Can Clause 49 improve governance?

More independent company boards are the order of the day, but blind copying of western models will not help.

Y M Deosthalee
CFO & Member of the Board
Larsen & Toubro Limited

Over the past four or five years, the subject of corporate governance has been widely discussed and debated not only in India but across the globe. Any corporate governance system is the product of a series of legal, regulatory, and best practice elements.

The proposed changes in Clause 49 and the Listing Agreement need to be viewed in the backdrop of significant increase in capital flows across the globe.

Lenders and investors, which are now a global community, are less willing to add governance risks to the country and industry risks that are already inherent in their investment portfolio.

The realisation that good corporate governance can and has proved to enhance shareholder value has continued to motivate regulators and legislators to tone up standard practices and laws.

This has been substantiated by stock exchanges that noted that a separate index of companies with high governance ratings significantly outperformed the market index.

International credit rating agencies have further turned up the heat through incorporation of corporate governance variables into their credit rating methodology.

But the most interesting development is the weightage of corporate governance in the investment selection process by fund managers, as opposed to the ownership management processes where it has hitherto been the most relevant.

As this calibration progressively gets fine-tuned, we could expect global banking systems to follow portfolio capital adequacy norms with risk weights for corporate governance.

Governance might thus become an explicit consideration for corporations issuing debt and, in due course, influence corporate cost of capital.

Hence, for companies to be competitive, well-honed internal systems, process and governance standards are as essential as business performance. In fact, corporate governance is fast turning into a business consideration!

More independent boards seem to be the order of the day. Almost all governance codes, both internal and international, address this issue by requiring a significant number of independent/ non-executive directors on the board. The strict definition of independence is also gaining momentum in all parts of the world.

While some time may be required for creating a reservoir of such independent directors, one cannot find fault with the need for independent professionals to make qualitative contributions to the board.

The role of such independent directors is to ask critical questions, bring in new perspectives to risk management and strategy, and evolve board meetings into brain-storming sessions that add value.

With the increase in complexity of businesses, it may not be feasible for the entire board to look at the financial statements of the company in detail.

It is, therefore, appropriate to expand the role of the audit committee and entrust to it the tasks of understanding such financial statements, discussing with internal and external auditors, and reviewing financial and accounting policies of the company periodically.

For the committees to perform efficiently, it is essential to have competent professionals with an understanding of finance, as members. In fact, much before the advent of Clause 49, proactive companies have appointed audit committees that are effective.

There are two types of corporate failures. The first involves "moral and ethical failures". In 2003, this failure resulted in $205 billion in destroyed wealth, as estimated by a study on the subject.

The second involves "performance failure" where the management either loses its priorities and/ or fails to recognise and respond to changes in business and performance trends. The second category has a larger impact on the markets.

Vigilance is the key word in corporate governance now, and hence the need for CEO/ CFO certification. This needs to be viewed as a culmination of immaculate systems and business practices.

Review processes by audit or other independent committees, or of subsidiary operations by the parent's representatives are to be constructively viewed as regulatory extensions to a healthy governance process. These, combined with meaningful disclosures, serve to appraise and appease the owners (shareholders) that all is well with their company.

The only way to comply with these requirements would be to establish a strong corporate governance culture, a healthy management style and appropriate system/ process controls. Inculcating a code of conduct, risk management and mitigation systems, whistle-blower mechanism and so on are essential sub-processes to sustain them.

Costs, rather investments, for matching the existing infrastructure to required standards will vary accordingly. But it's only a question of recognising the inevitable direction that corporations have to take, and for managements to clearly understand that healthy corporate governance is here to stay.

Jayant M Thakur
Chartered Accountant

Clause 49 of the Listing Agreement, which is the only comprehensive set of requirements for corporate governance for listed companies in India, has been put off for the second time "" and that too wholly "" leaving corporate India without statutory corporate governance for more than two years.

The Indian statutory corporate governance suffers from several pitfalls. First, it is an unhappy compromise between two extreme approaches. One form emphasises a non-statutory voluntary model where stress is on disclosure and transparency.

There are no penal consequences for non-compliance, but there is disclosure and transparency of the level of compliance where it is expected that the markets will punish aberrant companies.

The second model whose prime example is the US with its Sarbanes Oxley Act ("SOX Act"), where the provisions are to be followed to the letter and non-compliance can result in imprisonment and hefty penalties.

India has taken the compromise route where the requirements have a statutory force but with minimal penal consequences. From one perspective, one could say that it is a happy compromise. But realistically, it has several disadvantages.

One also wonders whether corporate governance of western models "" and we have unabashedly copied them "" are suitable to Indian conditions at all, where, for instance, promoters' holdings are typically more than 40 per cent, thus making the requirement of 50 per cent independent directors inappropriate and even unfair.

Another example is of the requirement of CEO/ CFO certificate that is almost identically worded as Section 302 of the SOX Act of the US. In India, in those companies that are promoter run, professional CEOs/ CFOs have far lesser powers and, hence, it would be difficult for them to give such broadly-worded certificates for the company.

Having said that, there are serious questions whether Clause 49 would have any enforceability. On the face of it, in view of a recent amendment to the law, violation of Clause 49 can result in a penalty of up to Rs 25 crore.

However, its peculiar wording and placement has resulted in doubts on whether, and on whom, the penalty can be levied. These lacunae make one question the effectiveness of the CEO/ CFO certificate, too.

An interesting study in the US was recently made with the intent of checking the effectiveness of corporate governance requirements. The hypothesis was that compliance of corporate governance requirements should result, other things being equal, in better valuation for the shares of the company since the investors would have greater confidence in the management.

In the years following the SOX Act coming into force, it was found that there was no effect on such valuations and that the new requirements were largely ignored.

If this study is taken as a basis for conclusion, it would appear that while on one hand companies have to make efforts to comply with the law and face punishment for even minor non-compliances, on the other hand, the intended benefits may not arise. One is tempted to conclude that a substantial part of the blame lies in the manner in which requirements of corporate governance are framed and designed.

Another glaring example of a requirement of Clause 49 being totally inappropriate to India is the control over directors' remuneration. In the US and other countries, it was found that directors and management received sky-high remuneration and perks, irrespective of the company's performance.

In typical promoter-driven companies in India, remuneration of directors is hardly an issue more so with the Companies Act retaining the archaic limits on managerial remuneration and sitting fees.

Of course, no one can deny the need for good corporate governance. In fact, that companies which are run on good principles of governance will reap rewards in terms of increased shareholder value, higher valuations, growth, and so on is almost an axiom.

The difficulty comes when matters of ethics and conscience are sought to be enforced as law. The result is that it will be followed exactly as most laws are followed to the letter and not in the spirit, and compliance would be only to the extent as one could get away with.

Arguably, corporate governance does not need a statutory mandate but a model, specifically framed for Indian conditions that Indian corporations and investors can identify and empathise with.

To conclude, the pitfalls in Clause 49 arise not in the concept but in the method and techniques. Instead of taking the short cut of copying methods unsuitable to Indian conditions, a fresh approach is required to bring willing and enthusiastic application of corporate governance which by definition is intended to benefit all stakeholders in the long run.