1.01 The global movement for better corporate governance progressed in fits and starts from the mid-1980s up to 1997. There were the odd country-level initiatives such as the Cadbury Committee Report in the United Kingdom (1992) or the recommendations of the National Association of Corporate Directors of the US (1995). It would be fair to say, however, that such initiatives were few and far between. And while there were the occasional international conferences on the desirability of good corporate governance, most companies — global and Indian alike — knew little of what the phrase meant, and cared even less for its implications.
1.02 More recently, the first major stimulus for corporate governance reforms came after the South-East and East Asian crisis of 1997-98. This was no classical Latin American debt crisis. Here were fiscally responsible, healthy, rapidly growing, export-driven economies going into crippling financial crises. Gradually, governments, multilateral institutions, banks as well as companies began to understand that the devil lay in the institutional, microeconomic details — the nitty-gritty of transactions between companies, banks, financial institutions and capital markets; the design of corporate laws, bankruptcy procedures and practices; the structure of ownership and crony capitalism; sharp stock market practices; poor boards of directors showing scant regard to fiduciary responsibility; poor disclosures and transparency; and inadequate accounting and auditing standards. Suddenly, ‘corporate governance’ came out of dusty academic closets and moved centre stage.
1.03 Barring Japan and possibly Indonesia, countries in Asia recovered remarkably fast. By the year 2001, Thailand, Malaysia and Korea were on the upswing and on course to regain their historical growth rates. With such rapid recovery, corporate governance issues were in the danger of being relegated to the back stage once again. There were projects to be executed, under-valued assets to be bought, and profits to be made. International investors were again showing bullishness. In such a milieu, there seemed no urgent need to impose concepts like better accounting practices, greater disclosure, and independent board oversight. Corporate governance once again settled into a phase of extended inactivity.
1.04 India’s experience was somewhat different from this Asian scheme of things. 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. 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.[1] Thirdly, it is fair to say that, since April 2001, listed companies in India are required to follow some of the most stringent guidelines for corporate governance throughout Asia and which rank among some of the best in the world. Even so, there is scope for improvement. For one, while India may have excellent rules and regulations, regulatory authorities are inadequately staffed and lack sufficient number of skilled people. This has led to less than credible enforcement. Delays in courts compound this problem. For another, India has had its fair share of corporate scams and stock market scandals that has shaken investor confidence. Much can be done to improve the situation.
1.05 Just as the global corporate governance movement was going into a bit of hibernation, there came the Enron debacle of 2001, followed by other scandals involving large US companies such as WorldCom, Qwest, Global Crossing, and the exposure of auditing lacunae that eventually led to the collapse of Andersen. Having shaken the foundations of the business world, that too in the citadel of capitalism, these scandals have triggered another more vigorous phase of reforms in corporate governance, accounting practices and disclosures — this time more comprehensively than ever before. As a US-based expert recently put it, “Enron and WorldCom have done more to further the cause of corporate transparency and governance in less than one year, than what activists could do in the last twenty.”
1.06 This is truly so. In June 2002, less than a year from the date when Enron filed for bankruptcy, the US Congress introduced in record time the Sarbanes-Oxley Bill. This piece of legislation (popularly called SOX) brought with it fundamental changes in virtually every area of corporate governance — and particularly in auditor independence, conflicts of interest, corporate responsibility and enhanced financial disclosures. The SOX Act was signed into law by the US President on 30 July 2002. While the US Securities and Exchanges Commission (SEC) is yet to formalise most of the rules under various provisions of the Act, and despite there being rumbles of protest in the corporate world against some of the more draconian measures in the new law, 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.
1.07 Although India has been fortunate in not having to go through the pains of massive corporate failures such as Enron and WorldCom, it has not been found wanting in its desire to further improve corporate governance standards. On 21 August 2002, the Department of Company Affairs (DCA) under the Ministry of Finance and Company Affairs appointed this 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 cost accountants, 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.
1.08 As is evident, the terms of reference to this Committee lie at the heart of corporate governance.[2] Before outlining the scheme of this report and moving on to other chapters, it is necessary to give a thumbnail sketch of the basic theory of corporate governance — if only to indicate how the chapters that follow derive from its core tenets
The Theory of Corporate Governance — A Resume
1.09 The fundamental theoretical basis of corporate governance is agency costs. Shareholders are the owners of any joint-stock, limited liability company, and are the principals.[3] By virtue of their ownership, the principals define the objectives of a company. The management, directly or indirectly selected by shareholders to pursue such objectives, are the agents.[4] While the principals might wishfully assume that the agents will invariably do their bidding, it is often not so. In many instances, the objectives of managers are quite different from those of the shareholders.[5] Such misalignment of objectives is called the agency problem; and the cost inflicted by such dissonance is the agency cost.[6] The core of corporate governance is designing and putting in place disclosures, monitoring, oversight and corrective systems that can align the objectives of the two sets of players as closely as possible and, hence, minimise agency costs.
1.10 Corporate history suggests that there are two types of agency costs, and both relate to the basic concept of separation. The first is the separation of ownership from management, and is based largely on the examples of large US and British listed companies up to the mid-1980s. Vast Anglo-American corporations were characterised by very widely dispersed shareholding coupled with little or no managerial ownership of shares. Hence, managers had little incentive to align many of their decisions in line with those desired by the shareholders. Until the late-1980s, such differences were abetted by widely held share ownership, and the absence of powerful pension and mutual funds which could have used their relatively concentrated stockholdings to demand greater shareholder value. Such huge, and de facto uncontrolled managerial playing fields led to wrong investment decisions, unconnected diversification and taking of excessive risks with shareholders’ funds — which often resulted in falling efficiency and declining long-term corporate value. In the US, such agency costs had their denouement in the spate of hostile takeovers from the late 1970s right up to the late 1980s. Although the modern champion of this corporate efficiency aspect of agency cost is Michael Jensen of the Harvard Business School,[7] the essence of this concept was highlighted as early as in 1776, when Adam 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 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, p.31.
1.11 There is, however, a second dimension to agency costs — which also has to do with separation. This form of agency cost does not adversely affect corporate efficiency as it does minority shareholder rights. Consider, for instance, the three dominant characteristics of South-East and East Asian conglomerates. First, relative to their size, most Asian companies have low equity. This was traditionally facilitated by highly geared, credit and term-lending driven growth. Secondly, given the low equity base, the promoters found it relatively cheap to own majority shares. This is still true for many companies in Hong Kong, Indonesia, Malaysia, Philippines, Thailand and China, where the entrepreneur and his family own up to 75% of the equity, which thwarts all possibilities of equity-triggered take-overs. Thirdly, equity ownership was camouflaged through complex cross-holdings.
1.12 None of this conforms to the model of the modern Anglo-American 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. 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 late-1980s. However, he can do a great many 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 the 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 in the secondary market, and the like.
1.13 In the Indian context not only a large number of retail investors, but also several creditors, especially financial institutions, will echo this sentiment. Sharp practices may, on their own, add to agency costs, and the consequent depletion of shareholder value. Stakeholders seem to believe that this is a necessary evil that they will have to live with, especially if returns on their investment are perceived by them to be higher than the market average. However, in India a lot more has happened. Vanishing companies are a downright fraud, where shareholder money has simply disappeared. There have been subtler frauds too, such as the promoter-manager of a listed company utilising shareholder money to buy small private companies at exorbitant prices with every likelihood of the promoter-manager having a beneficial interest in such private companies; or, that of the promoter-manager using shareholder money to artificially raise the price of the company’s shares, to induce existing investors to invest more, and new investors to invest anew. Even where frauds have not been committed, and promoter-managers have not actually destroyed share value, it can be safely said that more often than not wealth has not been fairly shared; in fact, such promoter-managers seem to have fine-tuned their ability to keep returns just above expectations of the shareholders.
1.14 It will take much more research before one can definitively apportion agency cost effects between efficiency and expropriation. 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 competition and earn returns that exceed the opportunity cost of capital can also have poor corporate governance. And this can manifest itself in a steady expropriation of minority shareholder rights.
1.15 Two broad instruments that reduce agency costs and hence, improve corporate governance, are financial and non-financial disclosures and independent oversight of management. A company that discloses nothing can do anything. Improving the quality of financial and non-financial disclosures not only ensures corporate transparency among a wide group of investors, analysts and the informed intelligentsia, but also persuades companies to minimise value-destroying deviant behaviour. This is precisely why law insists that companies prepare their audited annual accounts, and that these be provided to all shareholders and be deposited with the Registrar of Companies (ROC). This is also why a good deal of effort in global corporate governance reform has been directed to improving the quality and frequency of disclosures.
1.16 Independent oversight of management comprises two aspects. The first relates to the role of the independent, statutory auditors — who are appointed by shareholders to audit a company’s accounts and present a ‘true and fair’ view of the financial health of the corporation. Indeed, the quality and independence of the statutory auditors are fundamental to corporate oversight. While it is the job of management to prepare the accounts, it is the fundamental responsibility of the statutory auditors to scrutinise such accounts, raise queries and objections (if the need arises), arrive at a true and fair view of the financial position of the company, and report their independent findings to the board of directors and, through them, to the shareholders and investors of the company. No doubt, auditors have the skills to scrutinise complex accounts of today’s multi-divisional, multi-segmental corporations, but these skills would come to nought if an auditing firm did not have a strict, arm’s length independent relationship with the management of the companies they audit.
1.17 The second aspect of independent oversight is the board of directors of a company. A joint-stock company is owned by the shareholders, who appoint directors to supervise management and ensure that it does all that is necessary by legal and ethical means to make the business grow and maximise long term corporate value.
1.18 The point to note is that the board is appointed by the shareholders and are, therefore, accountable to them. Directors are fiduciaries of the shareholders, not of the management. That doesn’t mean an adversarial or a non-collegial board. However, 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, and stand up and be counted. This is precisely the reason why ‘independence’ has become such a critical issue to determining the composition of any board.
1.19 Clearly, a board packed with executive directors or friends and cronies of the promoter or CEO cannot be normally expected to exercise independent oversight judgement at times when it is most needed. The failure of many large corporations in recent times, be these Japanese keiretsus, Korean chaebols, Indonesian empires, Indian groups or US conglomerates, has much to do with the poor quality of boards and the lack of independent oversight. Part of this failure is related to inadequate disclosure of key corporate information to boards as well as shareholders and other stakeholders — an issue that will be addressed in the course of this report. But much has to do with poor board composition where directors, due to their close business and social relationships with promoters, did not feel the necessity of asking the right questions when occasions demanded much more detailed scrutiny and debate. They were, as US observers picturesquely put it, “parsley on the fish” — meant for decoration and little else.
Structure of the Report
1.20 A look at the terms of reference to this Committee outlined in paragraph 1.07 above shows that it is entrusted to look into the two key aspects of corporate governance: (i) financial and non-financial disclosures, and (ii) independent auditing and board oversight of management. There are related aspects — the need for independent oversight of auditors, and efficacious disciplinary procedure for professionals. Having outlined the basic theory of corporate governance that will inform the recommendations of the Committee, we now turn to the structure of the report.
1.21 Chapter 2 deals with the entire range of the statutory auditor-company relationship. The objective is to suggest ways of ensuring, and enhancing, the independent, professional nature of this key corporate governance link. Among other things, the chapter examines issues such as the rotation of audit firms versus that of auditing partners, restrictions on non-audit work and fees from such work, the procedure for appointment of auditors, determination of audit fees, and allied subjects. It also looks into measures that may be required to ensure that management and auditors actually present the ‘true and fair’ statement of financial affairs of the company and, in light of section 302 of the SOX Act, whether it is necessary to introduce measures such as CEO and CFO certification
1.22 Chapter 3 focuses on the issue of who audits the performance of auditors — and examines whether the present system of regulation of chartered accountants, company secretaries and cost and works accountants is sufficient and has adequately served the interests of corporate shareholders and stakeholders. In this context, the chapter analyses the need for setting up an independent regulatory body to oversee the quality of audit of public limited companies as has been done in the case of the Public Company Accounting Oversight Board prescribed by the SOX Act.
1.23 Chapter 4 relates to the independence of the board of directors. It examines the definition of ‘independence’ currently used in India, and reviews whether there is a need to tighten such a definition. The chapter then goes on to discuss the composition and size of corporate boards, and steps that can be taken to ensure and enhance independence of judgement. Thereafter, it examines in detail the role and functions of the Audit Committee of the board, and suggests things that can be done to strengthen this key committee. The chapter then looks at the remuneration and liabilities of non-executive and independent directors, and finally suggests the need for a concerted nation-wide training programme for directors.
1.24 The report concludes with Chapter 5, which discusses some related or allied matters, and recommendations of a consequential nature. It covers some of the concerns that emanated during discussions on the terms of reference, such as improving the conditions and functioning of ROC offices, strengthening the inspection wing of the DCA, harmonisation of action between SEBI and DCA, the need to set up a Corporate Serious Frauds Office, random scrutiny of accounts, and the like.
Approach of the Committee
1.25 The Committee has had the good fortune of being able to benefit from hearing the views of a large cross-section of players — academics specialising in corporate governance, regulators such as SEBI and the DCA, representatives of Comptroller and Auditor-General, RBI, banks, financial institutions and insurance companies, professionals involved in audit and secretarial functions, lawyers, representatives of investors, industry associations and business chambers, and others. Appendix 2 gives a list of those who the Committee met. Given the shortage of time, the Committee could not meet with more people and organisations, but has taken on record papers, notes and depositions sent by all. Appendix 4 gives a list of all documents that were received by the Committee.
1.26 Before moving on to the substantive chapters, it is necessary to clarify the approach taken by this Committee in framing its recommendations. In a sentence, the approach has been to maximise corporate governance reforms, keeping in mind pragmatic considerations and ground realities of India. In the past, well-meaning recommendations have been often discarded as unrealistic, or have been distorted to bestow excessive monitoring and supervisory powers upon otherwise ill-equipped government departments and regulatory authorities. The Committee has been acutely conscious of the attendant risks, even as it has been aware of its responsibility to recommend substantive changes.
1.27 Suggesting major reforms in the structure and practice of corporate governance is fraught with yet another hazard. Given the nature of the subject, one has to deal with polarised points of view of various parties and interest groups. At the one extreme is the view that all corporations are intrinsically ‘bent’. Those with such a view inevitably propose more regulation and a heavier arm of the law — without realising that the way in which the machinery of enforcement might work may result in unintended consequences. The other extreme is the pure laissez faire view, which naively believes that the market itself can take care of all structural ills, without the need for more focused regulatory oversight. Like most things, the truth lies somewhere in between.
1.28 Hence, the leitmotif of this Committee has been pragmatic radicalism. Every recommendation in this report has been the outcome of careful debate. And each has been derived from well-defined theoretical and empirical arguments, and reinforced by transparent, workable institutional arrangements, with clear guidelines and time tables. In its deliberations, the Committee was conscious of improving regulatory oversight without diminishing managerial initiative and risk-taking —which are the lifeblood of any business enterprise. Thus, wherever possible, the Committee has imposed reasonable bounds upon the regulatory powers of Government — based on the well-proven ground that excess of regulation invariably begets dirigisme, delays, discretionary abuse and rent-seeking. This does not mean that regulation is not important. Far from it, and readers will see several new regulations and disclosures that have been recommended in this report. But, all such regulations need to be transparent, fair and incentive-compatible — so as to deliver the desired results.
1.29 Finally, the Committee wishes to emphasise that the recommendations have to be viewed as an integrated package. There is an overarching logic that knits all of them together; each recommendation can be feasibly implemented; and, given the strong empirical basis and realistic bias, none of the recommendations should result in unintended, adverse outcomes. It might be imprudent to pick and choose proposals according to expediency. Hence, the Committee advocates that the recommendations be viewed in their totality, and implemented in integrated fashion.
[1] In December 1995, the Confederation of Indian Industry (CII) set up a committee to prepare a comprehensive voluntary code of corporate governance for listed companies. The final draft report was was released in April 1998. . Thereafter, SEBI appointed a committee under Mr. Kumar Mangalam Birla to draft a code for corporate governance. Much in common with the CII report , the recommendations of this committee were then incorporated as Clause 49 of the Listing Agreement for all stock exchanges.
[2] The constitution of this Committee and its terms of reference are given in Appendix 1 to this report.
[3] This is the reason that, when addressing a body of shareholders, the Chairman refers to the company as “Your company”.
[4] In the context of a democratic government, the principals are the elected representatives of the people, while the agents are the civil servants.
[5] For instance, a chief executive may want to increase his managerial empire and personal stature by using the company’s funds to finance an unrelated, flavour-of-the-times diversification, which could reduce long term shareholder value. The shareholders and other stakeholders of the company may not be able to counteract this — because of inadequate disclosure about such a foray and because the principals may be too dispersed to effectively block such a move.
[6] Examples of agency costs abound in corporate governance literature, the most recent being the case of Enron. The objectives of senior management (the agents) were clearly not aligned to those of the shareholders (the principals). Thanks to the inability of the principals to monitor and rein in the actions of Enron’s senior management, the company did things that led to its eventual bankruptcy.
[7] See Michael C. Jensen, and William J. Meckling (1976), ‘Theory of the Firm: Managerial Behaviour, Agency Costs and Ownership Structure’, Journal of Financial Economics, 3(4), 305-360; Michael C. Jensen (1986), ‘Agency Cost of Free Cash Flow, Corporate Finance and Takeovers’, American Economic Review, Papers and Proceedings, 76(2); and, Michael C. Jensen (1988), ‘Takeovers: Their Causes and Consequences,’ Journal of Economic Perspectives, 2(1);