above should be seven — of which at least four should be independent directors. However, this will not apply to: (1) unlisted public companies, which have no more than 50 shareholders and which are without debt of any kind from the public, banks, or financial institutions, as long as they do not change their character, (2) unlisted subsidiaries of listed companies. 27. The Boards, and their committees, should not merely have meetings pro forma prior to a nice lunch. The shareholders have a right to know how much time the Board and its committees spent in discussing the shareholders’ interest. The committee, therefore, recommends that duration of Board/committee meetings be disclosed.

Recommendation 4.4: Disclosure on duration of board meetings / Committee meetings

The minutes of board meetings and Audit Committee meetings of all listed companies, as well as unlisted public limited companies with a paid-up share capital and free reserves of Rs.10 crore and above or turnover of Rs.50 crore must disclose the timing and duration of each such meeting, in addition to the date and members in attendance. 28. The Committee feels that the quality of Board meetings is enhanced with a fuller attendance. Since there are technological means available to do so, the Committee suggests that increased presence of members of the Board be encouraged through tele and video conferencing, subject to certain safeguards. This might also reduce cost of Board/Committee meetings to the company.

Recommendation 4.5: Tele-conferencing and video conferencing

If a director cannot be physically present but wants to participate in the proceedings of the board and its committees, then a minuted and signed proceedings of a tele-conference or video conference should constitute proof of his or her participation. Accordingly, this should be treated as presence in the meeting(s). However, minutes of all such meetings should be signed and confirmed by the director/s who has/have attended the meeting through video conferencing. 29. The Committee noted that both the 1997 Report of the Working Group on the Companies Act, and clause 49 of listing agreement list out, adequately, the information that must be placed before the board of directors. To ensure that asymmetry of information for stakeholders, especially shareholders, is further reduced, the committee recommends

Recommendation 4.6: Additional disclosure to directors

In addition to the disclosures specified in Clause 49 under ‘Information to be placed before the board of directors’, all listed companies, as well as unlisted public limited companies with a paid-up share capital and free reserves of Rs.10 crore and above, or turnover of Rs.50 crore and above, should transmit all press releases and presentation to analysts to all board members. This will further help in keeping independent directors informed of how the company is projecting itself to the general public as well as a body of informed investors. 30. If audit committees are indeed to be independent, they should really consist of only independent directors. There were doubts on the advisability of excluding nominee directors of financial institutions from audit committees. The Committee preferred to be consistent in not considering directors with a certain mandate to be really independent.

Recommendation 4.7: Independent directors on Audit Committees of listed companies

Audit Committees of all listed companies, as well as unlisted public limited companies with a paid- up share capital and free reserves of Rs.10 crore and above, or turnover of Rs.50 crore and above, should consist exclusively of independent directors, as defined in Recommendation 4.1. However, this will not apply to: (1) unlisted public companies, which have no more than 50 shareholders and which are without debt of any kind from the public, banks, or financial institutions, as long as they do not change their character, (2) unlisted subsidiaries of listed companies. 31. The committee has recommended that the role and functions that an audit committee is supposed to discharge in a company is clearly laid out in an audit committee charter.

Recommendation 4.8: Audit Committee charter

- In addition to disclosing the names of members of the Audit Committee and the dates and frequency of meetings, the Chairman of the Audit Committee must annually certify whether and to what extent each of the functions listed in the Audit Committee Charter were discharged in the course of the year. This will serve as the Committee’s ‘action taken report’ to the shareholders.

- This disclosure shall also give a succinct but accurate report of the tasks performed by the Audit Committee, which would include, among others, the Audit Committee’s views on the adequacy of internal control systems, perceptions of risks and, in the event of any qualifications, why the Audit Committee accepted and recommended the financial statements with qualifications. The statement should also certify whether the Audit Committee met with the statutory and internal auditors of the company without the presence of management, and whether such meetings revealed materially significant issues or risks.

32. The maximum sitting fee permitted by the DCA is Rs.5,000. The committee was repeatedly reminded that peanuts fetch monkeys. The Committee believes that companies cannot hope to get the best talent unless they make it worthwhile for professionals to extend their time and expertise. The committee was cautioned that far too much payment may itself impair independence, just as over-reliance on a single client compromises the independence of auditors. However, the committee felt that advantages of adequate remuneration require government to review the position.

Recommendation 4.9: Remuneration of non-executive directors

- The statutory limit on sitting fees should be reviewed, although ideally it should be a matter to be resolved between the management and the shareholders.

- In addition, loss-making companies should be permitted by the DCA to pay special fees to any independent director, subject to reasonable caps, in order to attract the best restructuring and strategic talent to the boards of such companies.

- The present provisions relating to stock options, and to the 1 per cent commission on net profits, is adequate and does not, at present, need any revision. However, the vesting schedule of stock options should be staggered over at least three years, so as to align the independent and executive directors, as well as managers two levels below the Board, with the long-term profitability and value of the company.

33. Not even the most stringent international tenet of corporate governance and oversight assumes that an independent director — who interfaces with the management for no more than two days every quarter — will be in the know of every technical infringement committed by the management of a company in its normal course of activity. Indeed, making independent board members criminally liable for such infringements is akin to assuming that they are no different from executive directors and the management of a company. This is certainly not so. In fact, the principle is quite the opposite: independent directors are not managers; they are fiduciaries who perform wider oversight functions over management and executive directors. 34. At a more practical level, the Committee is of the opinion that it would be very difficult to attract high quality independent directors on the boards of Indian companies if they have to constantly worry about serious criminal liabilities under different Acts.

Recommendation 4.10: Exempting non-executive directors from certain liabilities

Time has come to insert provisions in the definitions chapter of certain Acts to specifically exempt non-executive and independent directors from such criminal and civil liabilities. An illustrative list of these Acts are the Companies Act, Negotiable Instruments Act, Provident Fund Act, ESI Act, Factories Act, Industrial Disputes Act and the Electricity Supply Act. Independent directors should also be indemnified, as outlined in paragraph 4.54 of the report, from costs of litigation etc. 35. A professional may give excellent corporate advice that maximises long-term shareholder value, but may not be aware of the rights, responsibilities, duties and liabilities of a legal, recognised fiduciary. Understanding such issues requires training. The Committee feels that if companies can afford to compensate their independent directors well, then they should be able to provide them with good training too. DCA has a special role in encouraging and promoting training programmes in leading Indian institutions such as the Indian Institutes of Management, and in the Centre for Corporate Governance that they intend to set up.

Recommendation 4.11: Training of independent directors

DCA should encourage institutions of prominence including their proposed Centre for Corporate Excellence to have regular training programmes for independent directors. In framing the programmes, and for other preparatory work, funding could possibly come from the IEPF. · All independent directors should be required to attend at least one such training course before assuming responsibilities as an independent director, or, considering that enough programmes might not be available in the initial years, within one year of becoming an independent director. An untrained independent director should be disqualified under section 274(1)(g) of the Companies Act, 1956 after being given reasonable notice. · Considering that enough training institutions and programmes might not be available in the initial years, this requirement may be introduced in a phased manner, so that the larger listed companies are covered first. · The executing bodies must clearly state their plan for the year and their funding should be directly proportionate to the extent to which they execute such plans. · There should be a ‘trainee appraisal’ system to judge the quality of the programme and so help decide, in the second round, which agencies should be given a greater role and which should be dropped.

Recommendations from Chapter 5: Other Recommendations

36. The Committee was repeatedly reminded to be careful not to increase compliance cost to companies, as ultimately, not only is this against the interest of shareholders but it has the danger of making Indian industry uncompetitive. In this connection, a serious unnecessary cost noticed by the committee was the overlap and duplication between the SEBI and DCA. The Committee has recommended removal of this overlap, keeping in mind two other principles. First, subordinate legislation cannot override provisions enacted by Parliament. Secondly, the doctrine of ‘occupied space’ needs to be respected and complied with.

Recommendation 5.1: SEBI and Subordinate Legislation

SEBI may refrain from exercising powers of subordinate legislation in areas where specific legislation exists as in the Companies Act, 1956. · If any additional requirements are sought to be prescribed for listed companies, then, in areas where specific provision exists in the Companies Act, it would be appropriate for SEBI to have the requirement prescribed in the Companies Act itself through a suitable amendment. · In recognition of the fact that SEBI regulates activities in dynamic market conditions, the DCA should respond to SEBI’s requirements quickly. In case the changes proposed by SEBI necessitate a change in the Companies Act, the DCA should agree to the requirement being mandated in clause 49 of SEBI regulation until the Act is amended. · It would be appropriate for SEBI to use its powers of subordinate legislation, in consultation with the DCA, and vice versa. All committees set up either by SEBI or DCA to consider changes in law, rules or regulations should have representatives of both SEBI and DCA. · A formal structure needs to be set up to ensure that the DCA, which regulates all companies, and SEBI, which regulates only listed companies, act in coordination and harmony. 37. Even while we try to move our economy and our companies to the 21st century, the Department which deals with companies seems to be firmly moored in the past. Its physical strength and equipment have simply not kept pace with either the times or with the increased strength of companies in India. The Committee, therefore, recommends a paradigm shift in the approach to staffing and equipping the Department of Company Affairs. Companies pay, largely by way of fees, approximately Rs. 300 crores annually. In recommending these increases, the Committee is only asking that services be commensurate with the income from fees charged.

Recommendation 5.2: Improving facilities in the DCA offices

· The Government should increase the strength of DCA’s offices, and substantially increase the quality and quantity of its physical infrastructure, including computerisation. · This should be accompanied by increased outsourcing of work, contractual appointments of specialists and computerisation — all of which will reduce, though not eliminate, the need to increase the officer-level strength of the Department. · The inspection–capacity of the Department needs to be increased sharply; inspections should be a regular administrative function, carried out largely on random basis. · Officers of the DCA need to go through refresher and training courses regularly. In view of the very dynamic world in which they function, continuous upgrading of their skills is essential 38. Fraudsters are enemies of both the stakeholders that they cheat directly, and of the corporate sector, which loses because, the fraudsters scare away existing and potential investors. Corporate frauds are so intricate that they can only be unravelled by a multi-disciplinary task force. The Committee, therefore, suggest setting up a Corporate Serious Fraud Office (CSFO), without, at this stage, taking away the powers of investigation and prosecution from existing agencies. A corporate frauds task force has been set up recently in the US.

Recommendation 5.3: Corporate Serious Fraud Office

· A Corporate Serious Fraud Office (CSFO) should be set up in the Department of Company Affairs with specialists inducted on the basis of transfer/deputation and on special term contracts. · This should be in the form of a multi-disciplinary team that not only uncovers the fraud, but is able to direct and supervise prosecutions under various economic legislations through appropriate agencies. · There should be a Task Force constituted for each case under a designated team leader. · In the interest of adequate control and efficiency, a Committee each, headed by the Cabinet Secretary should directly oversee the appointments to, and functioning of this office, and coordinate the work of concerned departments and agencies as described in paragraphs 5.17 and 5.20. · Later, a legislative framework, along the lines of the SFO in the UK, should be set up to enable the CSFO to investigate all aspects of the fraud, and direct the prosecution in appropriate courts. 39. Good corporate governance is good business because it inspires investor confidence, which is so essential to attracting capital. All the confidence, however, that the good companies build, and the good work that they do over time can be largely undone by a few unscrupulous businessmen, and fly-by-night operators. Such exceptions require to be handed out deterrent punishments. The Committee felt that in doing so, the DCA is hampered as there are several weaknesses in law (the Companies Act, 1956) which, the Committee feels, need to be rectified as an important step towards better corporate governance in India. The principle that ill-gotten gains must be disgorged from the wrongful gainer needs to be enshrined in the Companies Act.

Recommendation 5.4

Penalties ought to be rationalized, and related to the sums involved in the offence. Fees, especially late fees, can be related to the size of the company in terms of its paid-up capital and free reserves, or turnover, or both. · Disqualification under section 274(1)(g) of the Companies Act, 1956 should be triggered for certain other serious offences than just non-payment of debt. However, independent directors need to be treated on a different footing and exempted as in the case of nominee directors representing financial institutions. · A stricter regime should be prescribed for companies registered as brokers with SEBI. Greater accountability should be provided for with respect to transfer of money by way of Inter · Corporate Deposits, or advances of any kind, from listed companies to any other company, as a necessary concomitant of the liberalisation that section 372A of the Companies Act, 1956 provides. · DCA’s prosecution wing needs to be considerably strengthened. Streamlined procedures be prescribed in the Companies Act, on the lines of the recent amendments to the Code of Civil Procedure. · To ensure that proceeds from illegal acts and frauds do not escape recovery, Companies Act needs to be amended to give DCA the powers of attachment of bank accounts etc., on the lines of the powers recently given to SEBI. Ill-gotten gains must be disgorged. · Managers/promoters should be held personally liable when found guilty of offences. In such cases, the legal fees and other charges should be recovered from the officers in default, especially if the offences pertain to betrayal of shareholder’s trust, or oppression of minority shareholders. It is patently unfair that the shareholder is penalised twice, once when mulcted, and again to have to incur the legal expenses to defend the fraudster. · Consolidated Financial Statements should be made mandatory for companies having subsidiaries. 40. Lack of basic statutory compliance, like filing returns with the ROC, is a source of concern as it prevents the stakeholders from discovering corporate mis-governance. The inability of ROC offices to regularly file all the documents received by them makes the situation worse. Strengthening of ROC offices to ensure better compliance has been recommended elsewhere by this Committee. The converse side of increasing strength of ROC offices is reduction in the workload at these offices. The Committee recommends outsourcing of non-statutory work, and tightening the law regarding lapses in secretarial compliance, by inserting a section analogous to section 233A (which permits the government to order special audits), to allow the government to order special compliance audits.

Recommendation 5.5

DCA should consider reducing workload at offices of ROCs by providing for a system of ’pre-certification’ by company secretaries; the system should provide for monetary and other penalties on company secretaries who certify incorrectly, even through error or oversight · The Companies Act be amended to enable the DCA to order a ’compliance audit’, much in the same manner as it can order special audits under section 233-A of the Companies Act. 41. The Committee also recommends a number of other steps that, it feels, would contribute to better corporate governance regime; these have been grouped under the head ‘miscellaneous’ towards the end of chapter 5. Broadly, these cover areas such as preventing stripping of assets, random scrutiny of accounts, better training for articles, and propagation of an internal code of ethics for companies.

Recommendation 5.6

MAOCARO should be amended to provide that auditors report certain violations, such as those listed in paragraph 5.39. · Section 293(1)(a) should be strengthened to prevent any unnatural stripping of assets, or sale of shares by management/promoters · To reduce workload in ROC offices, as well as to improve auditing standards, the government should consider introducing a system of ’random scrutiny’ of audited accounts, in the same way as is done by the Accountancy Foundation in the UK, or is proposed to be done by the Public Oversight Board in the USA. However, this recommendation should be implemented only if, and after, DCA can take care of concerns such as the genuineness of randomness, client confidentiality etc., and is confident of its own manpower strengths and skills · ICAI should re-consider the limits it has set on the number of articles that a partner can train; something that has the unintended consequence of denying young prospective accountants the chance to train with the best in the profession. · Companies should be required to establish, and publish, an “Internal Code of Ethics”. · DCA should sponsor, and financially support, from the IEPF, research on corporate governance and allied subjects that have a bearing on investor/shareholder well- being. 42. The profession of accountancy in India is dominated by small firms. This has not only opened them to threats of competition from larger better organised international firms, but has also limited their ability to fund top class human resource development. The Committee feels that, in the long run, Indian audit firms will have to consolidate and grow if they are to compete, especially in non-statutory functions, internationally. The Committee makes two recommendations in this regard.

Recommendation 5.7

ICAI should propose to the Government a regime and a regulatory framework that encourages the consolidation and growth of Indian firms, in view of the international competition they face, especially with regard to non-audit services. · The Government should consider amending the Partnership Act to provide for partnerships with limited liability, especially for professions which do not allow their members to provide services as a corporate body.