SAGE was founded in 1965 by Sara Miller McCune to support the dissemination of usable knowledge by publishing innovative and high-quality research and teaching content. Today, we publish over 900 journals, including those of more than 400 learned societies, more than 800 new books per year, and a growing range of library products including archives, data, case studies, reports, and video. SAGE remains majority-owned by our founder, and after Sara’s lifetime will become owned by a charitable trust that secures our continued independence. Los Angeles | London | New Delhi | Singapore | Washington DC | Melbourne

The Essential Book of

CORPORATE

GOVERNANCE

The Essential Book of

CORPORATE

GOVERNANCE G. N. BAJPAI

Copyright © G.N. Bajpai, 2017 All rights reserved. No part of this book may be reproduced or utilized in any form or by any means, electronic or mechanical, including photocopying, recording, or by any information storage or retrieval system, without permission in writing from the publisher. First published in 2017 by

SAGE Publications India Pvt Ltd B1/I-1 Mohan Cooperative Industrial Area Mathura Road, New Delhi 110 044, India www.sagepub.in SAGE Publications Inc 2455 Teller Road Thousand Oaks, California 91320, USA SAGE Publications Ltd 1 Oliver’s Yard, 55 City Road London EC1Y 1SP, United Kingdom SAGE Publications Asia-Pacific Pte Ltd 3 Church Street #10-04 Samsung Hub Singapore 049483 Published by Vivek Mehra for SAGE Publications India Pvt Ltd, typeset in 11/13 pt Berkeley by Diligent Typesetter India Pvt Ltd, Delhi, and printed at Sai Print-o-Pack, New Delhi. Library of Congress Cataloging-in-Publication Data Name: Bajpai, G. N., author. Title: The essential book of corporate governance / G.N. Bajpai. Description: Thousand Oaks, California : SAGE, 2016. | Includes   bibliographical references and index. Identifiers: LCCN 2016026478| ISBN 9789385985218 (pbk. : alk. paper) | ISBN   9789385985201 (epub) | ISBN 9789385985225 (ebook) Subjects: LCSH: Corporate governance. Classification: LCC HD2741 .B23155 2016 | DDC 658.4/2—dc23 LC record available at https://lccn.loc.gov/2016026478 ISBN: 978-93-859-8521-8 (PB) SAGE Team: Sachin Sharma, Sudeshna Nandy, Anjali Agarwal and Rajinder Kaur

Dedication To all young and budding entrepreneurs and managers who may wish to create wealth, including my grandchildren—Anand Chaturvedi, Anika Sharma, Aishwarya Sharma and Dia Pandey.

Thank you for choosing a SAGE product! If you have any comment, observation or feedback, I would like to personally hear from you. Please write to me at [email protected] Vivek Mehra, Managing Director and CEO, SAGE India.

Bulk Sales

SAGE India offers special discounts for purchase of books in bulk. We also make available special imprints and excerpts from our books on demand. For orders and enquiries, write to us at Marketing Department SAGE Publications India Pvt Ltd B1/I-1, Mohan Cooperative Industrial Area Mathura Road, Post Bag 7 New Delhi 110044, India

E-mail us at [email protected]

Get to know more about SAGE

Be invited to SAGE events, get on our mailing list. Write today to [email protected]

This book is also available as an e-book.

Contents List of Figuresxiii List of Abbreviationsxv Acknowledgementsxix Author’s Notexxiii   1. Prologue: Tyranny of Corporate Governance

1

 2. Introduction

6

  3. Stakeholders of Joint Stock Companies

25

  4. Raison D’être of Joint Stock Companies

39

  5. Greed, Hubris and Delinquencies: Barriers to Good Corporate Governance

45

  6. Fruition: Concept of Corporate Governance

52

  7. Pillars of Corporate Governance

60

  8. Boardroom Practices 

74

  9. Accounting and Financial Reporting Standards

142

10. Related Party Transactions 

157

11. Disclosures 

166

12. Risk Management 

175

13. Building Ethos: Ecosystem 

181

14. Building Enablers of Good Corporate Governance

187

15. Monitoring Pyramid 

195

16. Evaluation of Quality of Corporate Governance 

206

17. Conclusion: Corporate Governance—Triumph of the Enterprise 

233

viii  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

Annexure 1: Case Studies 249 Annexure 2: Board Allocation of Role Between Board and the Management 270 Annexure 3: Board and Its Subcommittees Meeting Protocols272 Annexure 4: Policies 276 Annexure 5: Charters 312 Bibliography329 Index332 About the Author334

Detailed Contents   1. Prologue: Tyranny of Corporate Governance

1

 2. Introduction 6 2.1. Evolution of Economies 6 2.2. Evolution of JSCs 9 2.3. Evolution of Securities Markets 17 2.4. Evolution of Capital Market Regulatory Framework 22   3. Stakeholders of Joint Stock Companies 3.1. Introduction 3.2. Organizational Structure 3.3. Organizational Structure and Corporate Governance 3.4. Corporate Governance at Financial Distress

25 25 30 36 37

  4. Raison D’être of Joint Stock Companies 4.1. Wealth Creation 4.2. Wealth Management 4.3. Wealth Sharing

39 41 42 43

  5. Greed, Hubris and Delinquencies: Barriers to Good Corporate Governance 5.1. Barriers to Good Corporate Governance

45 47

  6. Fruition: Concept of Corporate Governance

52

  7. Pillars of Corporate Governance 7.1. Introduction 7.2. Tiers of Monitoring Pyramid

60 60 71

  8. Boardroom Practices  8.1. Composition of a Board 8.2. Sourcing of NEIDs 8.3. Integration of the Board Members 8.4. Role of a Chairman 8.5. Role of a Lead Director 

74 76 79 83 87 92

x  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

  8.6. Retirement Policy—NEDs 94   8.7. A  llocation of Role and Responsibilities Between the Board and the Management 96   8.8. Allocation of Time of the Board 103   8.9. Business Management and Enterprise Management 104 8.10. Designing the Agenda for the Board Meeting 106 8.11. Drafting of the Board Notes 110 8.12. Minutes of the Board and Committees’ Meetings 113 8.13. Action Taken Report (ATR) 117 8.14. Vision and Direction 117 8.15. B  arrier to Broader Debate in the Boardroom 121 8.16. Focus on Strategy 122 8.17. Budgeting Exercise 127 8.18. E  valuation of the Performance of Executive Directors131 8.19. Evaluation of the Performance of NEDs 133 8.20. Evaluation of Performance of the Board 136 8.21. Succession Planning 137 8.22. Constant Communication and Consultation 140   9. Accounting and Financial Reporting Standards 9.1. Quality Assurance 9.2. Management Assurance 9.3. Independent Assurance 9.4. Statutory Assurance 9.5. Conclusion

142 143 145 151 153 154

10. Related Party Transactions 10.1. What Is an RPT  10.2. Why RPTs Are an Issue of Significance 10.3. RPTs, Auditors and the Audit Committee  10.4. Board and the RPTs 10.5. RPT Policy 10.6. RPT Procedure 10.7. Conclusion

157 159 159 161 162 163 163 165

11. Disclosures 11.1. Introduction 11.2. Means, Methods and Manner of Disclosures 

166 166 172

Detailed Contents   xi

12. Risk Management 12.1. Risk Management Process

175 178

13. Building Ethos: Ecosystem

181

14. Building Enablers of Good Corporate Governance 14.1. Code of Conduct 14.2. Whistle Blower Policy 14.3. Website 14.4. Board and Committee Meeting Protocols 14.5. Compliance Culture

187 187 189 192 192 193

15. Monitoring Pyramid 15.1. Compliance 15.2. Auditors 15.3. Board Committees 15.4. Board 15.6. Regulators

195 197 199 201 203 204

16. Evaluation of Quality of Corporate Governance 16.1. Rating of Corporate Governance 16.2. EVA Method 16.3. MVA Method

206 208 219 221

17. Conclusion: Corporate Governance—Triumph of the Enterprise 17.1. Value Builders: Philosophy 17.2. Value Enablers: Principles

233 238 239

Annexure 1: Case Studies 249 Annexure 2: Board Allocation of Role Between Board and the Management 270 Annexure 3: Board and Its Subcommittees Meeting Protocols272 Annexure 4: Policies 276 Annexure 5: Charters 312 Bibliography329 Index332 About the Author334

List of Figures   3.1 Stakeholders Chain   3.2 Organizational Structure   7.1 Edifice of Corporate Governance   8.1 Role of the Board   8.2 Senior Executives Helping Board   9.1 Pillars of Reliability  9.2 Stakeholders   9.3 Pyramid of Accounting and Financial Reporting 10.1 Fundamental Principles of Approving RPT 11.1 Pyramid of Disclosures 12.1 Risk Management Grid 15.1 Monitoring Pyramid 16.1 Management of Wealth Creation 16.2 Accountability Frame 16.3 Stakeholders Chain 16.4 The Virtue Matrix 17.1 Frame of Ideologies 17.2 Monitoring Process 17.3 Corporate Governance Wheel

29 31 61 102 141 143 155 156 162 168 178 196 223 224 228 231 241 241 246

List of Abbreviations AGM AOP ASX ATR BCCI BoD BOI BRT BSE CACG CAP CAR CCI CEO CESC CFO CLSA CGI CRISIL CSR CV DOA DLF EBITDA EGM EIC ERMC ESOP

Annual General Meeting Association of Persons Australian Securities Exchange Action Taken Report Bank of Credit and Commerce International Board of Directors Body of Individuals Business Round Table Bombay Stock Exchange Commonwealth Association for Corporate Governance Capital Asset Pricing Current Annuity Rate Controller of Capital Issue Chief Executive Officer Calcutta Electric Supply Corporations Chief Financial Officer Credit Lyonnais Securities Asia Corporate Governance Index Credit Rating Information Services of India Limited Corporate Social Responsibility Curriculum Vitae Delegation of Authority Delhi Land & Finance Company Limited Earnings Before Interest, Taxes, Depreciation and Amortization Extraordinary General Meeting East India Company Executives’ Risk Management Committee Employees Stock Options Plan

xvi  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

EV Enterprise Value EVA Economic Value Addition GAR Guaranteed Annuity Rate GDP Gross Domestic Product GVC Governance and Value Creation HDFC Housing Development Finance Corporation HOD Head of Department HQ Headquarters HR Human Resource ICGN International Corporate Governance Network ICRA Investment Information and Credit Rating Agency of India Limited ICSI Institute of Company Secretaries of India IFC International Finance Corporation IFRS International Financial Reporting Standards IMF International Monetary Fund IOSCO International Organization of Securities Commissions IT Information Technology JSC Joint Stock Company KRA Key Result Area LIC Life Insurance Corporation of India LLP Limited Liability Partnership LSE London Stock Exchange M&M Mahindra & Mohammed MCX Multi Commodity Exchange MD Managing Director MDA Management’s Discussions and Analysis MENA Middle East and North Africa MNC Multinational Company MV Market Value NACD National Association of Corporate Directors NASA National Aeronautics and Space Administration NED Non-executive Director NEID Non-executive Independent Director NFRA National Financial Reporting Authority NGO Non-government Organization NOPAT Net Operating Profit After Tax

List of Abbreviations  xvii

NSE OECD

National Stock Exchange Organization for Economic Co-operation and Development OPC One Person Company OTC Over-the-counter P/E Price/Earnings PCAOB Public Company Accounting Oversight Board PPP Private­–Public Partnership PSU Public Sector Undertaking R&D Research and Development ROCE Return on Capital Employed RMC Risk Management Committee RPT Related Party Transaction S&P Standard & Poor’s SEBI Securities and Exchange Board of India SEC Securities and Exchange Commission SME Small and Medium-sized Enterprise SENSEX Sensitive Index SOE State-owned Enterprise SOP Standard Operating Procedure SPE Special Purpose Entities SPP Systems, Processes and Practices SRO Self-regulatory Organization SVG Stakeholders Value and Governance SX Stock Exchange TI Transparency International TSR Total Shareholders’ Return UK United Kingdom USA United States of America UTI Unit Trust of India UTI AMC Unit Trust of India Asset Management Company Limited WACC Weighted Average Cost of Capital WBM Whistle Blower Mechanism XBRL Extensible Business Reporting Language

Acknowledgements

M

y appointment as the chairman of Securities and Exchange Board of India (SEBI) was a break from the past practice of appointing retired or shortly retiring senior bureaucrats, which I believe was propelled by the widespread market misconduct in 2000, also known as infamous ‘Ketan Parekh Scam’. The misconduct was a consequence of the civil and criminal connivance of capital market intermediaries and entrepreneur—the managers of the firms. I had the mandate and more than that my own resolve to reform and re-orchestrate the capital market practices and restore the efficacy of the market and confidence of the investors and nation at large. I had assured the Joint Parliamentary Committee (JPC) examining the scam (when I appeared as SEBI Chairman) to bring down structural, systematic and operational risks to the minimum. Mandate, my resolve and assurance to JPC inspired SEBI to undertake fast-paced reforms to improve various aspects of capital market functioning. Governance of firms was one of the most important areas of that reform process. While piloting changes in and around the pillars of Corporate Governance namely, accounting and financial reporting standards, related party transactions (RPT), disclosures and boardroom practices, I could perceive serious discomfort albeit the feeling of pain of compliance on the faces of entrepreneurs and corporate managers alike. The perception inspired me to write a book on the transformation of Corporate Governance from felt pain to experiencing value creation. The concretization of the inspiration took quite some time. Hence, this book has been work in progress for endless years. During that long and slow-moving journey of discovery, research, assimilation of information, opinions and perceptions, innumerable persons have contributed. Much as I would like, it is very difficult to list out the names of all those individuals and

xx  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

organizations that helped my thinking. Hence, I would mention them as a group. Without their help, wisdom, research, writings and support this treatise would not have shaped. To begin with, I am deeply grateful to all those institutions and individuals whose writings and research works have been used and quoted in the book, especially the authors of The EVA Challenge, Joel M. Stern and John S. Sheily, also Irwin Ross, McKinsey, Credit Rating Information Services of India Limited (CRISIL), Investment Information and Credit Rating Agency Of India Limited (ICRA) and Professor Roger L. Martin of (then) Rotman School of Management of Toronto, Canada. I am grateful to the fraternity of directors on the boards of companies, professionals such as lawyers, chartered accountants, company secretaries and SEBI officers who have helped me with ideas in my positions as chairman, SEBI, non-executive chairman and director of companies post superannuation and during my interactions in seminars, conferences and other forums. They facilitated in understanding the issues and crystallizing my answers to those issues. I am thankful to Mr Deepak Parekh, Chairman, Housing Development Finance Corporation (HDFC) Group; Mr Narayan Murthy, Chairman Emeritus, INFOSYS; Mr A. M. Naik, Chairman L&T Group; Mr Anand Mahindra, Chairman Mahindra & Mohammed (M&M) Group; Mr Adi Godrej, Chairman, Godrej Group and Mr Kishore Biyani, Chief Executive Officer (CEO), Future Group, who agreed to my request of interview, spent their valuable time and proffered wisdom, knowledge, understanding and opinion on the various facets of Corporate Governance. I would like to thank Mr Deepak Satwalekar, former managing director (MD) and CEO of HDFC Standard Life Insurance Company Ltd; Omkar Goswami, the chairman of Corporate and Economic Research Group (CERG) Advisory Pvt Ltd; Shailesh Haribhakti, the chairman of DH Consultants Pvt Ltd, all of who are respected and valued independent directors on many boards, K. K. Rathi, the MD of India Nivesh Fund Managers Pvt Ltd and Kamalji Sahay, former MD and CEO of SUD Life and former executive director of LIC of India who took pains

Acknowledgements  xxi

of going through the manuscript and suggesting very insightful changes necessary to make this book readable and useful. I am thankful to Mr Amitabh Chaturvedi, now MD, Essel Finance, for silently encouraging and helping me in the initial years of research and writing. I would like to take this opportunity to thank the staff of Intuit Consulting current and past, in particular Ms Ankita Trivedi and Ms Surabhi Jain, the consultants who helped greatly in researching for the book and reading the manuscript. I am indeed grateful to my executive assistant, Ms Connie Franco, who went through the tribulation of taking dictations, transcribing and typing over and again any number of times, willingly with smile and happiness. I would also like to thank Ms Dipti Patel of Word Famous Literary Agents for helping me to reach out and sign with SAGE for the publication of the book. I am thankful to SAGE and, in particular, Mr Sachin Sharma for a very helpful approach in evaluating the manuscript and agreeing to publish it. Acknowledgements would remain incomplete, if I do not thank my wife, Asha Bajpai; my daughters, Deepti Chaturvedi, Deepali Sharma and Devina Bajpai Pandey, and my son-inlaws, Ved Chaturvedi, Mukul Sharma and Ritesh Pandey, who encouraged me, were patient to hear some of the stories written in the book and happily accepted my indifference during conversations and bonhomie whenever we got together while I was writing this book. I thank Mr R. S. Pandey, former Senior IAS and currently MLA, Bihar legislative assembly (father-in-law of my daughter) and his wife Mrs Sharda Pandey. They took a lot of interest in the progress of my book which encouraged me greatly.

Author’s Note

O

ne of the greatest inventions on the planet Earth has been the creation and evolution of joint stock companies (JSC). A significant part of the global economic progress over time, beginning with the seventeenth century, can be attributed to the institution of JSCs. This institution enables savers with excess capital to pool in the surplus with the entrepreneurs who have ideas, abilities and urge to create wealth. The savers employ the capital and take the risk along with the entrepreneurs who toil to create value. The active owners–entrepreneurs and/or professionals are expected to manage the enterprise in the best interest of and share the wealth sagaciously with all the stakeholders, inclusive of passive owners. In summary, the raison d’être of JSCs has been optimal wealth creation, maximal wealth management and efficacious wealth sharing. Since such enterprises mobilize all forms of resources—physical, financial and human—the stakeholders includes a variety of groups, which can be broadly grouped into (a) shareholders, (b) work force, (c) customers, (d) suppliers of debt capital and other resources and (e) society. Over the centuries, various forms of JSCs—private and public, for profit and not for profit, limited liability share capital or guarantee and unlimited liability, listed and unlisted, private sector and state enterprises—have evolved. The journey of evolution and growth of JSCs has been chequered. The active managers of the enterprises have often failed to multiply and/or create expected value, appropriated disproportionately and/or have played against the interests of the silent majority of stakeholders. There have been instances of both failures and misdemeanours, which have at times shaken the confidence of the stakeholders in the basic fabric of the structure itself. Such instances have arisen out of greed, hubris, incompetence

xxiv  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

and delinquencies. This phenomenon has not been unique to a country and has been witnessed around the world, which has given rise to the concept of Corporate Governance. The concept of Corporate Governance has been in the melting pot ever since. A number of commissions, committees and forums trade associations, voluntary organizations and so on continue to contribute to the development of the frame and pillars of Corporate Governance. The four pillars on which the edifice of Corporate Governance is erected are (a) disclosures, (b) RPT, (c) accounting standards and (d) boardroom practices. Human ingenuity continues to play around the frames and pillars, and consequently the frame remains on the evolutionary platform. Instances of failure of Corporate Governance have been analysed and lessons have been incorporated while improving the Corporate Governance frame. However, a broad frame, along with the pillars, has since stabilized, which is being made applicable with different intensities depending upon the structure of the company—public and private, listed and unlisted and for profit and non-profit. Simultaneously, the enforcement mechanisms have been developing around the world. The enforcement has both private and public sector mechanism. The securities market regulator (along with the sector regulator and in some cases the state), and the market forces are expected to monitor the public and private sector enforcement, respectively. Since private sector enforcement has not been very effective and misdemeanours continue to surface, regulatory activism has been on an overdrive in most countries. This has caused both pain to enterprises and anguish to the managers of the companies. The enforcement of Corporate Governance norms is often being perceived as a tyranny unleashed by the regulators. Is it really a tyranny? Can the exercise be converted into a triumph of the institution of JSCs? These are the questions which need to be answered to make the enforcement and/or compliance an operation of value delivery. Architecturing excellence in Corporate Governance necessitates the involvement of managers at all levels with an attitude and approach to value creation rather than merely compliance

Author’s Note  xxv

with regulatory dictate. Designing of effective systems and processes is also warranted for rendering efficacious Corporate Governance. Alongside, it is important that the monitoring pyramid of auditors, board committees and the board of directors functions effectively. There are examples of enterprises which have done so and have created a model of a greater multiplier of wealth and sustainability. It will be helpful to understand what they have done and how and what kind of benefits such institutions have delivered to their stakeholders. It is understood and established by several empirical research works that market offers extra valuation to the companies with perceived good Corporate Governance. The fundamental underpinning of the creation of the institution of JSCs was to facilitate the flowering of entrepreneurship as well as better utilization of surplus resources for eventual maximization of wealth creation for the benefit of all stakeholders including the society. The management of resources as well as the interest of the stakeholder optimally, are the sine qua non for the continued confidence in the institution of JSCs. This can be ensured by scrupulous observance of the norms of Corporate Governance, both in form and substance. Corporate Governance as a tool will only be as effective as efficaciously it is applied. Measurements of the impact of good Corporate Governance can be undertaken by using techniques akin to economic value addition (EVA), wealth-sharing parameters and so on. The environment is undergoing an unremitting transformation, which threatens the validity of every tool of management inclusive of Corporate Governance. What needs to be done to ensure that this important tool, essential for the very existence of the institution, remains potent and managements get enthused and encouraged to use it in both form and substance in the enlightened interest of all stakeholders, including themselves, is the answer this book seeks to dwell on. Constantly improving the quality of Corporate Governance seems to be the only way forward and this book will attempt to show how. The secret of good Corporate Governance lies in the boardroom practices, as this is where one company scores over the other. Hence, the journey of improving the quality of Corporate

xxvi  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

Governance begins with the composition of the board. Selection of the directors has to be supplemented by creating a strong framework of constant communication and ensuring their commitment and utilization of their talent, expertise and skills. Board agenda and the focus on deliberations influence the outcomes substantially. Vision and direction—strategy loop are the areas where the board has a greater role to play and, therefore, must spend more of its time and attention. The executive management has to focus on execution and value delivery—operations loop. Whereas complementarity in the roles is welcome, transgressing jurisdiction is not desirable. Replication by the board of what management is expected to do significantly reduces the contribution of the board and eventual value creation. The contribution of each board member has to be evaluated at least annually, inter alia, to decide continuance and even compensation. Furthermore, systems and processes need to be re-engineered periodically to ensure that all the pillars of Corporate Governance are not only strengthened constantly but also provide support to the other pillars, thus, ensuring that the edifice of enterprise stands tall and erect. This will involve building strong mechanism for inculcating habits of transparency, diligence and accountability amongst the rank and file of the organization, where reward, recognition and penal processes are inextricably interwoven. This is where the role of monitoring pyramid comes into sharp focus. Superficiality can be injurious to the overall frame and delivery of the output. The effectiveness of the monitoring pyramid has, therefore, to be assessed rigorously and religiously every year. Above all, the quality of Corporate Governance is influenced by the importance that the executive management attaches to leveraging the talent of the board members and value creation via the Corporate Governance, which is a vehicle on which an enterprise traverses its journey towards the goal of success and sustainability of the confidence of the stakeholders. Thus, the entire exercise can eventually lead to the triumph of the organization, and this book suggests the ‘how of it’.

1 Prologue: Tyranny of Corporate Governance

A

n individual consumed by ambition is unrestrainable. He is a dreamer. He challenges himself. He is undaunted. He has nerves of steel. He creates a magnetic structure. He marshals resources—human, physical and financial. Such individuals are visionaries. A visionary such as the celestial character Arjuna of Mahabharata (Indian mythical epic) fame, who visualizes only ‘tryst with his dream’. Visionaries cohabit all the fields—social, political and economic. Visionaries in the area of economics, dream of building magnificent ‘enterprise(s)’. Often, such enterprises take birth in garages, living rooms, 200 sq. ft offices and so on. Microsoft is one such sterling example of the birth of the most successful enterprise of its time in a garage. Bill Gates was consumed by his ambition, so was Steve Jobs. However, every new enterprise conceived and created by a visionary leader does not turn out to be a Microsoft or Apple. But, visionary leaders live up to the text of Robert Bruce, ‘Try again, try again and keep trying …’.1 Abraham Lincoln was one such leader in politics. He became one of the most successful presidents of USA after 32 unsuccessful attempts to occupy positions in the political hierarchy. Mahatma Gandhi https://www.youtube.com/watch?v=j2HMBGELeFM (accessed on 30 May 2016). 1

2  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

was another politico-spiritualistic leader who emancipated India out of political subjugation through ahimsa (non-violence). Steve Job is the most outstanding example of current times from business, who right from his birth went through ups and downs, trial and tribulations, yet never gave up and occupied enviable front rank of modern business even while fighting incurable physical ailment, which eventually took away his mortal body but not the ‘spirit to succeed’. Leaders sometimes, gripped by greed and hubris, loosen their guards and tread the path of indiscretion, which takes the enterprise into the lane of destruction. Society is a facilitator. It plays a supportive role in the development, growth, success and sustainability of enterprises. One among the facilitations that the society offers is the raising of resources, particularly financial, from a large number of passive contributors who share the vision of the entrepreneur(s). The success stories of enterprises across geographies continue to enthuse people around the world to pool in resources with the fond hope of multiplying their wealth. Financial resources are raised in various forms and through a variety of instruments. The most commonly used structure of raising risk capital is a joint stock company, which can be shaped in a variety of formats—private or public, limited by capital or guarantee or unlimited and listed or unlisted in the stock market. The contributors of financial capital to such enterprises, depending upon their own risk appetite, choose the financing route. It could be debt with a tenor or perpetual, preference capital, voting and/or non-voting equity and so on. However, the most popular form of raising risk capital by a public limited company in India, emerging markets and around the world is the ‘equity’ capital, also called ‘common stock’, which is listed on stock exchanges (SXs). Listing on SX offers the benefit of accommodating a large number of providers of risk capital and ease of entry and exit at will. The evolution of JSCs (discussed later) helped the availability of goods and services from across borders, spread of capitalism and eventual prosperity. The promoters of the enterprise(s) as also the other contributors of financial resources have benefited immensely in many cases by such collaboration, while in equal or possibly larger number, they have lost even the capital contribution. In some cases, the promoters as active owners of the enterprise have

Prologue: Tyranny of Corporate Governance  3

benefitted disproportionately and even to the prejudicial interest of others, that is, passive investors. There are innumerable instances to suggest that the management of the business enterprise is often not conducted in the best interest of all the stakeholders. The equity and fair play are deficient. There have also been many cases of downright cheating, forgery, fraud and misappropriation. This has propelled the society through its governments across geographies to sit up, take notice and architect a framework to bring about more orderly management and governance of enterprises and help the flowering and thriving of only such enterprises that serve the greatest good of all the stakeholders. The design of the regulatory framework has been legislated and the institution of regulators—‘high priest’ to monitor the compliance of the ground rules so laid down—has been created. Today, a listed company is required to comply with a comprehensive list of guidance, directions, rules, regulations and legislations notified from time to time by the government, regulators and self-regulatory organizations (SROs) and so on. The compliance has become an operational function by itself and entails a substantial cost. The cost of Corporate Governance, particularly for a small and medium-sized enterprise (SME), aggregates to be a significant percentage of its resources. The compliance with the governance framework is not limited to constitution of board and its meetings but has a wide spectrum commencing with the incorporation, conduct and winding up of the enterprise and extends right to the maintenance of accounts, disclosures, related party transactions (RPT), risk management, manning of critical positions such as chief executive officer (CEO), chief financial officer (CFO), head of internal audit and compliance officer, and even the conduct of day-to-day operations and communications and so on. The compliance is dated for obligatory actions, and delays are punishable with civil and criminal liabilities. Serious discomfort is being experienced by the managers of enterprises in the journey of compliance with Corporate Governance norms. A senior industrialist managing a mediumsized commercial empire once asked me (when I was on the chair of ‘high priest’—Securities and Exchange Board of India (SEBI) Chairman), in one of the trade associations’ meeting in

4  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

Kolkata (India), ‘Why do you insist on complying with the entire rigmarole of governance framework including the appointment of one-third as the Independent Directors on the board, when owner Managers and their associates own 90% and only 10% is held by others’. This question apparently smacks of discomfort with the (tyranny of) Corporate Governance compliance that he and his team were probably undergoing. Ask formally any CEO, he would pronounce Corporate Governance compliance as an immensely useful, affirmative activity and adds value to the company, but meet them informally, you will hear whispers such as ‘it’s a tyranny unleashed on the Managers of enterprises by the Regulators and the Government alike’. Furthermore, it is being increasingly felt that a listed company is significantly disadvantaged over an unlisted company in the same line of business because of much larger areas and scope of compliance, including mandatory disclosures. The unlisted competitors can piece together strategic approach and re-engineer their own framework to beat the listed company down. In yet another interaction with a prominent industrialist in Mumbai (India), I was confronted with a question as to why an unlisted company is not required to undertake similar disclosures. This, according to him, exposes the listed companies to more intense competition from the unlisted companies. The managers feel handicapped to talk to the media, stakeholders and even in business forums about their enterprise as freely as they would like to. The disclosure requirements warrant that every price-sensitive information must be disclosed to the SXs first, where all the companies are listed and even the manner, method and sequence of disclosures are prescribed. And what is price-sensitive is always open to interpretation. A similar sentiment of tyranny is felt by the companies in the area of the observance of accounting and financial reporting standards and in maintaining internal controls and certifications. Most CEOs feel that they should be called upon only to deliver the ever higher amount of profits, thereby ensuring greater returns to all the stakeholders. There is no point in wasting time, energy and resources in complying with the disclosures, accounting and financial reporting standards, boardroom configuration and practices and so on, they argue.

Prologue: Tyranny of Corporate Governance  5

There is a serious discomfort amongst entrepreneur managers and also professional managers on the regulatory obligation of inducting rank outsiders (unrelated and unconnected persons) as independent directors in the board of companies managed by them, which has since been compounded in some jurisdiction by compulsion of appointing a woman director. They feel that in most cases, the contribution of non-executive independent directors (NEIDs) is negligible or marginal and their presence and interventions, particularly in the critical committees, are painful. Over a period of time, the regulatory framework relating to the management of an enterprise à la Corporate Governance has been evolving and with every significant governance failure the framework is becoming still more rigorous. All this made me sit up and ask myself, ‘Is Corporate Governance merely a Tyranny or can it serve as an effective tool to enhance enterprise value?’ This book seeks to address this fundamental issue, ‘whether Corporate Governance is a tyranny or triumph’ and the cost of compliance is an investment into value creation or an avoidable expenditure. Although the patience of the readers will be tested as some part of the material may appear boring and repetitive of what is already known and said, hopefully, at the conclusion of the reading, it may be possible to decipher a ray of hope that good Corporate Governance at the very least boosts the value of enterprise, if it does not become the sunshine for sustainable growth of the organization with the continued trust and confidence of all the stakeholders. Let me commence this journey of discovery with a bit of history of the ‘instrumentality’ of Corporate Governance. It all began with Homo sapiens organizing into societies. Societies traversing into civilizations, civilizations giving birth to economics, economics inventing the methods of marshalling resources, resources finding passages for multiplication, passages creating ‘principle–agent’ relationships, ‘principle–agent’ relationships resulting into ‘agency costs’. As a student of Financial Economics, I consider Corporate Governance’s instrumentality as a reflection of the ‘agency costs’. To cut the long history of millenniums short, I would engage your attention beginning with economics and the economic orders.

2 Introduction 2.1. Evolution of Economies

T

he world has been traversing the passage of progress on the vehicle of economic order. Everything has a life cycle—the universe, planet, civilization, company, product and even the economic order and to disregard the realism is to invite oblivion ahead of time. The life of every new economic order, which has been propelling the progress of the planet Earth, is contracting. The phase of hunting and gathering—nomadic economy—led the life on the planet Earth for hundreds and thousands of years. The agricultural economy’s preponderance sustained for about 10,000 years. It gave birth to societies, habitations and civic life. It also gave birth to the formal economics of the barter system—the exchange of surplus for meeting the shortages. It distinguished humans from the beasts. It facilitated the formations of orderly societies. It made the life civil. Even though the invention of wheel and gun power revolutionized the world economy, shifted the balance of power and made crowns the subjects; the evolution and growth of JSCs really aided and abetted the flowering of the industrial economy. The industrial economy propelled further inventions and innovations.

Introduction  7

It enhanced productivity and helped the production of goods beyond the basic needs. It brought about urbanization and promoted agglomerates. The industrial economy was dwarfed by the information economy in a span of just about 200 years. We are now in the age of information-led economy—the information economy, which drives the various facets of the environment: social, political and economic. The role of ‘common stock’ in the flowering of information economy cannot be over emphasized. The overwhelming influence of the information economy can be observed in every walk of life. The information economy enables the designing, manufacturing and marketing of products. It drives efficiency. It makes work life less monotonous and dreary, if not delightful. It has weaved a matrix of inventions and innovations and converted even the impossible into a reality. Currently, the competitive edge determines the rate of growth of an economy and resources—physical, financial and even human—facilitated by communication revolution, and discovers the islands of opportunity globally for architecting optimal leveraging ability levels. The information economy led to the death of distance, globalized the world and converted it into a planetary village. It has contracted time and enabled scale. It helps in exploiting both economies of scale and scope. It has customized manufacturing and personalized service. In fact, it has an overwhelming influence on the creation and management of wealth. Yet the conclusion of the information economy’s life span is within viewing distance and a new economy, christened as ‘bioeconomy’, is shaping up slowly but steadily overshadows the information economy and may eventually consign it to the wreckage of history in just about a quarter of a century like other economies. The developments in the bioeconomy are bringing about awe-inspiring consequences in the life—humans, animals, plants, metals and minerals and so on—and revolutionizing the reproductive quality and longevity. The probability of the use of rock-eating bacteria such as Acidithiobacillus and Leptospirillum to extract metals from low-grade ores, mine waste or industrial effluent or to clean the non-laced groundwater using bacteria is

8  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

on the horizon; the bioleaching recovery methods. It also has the propensity to redefine risks—kind, class and proportion. The developments of mind-like computers—a step ahead of artificial intelligence—neural networks, genetics and extreme miniaturization are the three core technologies which will have remarkable repercussions on the blooming of the bio and emergence of the next ‘cosmic economy’. Actually, predictive theory is the bridge between science and economy and technology cements such bridges. Human genome-like projects and mapping of the entire genetic blue print have already revolutionized diagnosis and is transforming treatment. It may make other planets habitable and expand the human civilization beyond Earth. By the time the world really experiences the predominance of the bioeconomic era, the planet Earth would have accomplished the comprehensive blending of genetics and computers, which will take us (a) deeper into everything and (b) further away in time and space. An era will hopefully dawn where clinical deaths will not be permanent and total, aging will be prevented and renewal will be possible. It has already become feasible to change diseased, eroded and aging parts of the human body including hands, legs, eyes, ears, heart, liver and may be even brain one day. Such developments have really revolutionized risk sensitivity and the product architecture. However, the rays of next age cosmic economy beyond bioeconomy are discernible to an incisive eye though far in the horizon of time. Nevertheless, the information economy will continue to impel growth processes for quite some time to come. Bioeconomy and the next cosmic economy will metamorphose the risk landscape and transform the complexion of the challenges before trade, commerce and industry. It must be clarified here that with the evolution of the new economy, the old economy does not disappear altogether. It is just that the influence of older economy reduces and new economy increases as it flowers the multiplication of wealth creation and management. Let me conclude this section by quoting Dr Robert Jastrow, the founder of the National Aeronautics and Space Administration’s (NASA’s) Goddard Institute, ‘The era of carbon-chemical life is drawing to a close on the Earth and a new

Introduction  9

era of silicon-based life—indestructible, immortal and infinitely expandable—is beginning’.1 The change in economic order warrants transformation in the processes of management and governance of the enterprises recurrently. The formidability of risk management grows greater with every new innovation. Hence, the perception and treading of the emergence of trends, inter alia, in the economic order becomes essential for sustainability, albeit survival. The centrality of JSC and its component, common stock in the marshalling of financial resources for economic growth, is well recognized and continues to grow in significance. Hence, let me move on to the evolution of JSC.

2.2. Evolution of JSCs One of the most significant, albeit less talked about, inventions in economics is the institution of JSCs. It has engineered imagination becoming ideas, ideas transforming into inventions, inventions supplemented by innovations and commercialization, delivery of profits and eventually creation and multiplication of wealth. It has enabled the envisioning and development of modern corporation. It would be hard to imagine how bereft of the vehicle of JSCs, the owners of surplus financial capital would have channelized it to the users and facilitated ever-increasing wealth creation globally. Thomas Piketty (2014), in his seminal work, propounds that the inequality is increasing because returns on capital are far higher than on the labour. I believe that higher returns on capital have been enabled by the institution of JSC. ‘Necessity is the mother of invention’, goes the adage. Something similar happened in the birth and evolution of JSCs. In the fourteenth, fifteenth and sixteenth century, the Europeans were sailing across seas in search of riches and eventual colonization. Exploring geographies necessitated the reconnoitring of methods 1 http://biographies-memoirs.wikidot.com/jastrow-robert (accessed on 30 May 2016).

10  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

of cooperation—pooling of resources and sharing of risks—in the journeys so undertaken, and thus emerged the construct of JSC as a separate legal entity. Structural design facilitated individuals with risk appetite to contribute capital and reap economic gains from the operations of the enterprise in proportion to the ownership share held; something akin to the current format of equity shares. JSC structures had several forms and dimensions depending upon the ownership frames. It could be just for a particular voyage, for a number of voyages or in perpetuity for all the voyages to be undertaken since the incorporation. Such varied ownership frames were facilitated by subscription in separate subordinate organizations or syndicates within the company. The profits were shared at the end of each voyage undertaken by the enterprise. It is being increasingly believed that the origin of JSCs is linked to the medieval guilds. One of the research papers has revealed that 95 shares of Bazacle Mining Company were traded at the value of the profitability of the mill, sometime around the year 1250 at Toulouse in France. There is a record of the transfer of stocks of a Swedish Company, Stora, in 1288.2 The company of Merchant Adventures to New Lands, chartered in 1553 with 250 shareholders, is believed to be the earliest recognized company. Russia’s Muscovy Company, with a monopoly to trade between Moscow and London, was charted in 1555. The construct of the JSC received a fillip during the sixteenth century, following the expansion of foreign trade to newly discovered geographies and grant of incorporation and trade monopolies by royal charter to all those who supported the government in equipping the navy, establishing colonies or discovering new trading routes. Initially, such royal charters were granted to individuals, but it was soon realized that to disperse the risks and collect a large amount of resources, in particular financial, it is desirable to confer royal charter status on the collective endeavours of a large number of individuals in the garb of companies. The British were first to give birth to a modern JSC. The earliest recognized company was the famous English (later British) East India Company (EIC). It was conferred royal charter on 31st 2

http://en.wikipedia.org/wiki/Stock (accessed on 30 May 2016).

Introduction  11

December 1600. The royal charter gave it a 15-year monopoly on all trade in the East India. Eventually, it ruled India having acquired auxiliary government status and military prowess. The Dutch EIC followed suit with its incorporation in 1602. JSCs were also used as an instrument of state foreign policy during the heydays of mercantilism. The monopolist structure, framework and corporate personality were proffered to help these enterprises receiving finance from growing merchant class. Ron Harris, a prominent historian, argues that in the early years of EIC, the birth and growth of JSC was helped by the cooperation between insider entrepreneurs and (outsider) providers of capital. The cooperation entailed participation in the governance of the enterprise too. This ensured information flow to the investors, which eventually helped them to opt out of the investment, if so desired. The process of governance necessitated the managers (directors) of the company building their reputation and goodwill with the investors through performance—delivering results in the shape of dividends, in particular. This helped in repeated transactions and extended the pool of investment capital beyond personal relationships, merchant groups and networks. Furthermore, the high risk and multiplicity of the skills needed in the case of foreign trade and colonization, warranted development, assimilation and employment of skills in the management of the enterprise, and the professionalization of management started shaping as an underpinning of success. By the middle of the seventeenth century, the broad characteristics of a modern company such as raising share capital, limited liability, sharing of profits via dividends, liquidity through transfer of shares, internal structure of the board of directors (BoD) and shareholders’ meetings, appointment of directors by shareholders, keeping the accounts on a permanent basis and their disclosure to shareholders, periodically evolved through its inclusion in the charters and/or by business practices. The revolution of 1688 established the supremacy of the parliament and judiciary and made the crowns subservient to the new political order. The parliament overtook from the crown, the powers of granting the royal charter. Thus, began the journey of conferring the corporate status, particularly to a business organization by a

12  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

political process. The democratic ethos of the parliament encouraged the grant of charters for carrying out public benefit works, government functions and policies. Hence, JSCs came to play a very important public role when the governments were still evolving and had inadequate finance and other resources to manage and govern the society. The private–public partnership (PPP) had taken birth then, albeit in a different incarnation. In fact, there were two kinds of JSCs which came into existence at that point in time: (a) created by a charter or Act of Parliament and (b) unincorporated JSCs, which functioned under the adapted tutelage of partnership law. Such companies drafted their own rules to deal with the large number of shareholders and replicated most of the attributes of an incorporated company, notwithstanding the lack of legal recognition. Such unincorporated companies were conceived as the aggregates of individuals without a separate existence from their shareholders. The differences between an ordinary partnership and unincorporated JSCs were the number of shareholders, scale of operations and more sophisticated financial requirements necessary to accommodate a relatively large number of passive investors who were not involved in the management and were allowed to transfer their shares without the approval of the managing shareholders; conceptually, a kind of private company. The boom in the formation of JSCs—incorporated and unincorporated—came about post-1688 revolution. It happened in a wide range of industries such as treasure salvaging, mining, fire insurance, water suppliers, banks and arms manufacturing, textiles, soaps, sugar, paper, glass and so on. This boom was inextricably interwoven with the growth and development of stock markets, which facilitated the trading (liquidity) of shares of JSCs and helped the growth of each other as the instrumentalities of intermediation and economic growth. The institutional structures of the modern stock market, which included professional brokers, payment of their fees, availability of a variety of scrips for trading and price information, eventually evolved through commercial practice with a very little legal facilitation. In fact, the first publication of stock market prices took place in 1692.

Introduction  13

The growth of stock market, which provided the liquidity, was enabled by the growing number of JSCs. The EIC and other charter companies were very successful in raising large amounts of capital from a broad base of investors, right from the beginning of the seventeenth century, when the powers of crown were still intact. The British Parliament, so also other European legislatures, perceived share trading as speculation and, hence, undesirable. This led to the enactment of several laws that attempted to regulate brokers and share traders. These enactments were a kind of precursor to the Bubble Act. In fact, the hostility of the parliamentarians towards the JSCs, stock market and share trading is believed to have emanated from the landowning class who, during the eighteenth and early decade of nineteenth century, overwhelmed both the parliament and judiciary. The boom in the formation of JSC of the last decade of the seventeenth century was followed by a significant decline until the end of the first decade of the eighteenth century. In UK, the boom returned in the end of 1719, when the share prices of the three large companies went up very significantly. This rise spilled to smaller companies, which were described as ‘bubbles’. Most of the bubble companies were unincorporated JSCs. These companies could not be granted incorporation and/or charter mostly because of the inadequacy of the resources of parliament and crown law officers. The persistently uncomfortable situation led to the enactment of the Bubble Act in 1720. Its broad aim can be seen from the part of its full title: ‘An Act to Restrain the Extravagant and Unwarrantable Practice of Raising Money by Voluntary Subscriptions for Carrying on Projects Dangerous to the Trade and Subjects of this Kingdom’. The Bubble Act propelled the promoters of the JSCs to take a cautious approach for the fear of contravening its prohibition. The contraventions were treated as criminal offences. This led to seeking legal advice, which possibly helped in the evolution of the English Company Law and Practice. Apparently, the enforcement of the act was weak as there was only one isolated instance of criminal prosecution during the entire eighteenth century.

14  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

However, the Bubble Act, albeit vicariously, played spoilsport and led to the decline in the use of vehicles of JSCs and SXs as resources’ raising routes in the decades following its introduction. In fact, economic historians assign significant weightage to the Bubble Act for the crisis of 1720. Later periodic booms and busts reinforced the propensity of the underpinning of the Bubble Act and led to various Acts that prohibited certain market practices including dealing in options and futures and ‘the infamous stockjobbing’, as described in the Bubble Act. The later half of eighteenth century saw an increase in the number of canal companies and broadening of shareholder base, which eventually led to the legitimization of share investment. The shareholders’ base of canal companies was very large; in some cases, it was in thousands. The opposition to such companies or the so-called hostility was much lower because these served public purpose and also because most shareholders were local landlords and merchants who benefited from the improved transport infrastructure. The merchants and landlords eventually became long-term shareholders. The Universal Suez Ship Canal Company (Compagnie Universelle du Canal Maritime de Suez) was formed in 1858 by Vicomte Ferdinand Marie de Lesseps to construct the canal. It had the right to run the canal for 99 years. When it ran into financial troubles, part of the holding (44 per cent) changed hands to Pasha Said and from him to the British Government. Under the 1888 Convention of Constantinople, the canal was opened to the ships of all nations in war and peace. The marvel of engineering was facilitated by the institution of JSC, which substantially contracted the cost and time of trade between East and West. Similarly, another feat—The Panama Canal, with its ups and downs on the way, was completed in 1914 in the ownership of JSC. Initially, the use of JSCs’ structure in manufacturing enterprises was rare. The predominance of partnership and family firms in that segment continued until the last quarter of the nineteenth century. In fact, the participation of corporations and/or unincorporated JSCs was determined by the strength of the vested interest in the related industries and their preponderance in the parliament to the erect barriers of entry, which could

Introduction  15

block incorporation applications submitted by new entrepreneurs likely to be potential competitors. The approach eventually led to adhocism in the incorporation of companies by the parliament. Until the second half of the eighteenth century, the unincorporated companies were struggling to build legality around the structure when the ingenuity of entrepreneurs and the lawyers came up with the idea of creating a trust under which the firm’s property was placed in the name of the trustees. The trustees were usually chosen from the shareholders and were authorized under a deed of settlement which contained the constitution of the company to conduct the management of the enterprise. A person became a member by signing the deed. The trust deed usually provided free transferability of shares and fundamental need of the founders of the company and its investors. This set in motion the concept of fiduciary responsibility of the managers of the enterprise, which includes the BoD. Two important innovations in the structure of the JSCs, which really helped its functionality and sustainability, were (a) use of common seal and (b) perpetual succession. Common seal provided a method by which the act of the entity—JSC—could be identified. The use of common seal, which is used even today, became popular in the thirteenth and fourteenth centuries and was first used for guilds. The perpetual succession commenced with the guild established by Orcy at Abbostbury, which was granted property for guildship, ‘to posses now and henceforth’. Later, other guilds were established on ‘even more to lasten’ and ‘to abyde, endure and be maynteyned withoute ende’. This helped JSC to live forever and successive owners could own its assets as liability also.

2.2.1. Evolution of JSCs in India India had its own institutional structure of running businesses, which was mostly in the shape of either proprietary, joint family or a community ownership. The advent of EIC into the shores of India ushered in new thinking in the management of the affairs, both politics and economics. EIC began its journey with seeking favour of access to trade with India, eventually becoming the

16  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

conqueror of territories with the support of the mighty (then) British crown. The economic success of EIC enormously ballooned its prowess and transformed it into a political master, which was however taken over by the British crown itself. It is a matter of pity that over a period of time, the company went into dumps and has since been bought over by an Indian for just a few million pounds, more as a treasured relic of history. The subjugation of India by the British crown, inter alia, introduced many elements of managing businesses, economy, politics and even social order. Among them was the introduction of the institution of the JSC. Breen & Co., now known as Jessop (as from 1820), was incorporated in 1788. Later on, many companies were launched, which included the most circulated English newspaper, Times of India. Notable amongst the companies that have survived more than a century of trials and tribulations are the following: 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13.

CSEL Britannia Biscuits OTC Kirloskar TVS Calcutta Electric Supply Corporations (CESC) Dabur Tata Steel Bennett, Coleman & Co Godrej & Boyce Indian Hotels Jessop & Company Walchandnagar Industries Ltd

Britishers also introduced managing agency system, wherein one organization would have a right to manage a number of companies for a fee, mostly a share of profit. One among the prominent managing agency, which still exists in some form, is Andrew Yule. The managing agency system was abolished in 1969. The Indian Parliament also legislated the Companies Act on the lines of British Companies Act for the incorporation, functioning and

Introduction  17

winding up of the companies. The last act of 1956 has since been repealed by the new Companies Act of 2013, bringing about wide ranging changes. The JSC came into being and developed as a capitalist institution which benefited investors and society at large. This organizational design was propelled by the necessity of meeting large financial requirements. The development of a healthy relationship between active and inactive investors was facilitated by the establishment of an institutional framework that engineered investor confidence. This framework consists of rules and norms, which regulate the actions of the active (in management) shareholders in the company and prevents the alienation of the interests of inactive shareholders and/or former’s dishonest behaviour and conduct. These rules and regulations eventually determine how the management of the company would be run, that is, building governance practices, the efficacy of which is so vital for the continued confidence of the shareholders, in particular, inactive. The entire development coupled with the emergence of a number of related and complementary economic and political institutions enhanced the wealth of Western Europe and North America, and laid firm foundations for the rise and growth of capitalism around the world. This also laid the foundations of Corporate Governance practices. The growth, development and capacity of JSC to contribute an ever-increasing level were facilitated by the ease of entry and exit, which was organized by the securities market. Therefore, it would be helpful to explore a bit of development and pervading the impact of securities markets and the institutions of SXs. The securities market also created the enforcing structure for the formalized instrumentality of Corporate Governance.

2.3. Evolution of Securities Markets The genesis of the birth of the market lies in the perpetuity of gap between demand and supply. In fact, the formal economy commenced as a barter system; wherein, a person with surplus exchanged goods/services with another person in deficit for what

18  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

he had in surplus. Finding persons with surplus and deficit of the same goods/services was a challenge. Hence, the concept of a market, a place where people with surplus and deficit could gather to exchange, evolved. As the societies and the economies evolved, the concept of currency—a common medium—was created, which, over the generations, has taken various forms such as gold, silver, clay and even leather to facilitate the exchange of surplus goods and services for a price in the units of currency. Finally, the currency has moved substantially from its last avatar of paper to a digital number. Exploring of geographies in search of riches warranted pooling of resources by the owners of surplus savings with an urge to multiply. The vehicle was JSC as the owner of the enterprise. This gave birth to securities as a unit of ownership of the enterprise in exchange for the resources pooled in. Thus, the institution of securities market sprang up to facilitate the suppliers and users of the resources undertaking the transaction and entering into a relationship. This also became the place where the security could be exchanged with someone else (other than the managers of an enterprise), in effect providing liquidity without the need for an enterprise to redeem from the retained resources and/or the winding up of an enterprise. The financial sector (banks, insurance, pensions and the securities markets) plays a crucial role in the economic growth. It enables channelization of savings into investments and, thus, decouples the two activities. The savers and investors facilitated by the economy’s ability to invest and save are not constrained by their individual abilities. The intermediation of savings into investment makes financial markets the engine of economic growth. The securities market scores over banks and other institutions in allocational efficiency as it tends to funnel savings to such investments, which have the potential to yield greater returns, eventually leading to an increased productivity on investments and higher wealth creation. The securities market thus has the propensity to promote greater economic growth by converting the given stock of investible resources into larger flow of goods and services. The securities market opens up wealth creation hot spots for competing enterprises. It also provides transferability and

Introduction  19

liquidity; the basic foundation for the growth and development of the JSC. The liquidity to investors, so provided, does not inconvenience the enterprises issuing the securities. The liquidity and the yield proffered by the market encourage people to make additional savings out of their current income, which would otherwise be consumed, in the absence thereof. A number of studies, including those of the World Bank and IMF and other scholars, have established a robust two-way relationship between the development of the securities market and economic growth. An old study by Ross Levine and Sara Zervos (1996) found that the stock market development is highly significant, statistically, in forecasting the future growth of per capita GDP. Their regressions forecast (then) that if Mexico or Brazil were to modernize their stock markets to the level of Malaysia, their per capita GDP could additionally grow at the rate of 1.6 per cent per year. As the market gets disciplined, more developed and efficient, it avoids the allocation of scarce savings to low-yielding enterprises and forces the enterprises to focus on wealth creation, which is being continuously evaluated through share prices in the market. The companies also face the threat of takeover for poor or lower performance. The first securities market came into being in Belgium in 1531. Here, individuals with ideas, which required resources in excess of their own capacities, endeavoured to work in a group of people to pool their savings in support of their idea. Such informal markets sprang up across Europe shortly thereafter. The securities market came to assume greater prominence and serious significance at the beginning of the Industrial Revolution during the seventeenth century. Businesses needed a large amount of capital to finance bigger ventures, which very few promoters with the idea were capable of marshalling from their own resources. The first set of exchange helped not only capital creation but also liquidity with the availability of both primary and secondary market. London SX, the origin of which can be traced back to more than 300 years ago, started in a coffee house of the seventeenth century and became a very significant element in developing businesses.

20  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

The origin of New York SX goes back to 1792 when Buttonwood Agreement was signed by 24 New York City brokers and merchants. The process was simple. Every day at noon, securities were auctioned to the highest bidder. The seller paid a commission to the exchange on each of the stock and/or bond sold. The concept of securities market became a hit with the investors, as it helped them to get their investments pooled in a company. New York SX has since become one of the foremost securities market of the world. The development of capital markets in India had its inspiration from the West, in particular England where the capital markets had already started functioning. Bombay (now Mumbai) being made the trading centre, in particular for cotton trade, it was natural for the capital market activity to begin in Bombay. A bunch of individuals got together to start the trading activity. These individuals organized themselves into an informal association named Native Shares and Stock Brokers Association, Bombay in 1875. The trading began under the banyan tree in the Horniman Circle opposite Town Hall. The first script to be traded was obviously East Indian Company, which was a star amongst the companies in the British dominant geography. Slowly the trading activity flourished, which eventually developed into a boom in the share prices. It was the first boom in the history of Indian Capital Markets. This boom lasted nearly for half a decade and eventually bubble burst on 1 July 1865, which brought a sudden slump in the trading of share prices and took several years to restore the market confidence. This Native Shares and Stock Brokers Association eventually transformed into the current Bombay Stock Exchange. Since the British Government was not as much interested in the economic growth, the Indian capital market was neither developed nor organized well. The companies were dependent on the London capital market rather than the Indian capital market. Following the political independence, the builders of modern India provided focus to the development of Indian capital market. The country chose merit-based regime, which was implemented

Introduction  21

through the office of the Controller of Capital Issues (CCI). The CCI determined the timing, composition, pricing, allotment and floatation costs and so on of new issues. Such measure was in tune with the philosophy of the command economy, which was pursued in the initial decades of India’s independence. The regime of the CCI, coupled with the non-listing of public sector undertakings (the required capital was provided by the government) which were the drivers of economic growth then, became a serious handicap for the growth and development of capital markets in India. The rampant speculation in a few scrips in the 1950s led to the Indian capital market being described as ‘satta bazaar (speculation market)’. The satta (speculation), being the dominant sentiment about the Indian capital market, encouraged the Government of India to enact the Securities Contracts (Regulation) Act in 1956. The major initiative stemming out of the Act led to the development of financial institutions and the state financial corporations. The nationalization of life insurance companies and their aggregation into the Life Insurance Corporation of India (LIC) in 1956 and the setting up of the Unit Trust of India (UTI) in 1964 provided a fillip to the Indian capital market via institutional participation. However, the promulgation of the Dividend Restrictions Ordinance in 1974 limiting the payment of dividend by companies to 12 per cent of the face value or one-third of the profits of the companies, whichever was lower, brought yet another setback. The Government of the India took several initiatives such as compulsory listing of the Indian subsidiaries of multinational companies (MNCs), incentives for the listing of companies in the SX and so on, which provided a fillip to the Indian capital market in the 1980s. By that time, the country had seen the upsurge of 23 SXs, almost one in each of the major states, and the over-the-counter (OTC) market. However, transformation in the SXs from outcry to screen-based trading propelled by scams and new regulatory regime under the aegis of SEBI saw the eclipse of regional SXs, inter alia, the factors such as absence of potent central counter party, volume and liquidity bulldozed off their exuberance. Currently, the Indian stock market consisting of three functioning exchanges,

22  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

BSE, National Stock Exchange (NSE) and the newly established Multi Commodity Exchange (MCX) SX, is dominated by NSE. The Indian capital market has been afflicted periodically by scams. The infamous among them have been so-called Harshad Mehta and Ketan Parekh scam, which warranted the Government of India to provide stricter regulatory regime. Thus, came into being the SEBI in 1991, as an independent autonomous regulatory body to regulate the market, protect the interest of investors and develop the market. Today, the Indian stock markets are not only efficient and modern but globally competitive. The volumes have grown very substantially along with the number of listed companies, which makes the Indian capital market, on a combined basis, the third largest in the world.

2.4. Evolution of Capital Market Regulatory Framework The securities market regulation, in some form or the other, has been around as long as securities markets have existed. It is believed that King Edward decreed, sometime in the thirteenth century, that brokers in London should be licenced. Massachusetts, a state in the USA, required registration of railroad securities in as early as 1852. In fact, other states in USA passed laws relating to securities in the later part of 1800 and early 1900. The first comprehensive securities law requiring registration of both the securities and the intermediaries was enacted in Kansas in 1911, as a response to selling of worthless interests in fly-bynight companies and gold mines to unwitting investors. Thus, the Kansas Law was the first of the ‘blue-sky laws’ and is known even today throughout the industry as such. The Kansas Act provided directions on the sale of securities by any company, promise of a fair return and general philosophy of fairness, justness and equity of the transactions. The Kansas Securities Law was aped by 23 states. The new state laws were challenged on the constitutional grounds. However, the Supreme Court upheld the initial securities laws enacted by the state.

Introduction  23

The great stock market crash of 1929 and the ensuing depression propelled the enactment of US federal securities legislation christened as the ‘Securities Act of 1933’, which, inter alia, provided the setting up of the Securities and Exchange Commission (SEC). Since then, a number of laws have been passed by the USA. Over the next seven years the US Congress passed several more Acts pertaining to securities regulation.3 • Securities Act of 1933: The first federal law to regulate the issuance of securities. The purpose was to prevent fraudulent offerings and to ensure that the public had adequate information regarding the issuer and nature of a security. • Securities and Exchange Act of 1934: The primary thrust of the Act was to regulate the post-distribution trading of securities, including providing continuing information about issuers whose securities are traded in public market places, remedies for fraudulent actions in securities trading and manipulation of the securities markets, regulating the use of ‘insider information’ when purchasing securities and regulation of the securities markets and the persons using such markets. • Public Utility Holding Act of 1935: Designed to correct abuses by holding companies with little or no assets and to prescribe accounting and record-keeping requirements. • Maloney Act 1938: Amended 1934 Act to provide for the formation of the association of brokers and dealers that would create and enforce disciplinary rules and promote just and equitable principles of trade. • Trust Indenture Act of 1939: Provided protection for debt securities holders by requiring an indenture (trust agreement), administered by an independent financial institution trustee. • Investment Company Act of 1940: Established requirements and regulated specific type of businesses, principally http://www.sechistorical.org/museum/timeline/1930.php (accessed 30 May 2016). 3

24  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

so-called ‘mutual funds’, which invest in the securities of other companies. • Investment Advisors Act of 1940: Required registration (licencing) for all persons engaged for compensation in the business of rendering investment advice or issuing analyses or reports concerning securities. Similar developments of enacting legislation ensued in England and various other European countries. Over a period of time, a trail of market misconduct recurring periodically around the world led to innocent investors losing their lifetime savings. The discomfort and disquiet among the investors propelled the respective governments in each of the jurisdictions to take notice, legislate and issue directions for an orderly functioning of the markets. The approach gave birth to regulations and regulators in all the countries. Although the framework is in infancy in some markets, it has become excessive in others. There are coordinated attempts to bring sobriety to the management of the capital markets globally. Actually, the need and necessity of regulation were consequenced by the greed and hubris of the issuers of securities and intermediaries alike. The sharpest focus came on the efficacy of the market place itself. Although the operations in the market and the activities of the intermediaries have been outlined separately by each of the regulatory framework, the issuers are being bound by the cannons of good Corporate Governance; the subject that I will be discussing in the subsequent chapters. The enforcement structure for a good Corporate Governance, architected by the regulators, resides in the mechanism of SXs—the utility vehicles for the growth and prosperity of JSCs. The threat to the very purpose of the vehicle—entry and exit of financial engagement by a common surplus owner—propelled the design and enforcement of the structure.

3 Stakeholders of Joint Stock Companies 3.1. Introduction

A

JSC comes into being with the pooling of resources— physical, financial and human—by the respective owners. The promoters/managers of a JSC approach the owners of the resources to handover/permit, leveraging with the assurance that they would on agreed terms return and/or share the profits. The owners give their consent to the offer of the JSC with the fond hope that the assurances held out will be fully met. Thus, the poolers of the resources develop a stake in the functioning, growth and sustenance, albeit in the existence of the JSC. Owners of these resources can be segmented broadly into five categories: (a) equity holders/shareholders (b) workforce/human resource (HR) (c) suppliers of debt capital, goods and services (d) customers (e) society.

3.1.1. Shareholders These are the set of investors who provide the risk capital. The first set of such persons/organizations are called the promoters

26  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

who have a dream, an idea, a vision and the courage of conviction to transform their dream into a value creating enterprise. Such people are also known as entrepreneurs who eventually become the promoters of the enterprise—JSC. They risk their time, money and whatever other resources they have in the hope of building a successful enterprise. While traversing the journey of incubation, development and growth of products and eventually the enterprise, they invite and take on the board people who provide the financial capital. However, the capital can be of two kinds: (a) preference capital and (b) equity capital. Preference capital, as the name suggests, have a preference in payment of return by way of dividends and also in the sharing of the residual wealth in case of winding up. Preference capital holders are generally entitled to a fixed rate of return which can be both cumulative and non-cumulative depending upon the terms of issue. Cumulative preference share would mean that in case, in any year, there is an insufficiency of profits, the dividend payable to them accumulates and becomes payable as and when JSC makes profit and is paid before the payment of dividend to equity shareholders. In case of non-cumulative, the amount payable as dividend lapses in case of insufficiency of profits in the company in any year. The equity shareholders are the providers of real risk capital and share the profits only after all other stakeholders have been paid off. Equity shareholders are compensated only in case the enterprise succeeds, and are therefore the residual stakeholders, about which I will talk later in the book. In case the enterprise does not succeed and has to be liquidated and wound up, they are the ones who receive the residual, if any, and in most cases lose the most. The equity shares can also be of two types: (a) voting and (b) non-voting. Voting shareholders have a right to vote on all the propositions in the annual general meeting (AGM), extraordinary general meeting (EGM) or through circulation, whereas non-voting shareholders do not have such a right. These can be preferential or limited voting powers as well. It could be summarized that these become the ultimate stakeholders.

Stakeholders of Joint Stock Companies  27

3.1.2. Workforce or HR These are the set of individuals who offer their labour and skills and become part of the enterprise. Even though in most circles, it is believed that the shareholders are the most important stakeholders of the enterprise, I believe HR is equally important. In fact, it is fundamental to the utilization and leveraging of physical and financial resources, for the creation of wealth. It is the human ingenuity and competence which helps in optimizing wealth creation. ‘Dignity of individuals and value of their contribution is very important’. Hence, workforce becomes the second most important stakeholder; if not equal to shareholders. HR is both contractual and residual stakeholders as they have an interest in receiving not only their contractual compensation, but residual too, having thrown their lot in the sustainability of the enterprise. The importance of HR in the success is pronounced in most organizations by offering employee stock options plan (ESOP); ownership status as other shareholders.

3.1.3. Suppliers of Debt Capital, Goods and Services Along the journey of its development and growth, an enterprise needs additional doses of physical and financial resources, which are most often externally marshalled. Although the owners of these resources have a contractual relationship in the sharing of wealth, they become important stakeholders in the management of the enterprise as their compensation has a bearing on the quality of management, because various factors are considered while agreeing to make resources available. For example, the suppliers of debt capital agree for the rate of return in the hope of safety of their capital and payment of interest thereon, credit rating of the enterprise, that is, AAA, AA+, AA, AA– or A+ and so on. In case if the enterprise is not managed well and the rating goes down, then the enterprise becomes susceptible to higher risks with lower possibilities of returns of the capital and interest thereon, and risk premium in the shape of interest as the difference in the rate

28  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

of return goes up. Interest charged on the debt also includes the ‘risk premium’, assessed/determined by the possibility of default in the payment of various debt obligations, which is evaluated most importantly by credit rating agencies. Higher interest rate in the lower rated papers validates the surmise. Similar is the case with the suppliers of other goods and services for the extension of credit facilities. Thus, the suppliers of debt capital, goods and services are also an important stakeholder.

3.1.4. Customers The enterprise comes into being to create and market products which include services, and eventually, to make profit from pricing arbitrage. The product is purchased/consumed by someone at a price. Such persons/organizations are called customers. Customers become important stakeholders not only for the reasons of the quality and reliability of product/service but also because the post-sale service and/or continuous satisfaction with the product purchased depends upon the quality of management. Even otherwise, the confidence of the customers has a direct and proportionate bearing on the success and sustainability of the enterprise. Thus, the management has to clearly accept customers as yet another stakeholder of the enterprise while undertaking the process of governance. The ethics is of prime importance in the relationship with the customers. Consumers, particularly of services such as banking, insurance, pensions and health and so on, ascertain the quality of the Corporate Governance of companies while buying or continuing to buy their products.

3.1.5. Society The society allocates its scarce resources and provides an environment of harmony and peace along with other enablers such as the right to property, for an enterprise to come into being and continue to survive and thrive. The society, therefore, becomes a very important stakeholder of the enterprise. In case the wealth

Stakeholders of Joint Stock Companies  29

creation, wealth management and wealth sharing are not at the optimum level, the society can engineer—directly or indirectly— the redeployment of resources by taking over, changing the management and/or, in extreme cases, ordering the winding up of the enterprise. It is the society that determines whether the product produced by the enterprise can be sold, and if yes, how and in what form and also the manner of promotion of the products; tobacco and liquor products are cases in example. The society is both the contractual and residual stakeholder. Under the contractual relationship, it is entitled to certain payment, which can take the shape of taxes, rent, rates and so on. As a residual stakeholder, the sharing of the wealth is organized through what is now called ‘corporate social responsibility’ (CSR) in the Corporate Governance terminology. In the Indian Companies Act, 2013, an obligatory compliance clause of spending at least 2 per cent of the profits before tax on CSR has been incorporated. Figure 3.1 depicts the stakeholders in a pictorial form. These stakeholders eventually become the jury to pronounce the

Figure 3.1 3  Stakeholders Chain CONTRACTUAL Value Creation for Buyer

Value Creation for Supplier

CUSTOMERS

BOARD

ENTITLEMENT

Safety of Interest & Principal Enhancement of Portfolio Quality

SUPPLIERS

LENDERS

Taxes, Employment, Societal Commitments SOCIETY

EMPLOYEES

MANAGEMENT

RESIDUAL ENTITLEMENT

MAJORITY SHAREHOLDERS

MINORITY SHAREHOLDERS Value

Salaries Benefits Stability

30  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

judgment on the quality of the management of the enterprise; à la Corporate Governance.

3.2. Organizational Structure The entrepreneur conceives the idea of a business to create wealth. The creation of wealth needs a structure. The structures are broadly of two kinds: (a) 100 per cent owned structure (b) partly owned structure. The part ownership can vary from 1 to 99.9 per cent, legally. The structure of an enterprise to undertake business, either of manufacturing, distribution and/ or service, can take any of the following formats: (a) Proprietary ownership (b) Partnership (c) Cooperative society (d) Association of persons (AOP)/body of individuals (BOI) and (e) Company— private or public. The character of these structures is depicted briefly and graphically in Figure 3.2.

3.2.1. Proprietary Ownership A proprietary enterprise is fully owned by the entrepreneur himself and, practically, there is no legal distinction between the owner and the entity. He brings the entire capital required to start and run the enterprise. Any time further, if capital is required, he pumps the same in. The proprietor can, however, borrow from individuals, bank and/or other lending institutions with or without providing a security to protect the interest of the lender. However, his liability in this business is unlimited. In case the business fails and the assets of the enterprise are not adequate to meet the obligations, other assets of the proprietor, which may not be part of the business, can be liquidated to defray the liabilities. The merit of the structure lies in the 100 per cent ownership of the business, profits, wealth and value. It has high degree of flexibility, quick decision-making and zero risk of fraud by partner(s). The demerits are: (a) limited resources to run and expand the business, (b) low borrowing capacity and (c) unlimited liabilities

PARTNERSHIP

1. Limited Liability Partnership (LLP) 2. Unlimited

PROPRIETORY

Sole Ownership

Figure 3.2   Organizational Structure

7. 8. 9. 10.

1. 2. 3. 4. 5. 6.

Housing Building Retailers Utility Worker Business and employment Social Consumers Agricultural Cooperative banking

COOPERATIVE SOCIETY

TYPES OF ENTITIES

1. Municipal Corporation 2. Public works department 3. Social and Sports Clubs

AOP/BOI

Public

Incorporated, Unincorporated, Chartered, Statutory, Registered, One Person Company, Small Company, Public Sector Undertaking, State owned Enterprises, Government and Foreign.

LARGER DOMAIN

1. Limited by shares 2. Limited by guarantee 3. Unlimited Companies

Private

COMPANY

32  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

in case of the failure of the business. Obviously, demerits overwhelm merits and, therefore, any entrepreneur who wishes to build large-sized business either does not adopt proprietary structure or begins with proprietary structure and converts it into some other structure to grow, sustain and/or diversify.

3.2.2. Partnership As per Section 4 of the Indian Partnership Act, 1932, ‘Partnership is the relation between persons who have agreed to share the profits of a business carried on by all or any of them acting for all’. The definition in other countries, wherever such structures exist, is nearly the same, except in the case of limited liability partnership (LLP), where the liability of partners is unlimited. Different shades of partnerships can be created, some of which are briefly enumerated as follows: 1. Partnership at will 2. Unlimited liability partnership 3. Limited liability partnership LLP, where liability is limited by the capital subscribed, becomes a useful structure to build small businesses including consulting, accounting and other service-providing businesses. It is being extensively used in the USA. India has made the beginning for the SMEs and the Limited Liability Partnership Act, 2008 provides a legal status to this structure. This structure also suffers nearly from all handicaps as is the case with proprietary structure.

3.2.3. Cooperative Society This structure in effect is an autonomous AOP united voluntarily to meet their common economic, social and cultural needs and aspirations through a jointly owned and democratically controlled enterprise. In this structure as well, there are a number of limitations, but

Stakeholders of Joint Stock Companies  33

what really impedes is the availability of cohesiveness, capital and adequacy of the skills in the management of the enterprise.

3.2.4. Association of Persons An association of persons means two or more persons who join for a common purpose with a view to earn an income. The term ‘person’ includes any company or association or a BOI, whether incorporated or not. The association need not be on the basis of a contract. Therefore, if two or more persons join hands to carry on a business but do not constitute a partnership, they may be known as an AOP. But, an AOP does not mean any and every combination of persons. It is only when they associate themselves in an income-producing activity that it becomes an AOP. However, BOI means a conglomeration of individuals who carry on activities with the objective of earning some income. It would consist only of individuals. Entities such as companies or firms cannot be members of a BOI. Members have to be natural persons. This form of structure is generally used for setting up and running a social club, which could be cultural, sports and so on. In this structure, the membership is by the specifications and no capital is required to be contributed. However, members are required to pay some kind of an entrance fee supported by periodical subscription. Here, the members have no personal liability and in case of winding of the association the assets of the enterprise are used to meet the outstanding obligations. This kind of structure is not used for any other purpose because of the obvious limitations it has.

3.2.5. Company Company is the most popular structure for building a commercial entity. These are the AOP who contribute money to a common stock known as the capital of the company and are incorporated.

34  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

These entities have existence independent of its members; in effect an artificial person with a common seal and perpetual succession. There are various kinds of companies: 1. Incorporated companies. 2. Unincorporated companies. 3. Chartered companies: Under the charter issued by the sovereign or crown. 4. Statutory companies: A company may be incorporated by the means of a special Act of the parliament or any state legislature. 5. Companies limited by guarantee: It means a company having the liability of its members limited by the memorandum to such an amount as the members may respectively undertake to contribute to the assets of the company in the event of its being wound up and these could be with or without share capital. 6. Unlimited liability companies: Where the liability of the members is unlimited. 7. Company limited by equity capital not for profit: Such companies are formed not for making profit but for the purposes of promoting commerce, art, science, religion charity, poverty alleviation or any other useful social life. The company is not required to comply with the requirements of minimum paid-up share capital. A partnership firm can be converted into such a company. 8. Company limited by capital and for profit: This is the shape of the company which is the most commonly used structure for building businesses. The share capital of such companies is widely spread and the liability of shareholders is limited to the capital contributed and/or the purchase price of shares. These shares are called common stock. Such companies could be listed or unlisted. ‘Listed company’ means a company which has any of its securities listed on any recognized SX. The company could be a holding or a subsidiary company. ‘Holding company’, in relation to one or more other companies, means a company of which such companies

Stakeholders of Joint Stock Companies  35

are subsidiary companies. ‘Subsidiary company’ or ‘subsidiary’, in relation to any other company (that is to say the holding company), means a company in which the holding company 1. controls the composition of the BoD, or 2. exercises or controls more than one-half of the total share capital either on its own or together with one or more of its subsidiary companies; provided that such class or classes of holding companies as may be prescribed shall not have layers of subsidiaries beyond such numbers as may be prescribed. The following are the explanations for the purposes of this clause: (a) a company shall be deemed to be a subsidiary company of the holding company even if the control referred to in sub-clause (i) or sub-clause (ii) is of another subsidiary company of the holding company. (b) the composition of a company’s BoD shall be deemed to be controlled by another company if that other company, by exercise of some power exercisable by it at its discretion, can appoint or remove all or a majority of the directors. (c) the expression ‘company’ includes anybody corporate. (d) ‘layer’ in relation to a holding company means its subsidiary or subsidiaries. Similarly, there could be a private company which as per the Indian Companies Act, 2013 Section 2(68), means a company having a minimum paid-up share capital of one lakh rupees or such higher paid-up share capital as may be prescribed, and which by its articles 1. restrict the right to transfer its shares; 2. except in the case of one person company (OPC), limits the number of its members to two hundred; provided that where two or more persons hold one or more shares in a company jointly, they shall, for the purposes of this clause, be treated as a single member.

36  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

Section 2(62) of the Indian Companies Act, 2013 recognizes OPC, which means a company that has only one person as a member. Only a natural person can be eligible to incorporate an OPC.

3.3. Organizational Structure and Corporate Governance Before I deal with the Corporate Governance of enterprises it is important to understand that notwithstanding the kind of organization’s structure, the legality and the ethics have to remain the basic tenet of the governance of the enterprise at all times. Lack of ethics will not only jeopardize the economic interest of the entity and consequently its owners but may even threaten the very existence thereof. Similarly, conformance with the applicable laws of business conduct has to be scrupulously adhered to in all the cases. In the case of an enterprise organized as the proprietary entity, no call beyond what is mentioned in the earlier paragraph is ordained for the governance of the entity. The owner/proprietor can conduct the business of the entity as he likes. In case of partnership, in particular where there are sleeping partners, nominal partners or partners for profit only, it is important that certain standards of governance are obtained to ensure that the interest of such partners are not alienated at the altar of the active partners. In the case of cooperative societies, certain minimum standards of governance are expected to be observed. The governance standards broadly enshrine equity and fair play. They are specified also because such entities become entitled to certain benefits and that a number of stakeholders are common men/women and are often fairly large in a number. In the Indian context, these governance obligations have been enshrined in the various sections of The Cooperative Societies Act. In fact, some of the sections of the companies’ legislation also envisage certain do’s and don’ts in the matter of the governance of cooperative societies.

Stakeholders of Joint Stock Companies  37

However, in addition, cooperative societies have to observe governance guidelines issued by the sector regulator such as Central Bank, in case the entity is engaged in the business of banking services. Similar is the situation in the case of AOP/BOI where equity and fair play must remain as guiding principles at all times in the matter of the governance of entities. In the case of private companies, the Corporate Governance standards required to be observed are minimal. Of course, the basic principles as mentioned earlier of ethics, fair play and equity must remain the guiding lights. In the case of unlisted public companies, most regulatory jurisdictions enshrine certain basic standards of governance and these have to be observed scrupulously. However, in the case of listed companies, since a common man of the public gets involved, very rigorous standards of the Corporate Governance have been laid down. These standards, as mentioned elsewhere in this book, are being talked about as the tyranny of the Corporate Governance.

3.4. Corporate Governance at Financial Distress It is being increasingly believed that in majority of the cases, firms land up in financial distress mainly on account of deficiency in Corporate Governance. Be that as it may, I believe the significance of Corporate Governance grows when financial distress strikes a firm. Generally, it is observed that the shareholders—managers and, in some cases, even professionals—and managers in control of firms try to short-change HR, suppliers of goods and services including financial institutions, customers and even the statutory authorities, in times of financial distress, in particular. This approach, to my mind, will take the enterprise to a path of winding up, coupled with the destruction of reputation of the managers. Hence, I recommend the use of all the four pillars of Corporate Governance namely, reporting and accounting standards, RPT, disclosures and the boardroom practices to converge

38  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

to reassure all the stakeholders and also anyone else who is concerned that the unfortunate situation of distress is being faced with integrity and efficacy. The attempt should be convincing all the stakeholders, including minority shareholders, that RPT and/or reporting and accounting standards were not used to siphon off the funds and/ or other resources. The efficacy of the financials should be potent to convince that these really reflect the true and fair picture of the results declared and that there has been no attempt earlier or now to misstate the figures and/or recognition of income and expenses. The quality of disclosures should be reassuring for the stakeholders. They must feel convinced that they were always, and now too are, being kept adequately informed of all that is relevant for them to know. The boardroom discussions and decisions must be focused on protecting and promoting the interests of all the stakeholders. Also, the stakeholders must have a comfort that in the boardroom every attempt is being made to salvage the situation. Given the opportunity, the firm will do everything at its command to ensure that the firm meets the challenge with dexterity. If there is a decision to pursue a haircut by the lenders and/or other stakeholders namely, HR (in their compensation/exits and so on.), the appropriate economic hit must also be to the managers (controller of firm’s operations) and shareholders as well. The stakeholders must get a sense of the earnestness of approach of the managers (in control) in meeting the challenge with the least possible economic consequences to stakeholders. Furthermore, those consequences are spread adequately across the spectrum of all the stakeholders. Notwithstanding the fact that the letters of law may obligate the observance of the rigorous standards of Corporate Governance, my recommendation would be to apply the ideas detailed in this book for wealth creation, wealth management and wealth sharing irrespective of the organization’s structure. The logic is to benefit its owner and no less importantly to serve the society whose scarce resources are marshalled for promoting, building and sustaining the enterprise and eventually to continue to receive its patronage.

4 Raison D’être of Joint Stock Companies

I

t is important to understand the raison d’être or the fundamental purpose of building an enterprise in the character of a JSC. It is clearly evident from the evolution of the JSCs that the basic purpose of an enterprise organized in this format is to pool in the resources of large number of owners who either do not have the ability, time and energy or would like someone else with ideas and capabilities to multiply their resources—create wealth optimally. Since the level of riches and/or the possibilities of creating wealth were not as much in Europe in the fourteenth to seventeenth centuries, voyages were undertaken to destination riches. People with resources happily and enthusiastically contributed their resources in the quest for greater multiplication of the wealth, notwithstanding higher risks involved. Thus, the basic underpinning was and continues to be the creation and/ or multiplication of wealth out of the resources marshalled and efficacious sharing of wealth with the owners of these resources. The resources so collected under the umbrella of the JSCs can be broadly characterized into the following: 1. Physical Resources: Physical resources are land building, minerals, power, raw materials such as cotton, steel,

40  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

grains and so on. These physical resources are sought to be converted into finished products, which can be marketed for different uses at a price higher than the aggregated value of all the inputs. 2. Human Resources: Conversion of physical resources into the product of a kind and quality, which is better/more useful than what it was in the original shape, is facilitated by human endeavours, either exclusively and/or with the aid and assistance of machinery, tools and technology and so on. These HR have various levels of skills which range from administration to technical, from invention to execution. The utilization of HR can be either by hiring them exclusively for the JSC or by sharing them with others. It could also be engaged to fulfil a task or a bunch/ bundle of tasks at the customers’ door. 3. Financial Resources: Acquiring of physical resources and HR calls for the engagement of financial resources to buy, own and/or hire physical resources—including raw materials required for products—and HR. Financial resources are also required for taking the output of the finished product to the customers and for rendering post-sales services. A part of physical, human and financial resources is made available by the individuals, groups and/or enterprises, but a part of such resources is made available by the society. For example, a land belongs to the state and it leases out that land to enterprises either for free or on a minimal/subsidized cost and/or provides infrastructure to facilitate the creation of the finished output. In addition, the society lays down rules, regulations, legislations and directions, which facilitate not only the creation of a JSC but also its peaceful existence, right to ownership of assets and successful sustenance. The enterprise, which is allowed to take charge of the resources, has to create an output which is greater in value than the value of total input(s). The gap between the value of output and input is the wealth addition.

Raison D’être of Joint Stock Companies  41

4.1. Wealth Creation An enterprise is expected to create wealth out of the resources that it uses for manufacturing/producing finished products— goods and/or services. The difference between the values of all the outputs created minus the aggregate value of all the inputs utilized to create the output is the ‘wealth created’ by an enterprise. Let us take for an example the value of all the outputs created and/or produced by an enterprise equal to `100. If the aggregate value of all the inputs—physical, human and financial, including that of the entrepreneurs who manage the enterprise—is equal to `80, then the gap of `20 between `100 and `80 is the amount of wealth created by the enterprise. The resources of the society, nay, the entire planet Earth are limited. In an organized society, the resources should be allocated to those individuals and/or enterprises that can create wealth optimally by using the resources so allocated. Suppose ‘A’ creates a wealth of `20 (as mentioned earlier) but ‘B’ is capable of creating a wealth of `30, then, in the best interest of the society at large and fairness, the resources should ideally be allocated to ‘B’ and not ‘A’. There are three limitations to such a situation: (a) the standards of who can create the highest amount of wealth keep evolving, (b) the same resources can be allocated to different enterprises for creating different kinds of products and (c) priorities of the state in the interest of welfare of its citizens may have compulsions. Since a perfect society does not exist, the allocation of resources becomes an exercise in guesswork. Empirical studies have established that market, although not perfect, is a better allocator of resources. Hence, the evaluation of wealth creation as reflected by the valuation of enterprise is adjusted to be the level of confidence in the wealth creation, which is also called discounting of future profits. The creation of the structure of JSCs emerged and has been evolving through the force of market practices. It has been established over a period of time that JSC structure has the potential of creating wealth at a higher rate. Thus, the first and foremost

42  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

raison d’être of a JSC is the creation of wealth, which has to travel on an optimal platform at all times. In case JSC does not create wealth optimally and/or does not continue to do so during the course of journey of its life, it is only appropriate that the society either shifts the management of the enterprise to the hands that can do better or reallocate the resources to such an enterprise which can create wealth at the optimum level. The threat of the reallocation of resources should be so potent that it continues to challenge the managers of an enterprise to continuously improve wealth creation. This is what makes a hostile takeover an accepted proposition, though such takeovers do not always result in greater wealth creation. Market forces should be able to prevent such an eventuality. Hence, the assessment of the level of wealth creation should be an important element in the Corporate Governance practices.

4.2. Wealth Management The wealth so created by an enterprise belongs to all the stakeholders of the JSC. I have already discussed in the previous chapter who the stakeholders of the enterprise are. The wealth so created is owned by all the stakeholders—contractually or residually—and therefore has to be distributed, if and when, to all the stakeholders in proportion to their entitlement. The wealth sharing will be discussed subsequently. However, in the interest of running the enterprise and sustaining its success, it is important that atleast a part of the wealth created is retained within the enterprise until the dissolution or winding up is decided or becomes necessary. This is essential for beating the vagaries of environment, ups and down, growth and/or sustainability. The wealth so retained has to be used/managed in such a manner and by such a method that the returns tread maximal trajectory. Thus, the management of the retained wealth becomes the second most raison d’être of JSC. The management of wealth is a very challenging task. First, let us understand that the retained wealth takes various shapes. It

Raison D’être of Joint Stock Companies  43

could be physical, financial and/or human power. Full or part of such retained wealth may be utilized by the enterprise for furthering its business and/or may be invested in some other venture for driving up returns. It is important for the managers of the enterprise to understand that the authority to manage well eventually comes with the responsibility of maximizing the returns and must terminate in accountability for failure to do. Hence, they have to continuously assess, configure and reconfigure its management for the highest possible levels of returns. During my stay in the SEBI, a secondary research was organized (survey was limited to a few selected companies) to assess wealth creation, wealth management and wealth sharing. It transpired that in one of the well-known and published Corporate Governance failures, wealth creation was traversing on a very high platform. However, the retained wealth, instead of being managed with a view to maximizing returns, was seeping out through the tributaries of special purpose vehicles with zero or minus returns, which eventually led to the collapse of the enterprise itself. Hence, the management of the wealth, in whatever form retained, must be yet another important element of the Corporate Governance.

4.3. Wealth Sharing As mentioned earlier, wealth created by an enterprise belongs to all the stakeholders in proportion to the contribution of the inputs provided to the enterprise. While there are some stakeholders who have contractual ownership, there are other stakeholders who have the residual ownership. Contractual stakeholders belong to the categories such as HR, suppliers of debt and preferential capital and other goods and services, society and customers. Equity shareholders are the residual stakeholders. Yet there are stakeholders such as HR and society who in addition to contractual ownership have residual ownership as well. Furthermore, amongst the equity shareholders there are majority and minority owners. The contractual stakeholders take precedence in the sharing of wealth. For example, the HR and the suppliers of raw

44  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

materials and the debt and preference capital get precedence over the providers of risk capital—equity holders. Similarly, a part of the payment of wealth to the society in the shape of payment of taxes takes precedence over the payment to other stakeholders. Figure 3.1 in Chapter 3 depicts the ownership of the wealth in contractual and residential format. The enterprise, therefore, must so architect the disbursal philosophy and policies that the wealth is shared sagaciously. One set of stakeholders is not disbursed wealth, which is disproportionate to their contribution and/or is at the cost of other stakeholders. In most Corporate Governance misdemeanours it has been brought to light that the executive compensation was disproportionate to their contribution in wealth creation and wealth management. Similarly, the examination of related party transactions revealed benefiting one set of stakeholders of an enterprise at the cost of other stakeholders of the same or some other related enterprises. Thus, sharing of wealth becomes yet another significant factor in the operation of Corporate Governance practices. Summing up, the purpose of JSCs is to create wealth optimally, maximize returns on the retained wealth and share the wealth efficaciously. Anytime, and in any event, if either of the three purposes of the creation of JSCs is undermined, the basic philosophy of creating the JSCs is challenged and the deficit of Corporate Governance becomes apparent.

5 Greed, Hubris and Delinquencies: Barriers to Good Corporate Governance

T

he separation of ownership and control, which defines the modern corporation, is a fundamental development in the contemporary capital markets. The segregation has divided the owners of enterprises into two parts: (a) active and (b) passive. In most cases, a small minority manages the wealth and interests of a large majority of JSC stakeholders. However, in some cases, pure professionals manage the interests of all the stakeholders. A human being is basically selfish and, more often than not, seeks to serve his own enlightened self-interest even at the cost of others. To dissuade him from falling in the trap of this basic human tendency calls for society’s directed obligatory compliance with the fundamentals of equity, justice and fair play coupled with a moral suasion of being an honourable social being. Dereliction must face deterrent punishment and the delivery thereof must be a stitch in time. Unfortunately, in most societies and on many occasions it does not happen.

46  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

The greed and hubris, many a time, propels the active managers/ owners of the enterprises to drive the organization in the trajectory, which sometimes derails the journey of growth and sustainability and/or profit disproportionately to the detriment of the interest of inactive. Such a subjective management of enterprises leads to innumerable scandals, frauds, seeping and siphoning of resources and wealth. Although such misdemeanours have been very many during the existence of the institution of JSC, scandalous collapse of several large and significant companies such as Equitable Life, Ferranti International PLC, Bank of Credit and Commerce International (BCCI) and Colorado Group shook the environment in the UK. Similarly, misgovernance at WorldCom, Tyco, Enron and so on created a stir in the USA. MS SHOES and Satyam Computers are two well-known cases amongst the spate of Corporate Governance failures in India. Such instances of destruction of one-time successful enterprises are plentiful across geographies. It may not be necessary to elaborate here how a mix of greed, hubris and delinquencies has destroyed the value of the corporate world over time. However, it might be useful to exemplify by quoting atleast one instance from each of the three different aspects. Although a few (detailed) case studies are available in Annexure 1, a sense is sought to be provided in this chapter about the play of greed, hubris and delinquencies. Parmalat Finanziaria of Italy is an extreme example of greed wherein active stakeholders of the company appropriated the value and presented falsified accounts. The management lured the investors through imaginative, speculative and structured instruments designed by a group of bankers—global and Italian—and siphoned off moneys to a network of 260 companies. In Enron, which rose like a phoenix out of unbridled and unruly creativity, sheer hubris helped the top management to create a questionable business model which concealed true performance. The financial engineering was believed to be a remarkable innovation without any realization ever by the directors that Enron was essentially hedging with itself. Equitable Life, where nobody made financial gains out of the failure of governance, is a case of sheer delinquencies. The board indulged in collective rationalization. A policy without a

Greed, Hubris and Delinquencies  47

perception of potential blowup was pursued relentlessly until the balance sheet could not hold it anymore on its own. Technicians were allowed to abrogate absolute authority and, in their anxiety to deliver performance, they created complexity which was compounded over and again. The board forgot the basic tenet that managing includes visioning the propensities of the possibilities of the pursued policies. It must be understood that the economic agents—the executive management saddled with authority—have the tendency to be self-serving, arrogant, particularly with success, and, in the absence of well-laid-down manner of conduct, may exhibit unruly behaviour. Soft boardroom practices, which border on delinquencies, make the most important pillar of monitoring pyramid—board, ineffective. Greed, hubris and delinquencies compound that situation and they often fail to realize that they are leading the erosion of value and even the destruction of the organization itself. It is therefore important that those in control of the corporation are propelled and even compelled to manage it in the best interest of all stakeholders. Such a management has been termed as good Corporate Governance.

5.1. Barriers to Good Corporate Governance My analysis of various governance failures during my stint at the SEBI and researching for this book has revealed certain common barriers to good Corporate Governance. Even though the basic malaise emanates from the agent–principal relationship, I have tried to elaborate a little after grouping these into the following seven categories.

5.1.1. Agent–Principal Relationship The agency theory applies to a JSC as well. The principal in the case of JSC is the shareholder and the management is the agent. The principal (shareholders–owners) allows the agent

48  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

(management) to manage their interests. The basic underpinning of the separation of ownership with control gives birth to this prognosis. The managers have inherent inclination to promote their self-interests even to the disregard of the interests of the owners. The agency problem was highlighted by the great economist, Adam Smith, in 1937 in his book Wealth of Nations. This relationship is the fundamental barrier to good Corporate Governance, which is neither understood by the board, and even if understood, the challenge to turn this otherwise useful relationship into a win–win journey in the life of JSC is not worked upon while superintending the role of the management. The regulatory interventions, which add costs to the JSC, do not deliver the expected outcomes in the absence of the appreciation of the problem by the board.

5.1.2. Ownership Structure The concentration of ownership and/or its diffusion into a holding or subsidiary, group or remotely stationed ownership creates artificial road blocks in the selection, appointment, remuneration of the CEO and other critical functionaries such as CFO and directors and/or the management of the enterprise itself. It is sought to be explained that these are the rights conferred in terms of its ownership of the enterprise. Recently, the majority owners of a company in India triumphantly announced that one of the shareholders has lost its right to nominate an independent director. The right to appoint an independent director(s) challenges the efficacy of independence of the directors so appointed. Similarly, a right to appointment, remuneration and so on of critical functionaries who are to be (as per regulatory directions) appointed by the board on the recommendations of the Nominations and Remuneration Committee makes a mockery of the substance of compliance. It weaves a cob web of loyalty. Furthermore, the concentrated ownership bulldozes the minority owners in the critical decisionmaking. Protection of minority rights regulatorily ordained, which add to costs, most often turn out to be a wasteful expense.

Greed, Hubris and Delinquencies  49

The ownership structure does not allow corporate democracy to bloom, which prevents the free flow of discussions, voicing of dissent and even pointing out the lapses in the governance of the enterprise. Thus, the ownership structure becomes a barrier to good Corporate Governance.

5.1.3. Board Structure Similarly, the constitution of the board, its role and authority and functioning itself can become a barrier. An ideal board is the one which is dominated by the independent directors and not by the shareholders’ representatives. This is missing in most boards. In fact, the shareholders’ director(s) dominates the proceedings and even dictates, and the situation is compounded if a set of shareholders have the right to appoint or even recommend names for the appointment as independent director(s). In one of the board meetings of a listed company when I was told by a shareholder director that I was his nominee, not only did I refute but even offered to quit. Eventually, I resigned from the board and this was one of the reasons for my decision. I was so reminded probably because my thinking was not aligned to his thinking. In most cases, the role and authority of the board is not clearly delineated, which propels the executive management to abrogate the board’s role. Furthermore, the functioning of the board itself in quite a few cases is inefficacious. Thus, the board structure can also become a barrier to good Corporate Governance.

5.1.4. Non-alignment of Interests of Directors with Long-term Value Creation There are examples of directors who have a reciprocative (informal) arrangement to sit on each other’s board. There are also directors in companies who have (vicarious) conflict of interest. Similarly, there are directors whose remuneration is linked to short-term performance. In fact, the real weak link in the alignment is the

50  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

compensation structure in the company. Likewise, there are other areas which lead to the misalignment of interests and become a serious handicap in building a good Corporate Governance.

5.1.5. Abuse of Executive Powers There is a natural tendency amongst the executive management to overstep the delegations. Unfortunately, the current governance practices’ dispensation allocates excessive powers to the executive management. This is compounded by the ineffective superintendence by the board. Enron was a case of blatant abuse of powers by the executive management. The audit and other checks and balances including the threat of takeover could not prevent the abuse. The delegation of powers to the executive management also becomes a barrier to good Corporate Governance.

5.1.6. Abuse of Corporate Opportunity Sometimes, opportunities open up for an enterprise to enter into a new partnership, product line or even a business line. The executive management often makes use of those opportunities first for themselves and only later for the benefit of the enterprise. In some cases, an enterprise is completely deprived of those opportunities, particularly if the executive chairman and/or the CEO is a promoter shareholder as well.

5.1.7. Absence of Democracy The JSC structure enshrines the multiplicity of stakeholders, which necessitates the application of principles of democracy. The principles of democracy warrant promotion of the greatest good of the largest number. Democracy respects the dissent and cares for the interests of minority and prevents abuse of

Greed, Hubris and Delinquencies  51

majoritarianism. Absence of democracy is a significant barrier in building a good Corporate Governance. There is a belief in the minds of the majority or controlling shareholders in most companies that they are the owners not in coordination with other shareholders but absolute possessor of the enterprise and, therefore, can get away with the form of compliance of Corporate Governance. Similar situation obtains in the minds of some of the executive managers as well. They think that since there is no dominant owner and/or the company has been allowed to be professionally managed, they can conduct themselves without caring for the substance of compliance. The barriers, which build an ethos, have to be clearly understood and dealt with effectively. Unfortunately, I have observed in some of the boards that the directors including independent directors are not adequately conscious of their fiduciary responsibility and live in the comfort of ‘where ignorance is bliss’.

6 Fruition: Concept of Corporate Governance

T

he innumerable scandals stemming out of the failure of Corporate Governance, which include downright fraud and mismanagement in many geographies, have shattered the confidence of the investors of resources in the basic fabric of an enterprise as a JSC. An impression has been gaining ground that those in the active management by the virtue of the authority vested in them, treat the interest of other stakeholders with utter disregard, mismanage the enterprise, siphon off the resources and even organize and undertake daylight robberies on the wealth of the stakeholders. The disgust emanates from the fact that such irresponsible behaviour is being reflected by those who are expected to be the trustees of the interest of all stakeholders. Governance failures created an uproar in the financial markets, which made the governments and regulators sit up and take notice. There was a rethink on the role of the state, which is expected to provide basic support services such as law and order, a conducive legal environment, a decent and potent supervisory and regulatory infrastructure, a reliable accounting system, a vibrant securities market and so on, while the private economic agents carry on the economic activities. Even the

Fruition: Concept of Corporate Governance  53

allocational efficiency of the resources by capital markets has been questioned. Discipline of capital markets itself came under severe attack. It was felt that the rules and canons of market discipline were inadequate and even the existing code of conduct was not effectively enforced. This led to the formation of a number of committees and commissions and enunciation of codes around the world (noted amongst those have been mentioned below), beginning with the Cadbury Committee chaired by Sir Adrian Cadbury, CEO of the Cadbury Confectionary empire. Back home in India, the following committees have been appointed: • Kumar Mangalam Birla Committee on Corporate Governance (2000) • Naresh Chandra Committee on Corporate Audit and Governance (2002) • N.R. Narayana Murthy Committee (SEBI, 2003) • Naresh Chandra Committee Report of 2009 (CII Taskforce on Corporate Governance formed post Satyam episode) The corporate misdemeanours consequenced by greed, hubris and delinquencies have incited a global approach to bringing an order in the management of enterprises, particularly those which are publicly owned, where the number of shareholders is large and widespread and has a complement of minority shareholders. The orderly management of an enterprise has been christened as Corporate Governance. Many pundits in the field have defined Corporate Governance in many ways and it ranges from managing and maintaining financial health of an enterprise to including optimal wealth creation, maximizing wealth management and most efficacious sharing of wealth amongst all the stakeholders. Innumerable definitions of Corporate Governance have been laid down by the various committees, commissions and organizations. The excerpts from some of the definitions could be described as follows:

Naresh Chandra Committee on Corporate Audit and Governance (2002)

N.R. Narayana Murthy Committee (SEBI, 2003)

14

15

OECD principles of Corporate Governance (1999)

9

Kumar Mangalam Birla Committee on Corporate Governance (2000)

Combined Code of Best Practices (LSE) (1998)

8

13

Blue Ribbon Committee on Improving the Effectiveness of Corporate Audit Committees (1999)

7

Sarbanes Oxley Act (2002)

Hampel Committee on Corporate Governance (1998)

6

Derek Higgs Committee (2002)

Business Round Table (BRT)—Statement on Corporate Governance (1997)

5

12

CaIPERS—Global Corporate Governance Principles (1996)

4

11

Greenbury Committee on Directors’ Remuneration (1995)

3

CACG Principles for Corporate Governance in Commonwealth (1999)

Mervyn E. King’s Committee on Corporate Governance (1994)

10

Sir Adrian Cadbury Committee on Financial Aspects of Corporate Governance (1992)

2

Name of Committee

1

Sr. No.

List of Committees and their Country

India

India

India

USA

UK

Commonwealth Secretariat

OECD

UK

USA

UK

USA

USA

UK

South Africa

UK

Country/Organization

Fruition: Concept of Corporate Governance  55

‘The system by which companies are directed and controlled’ by Cadbury Committee, 1992. ‘The relationships among the management, Board of Directors, Controlling Shareholders, minority shareholders and other stakeholders’, states International Finance Corporation (IFC), Washington. The Organization for Economic Co-operation and Development (OECD) defines Corporate Governance as: involving a set of relationship between a company’s management, its board, its shareholders and other stakeholders. Corporate Governance also provides the structure through which the objectives of the company are set, and the means of attaining those objectives and monitoring performance are determined. Good corporate governance should provide proper incentives for the board and management to pursue objectives that are in the interests of the company and shareholders and should facilitate effective monitoring, thereby encouraging firms to use resources more efficiently.

According to the World Bank, Corporate Governance is: • • • •

Blend of law, regulation and appropriate voluntary private sector practices Which enables the corporation to attract financial and human capital, perform efficiently, and Perpetuate itself by generating long-term economic value for its shareholders, While respecting the interests of stakeholders and society as a whole.

A complex definition has also been provided by the advisory board of the National Association of Corporate Directors (NACD), New York: ‘Corporate Governance ensures that long-term strategic objectives and plans are established in place to achieve those objectives, while at the same time making sure that the structure functions to maintain the corporation’s integrity reputation, and responsibility to its various constituencies’. In one of the many books published since 1992, the Corporate Governance consists of five elements, which the BoD must consider:

56  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

• • • • •

Long-term strategic goals Employees: past, present and future Environment/community Customers/suppliers Compliance/legal and regulators

Taking a world view of the definitions, I would like to sum up Corporate Governance as the philosophy that a company practises in its relationships with its shareholders, lenders, employees and other stakeholders, including society at large. It mirrors the company’s integrity, efficiency and long-term growth. Corporate Governance must assure the investors and lenders alike that the company’s dealings with its stakeholders will be fair and transparent, the CEO and the BoD will be held accountable, the company will be responsible in its business transactions and will create wealth optimally, maximize wealth substantially and share wealth efficaciously. Any Corporate Governance definition must be inclusive of structuring, operating and controlling the enterprise with a view to: • Fructify the vision of its incorporation as modified from time to time • Erect pillars of sound business ethics • Meet the expectations of all stakeholders • Remain compliant in letter and spirit with all applicable legal and regulators prescriptions This makes the concept of Corporate Governance incredibly broad. In effect, good Corporate Governance is expected to balance the interests of, and relationships between, the various stakeholders of the company while ensuring the long-term sustainability and success of the enterprise. New setting unfolds a unique set of challenges in ensuring that a company’s assets are managed proficiently, prudently and honestly and what will eventually differentiate a company will be its capacity of wealth creation, dexterity of wealth management and efficacy of wealth sharing amongst all stakeholders.

Fruition: Concept of Corporate Governance  57

The world at large, though not simultaneously, woke up to the propensity of subjective management of enterprises and alienation of the interest of stakeholders, in particular minority. This has led to the visualization, conceptualization, articulation and institutionalization of rules and regulations, procedures and practices, which seek to reduce substantially, if not eliminate altogether the propensities of subjectivity in the management of enterprises and ensure that these are run in the best interest of all stakeholders. There are two schools of thought on the direction of the Corporate Governance. One believes that good Corporate Governance is intended to protect and further the interest of all shareholders—both active and passive, in control and not in control, minority and majority. The other school of thought considers that Corporate Governance should be directed to enhance and ensure the interest of all stakeholders. Their belief emanates from the underpinning that a corporation is created, built and sustains its growth and life by the contribution of all stakeholders. Stakeholders can be grouped in five categories: (a) shareholders—minority and majority, (b) workforce (c) suppliers of financial capital— debt capital and other goods and services, (d) customers and (e) society. It is their belief that if all these stakeholders did not provide full support, the enterprise may not come into being and/ or may not sustain its success. I consider myself as a part of the second school of thought which holds that Corporate Governance must protect and promote the interest of all stakeholders. In fact, I had the audacity to argue at various regulatory forums across geographies, whenever I participated in the meetings of committees, subcommittees and AGMs of International Organization of Securities Commissions (IOSCO). Fortunately, the concept has since gained currency across geographies and codes, rules, regulations and legislations are being amended to include all the stakeholders as mentioned earlier. In India, The Companies Act, 2013 incorporates specific provisions for CSR and lays down the statutory obligation of allocation of profits towards fulfilling that. In my belief, this is a part of wealth sharing with the society—one of the stakeholders.

58  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

The subject of Corporate Governance has been and continues to be a matter of debates and discussions in various forums and occasions in all parts of the planet Earth. These forums range from specifically formed for Corporate Governance to regulatory forums, academia, industry associations and even private organizations, though unconnected directly with the corporate world. In fact, there are quite a few organizations promoted by self-serving individuals who profess to champion the cause of Corporate Governance and make a living out of such initiatives. The occasions for discussions on Corporate Governance have been ranging from board and AGMs to social discussions over cocktails and dinners. Varieties of prescriptions have been laid out. In fact, there is quite a bit of confusion in the minds of many corporate honchos so as to what line of approach should be pursued. The Corporate Governance has since become a matter of perception. There are organizations where Corporate Governance is being perceived to be excellent, and then there are organizations where it is considered to be a sham. To understand the broader market view, I decided to talk to a few chairman–CEOs of some of the prominent companies in India to understand how they comprehend Corporate Governance. Here are some excerpts from those conversations. Narayana Murthy, chairman of Infosys, defined ‘good corporate governance as maximizing shareholder value while ensuring fairness, transparency, and accountability in dealing with every one of the stakeholders–customer, employees, investors, vendor partners, government of the land and society’. Deepak Parikh, the chairman of Housing Development Finance Corporation (HDFC) Group, said, ‘Good corporate governance is running the company in a way that it is not detrimental to any stakeholder. It gives good returns to investors, treats its employees well and above all deals with customers fairly, efficiently and effectively’. He summed up, ‘There is no softer pillow than clear conscience’, and went to add, ‘I am a trustee of stakeholders’ interest’. Anand Mahindra, Chairman of Mahindra Group, said, ‘I am a custodian of stakeholders’ interest of a cooperative enterprise’. He went on to add, ‘Corporate governance is all about building trust

Fruition: Concept of Corporate Governance  59

amongst stakeholders’. Adi Godrej, Chairman of Godrej Group, said, ‘Corporate governance is all about probity and corporate social responsibility’. He further added, ‘All the stakeholders must get the best out of the corporate decisions’. Kishore Biyani, CEO of Future Group said, ‘Corporate governance has a very wide meaning. It is how you govern the interests of your shareholders, employees, suppliers, vendors, society etc’. Naik, Chairman of L&T, said, ‘It is all about building trust amongst the stakeholders, which is around truth, honesty, compassion and supporting society’. Apparently, there is a common thread in the thinking of the people I talked to. By and large they all ruminate that the interests of all stakeholders must be promoted, protected and furthered in the governance of the firms. The undertone of building trust amongst stakeholders was manifest in all the conversations. Mr Narayana Murthy was explicit in his expression, ‘Living in harmony with the society is the most important of all because society contributes to customers, employees, investors, and vendor partners etc...’. ‘The driver for us is to build something lasting for society and money is not the prime motivator’, asserts Kishore Biyani. ‘Fear of God’, says Anand Mahindra, ‘inspires us to always uphold the values propounded by founders’. These observations may not be the representative view of the corporate managers. However, these are the views of the chairman–CEOs of the successful enterprises of India, which do indicate that Corporate Governance has to transit from mere managing the interests of shareholders to furthering the interests of all stakeholders. These views also indicate that sustainable success lies in good Corporate Governance. Let us move on to the thesis of building good Corporate Governance.

7 Pillars of Corporate Governance 7.1. Introduction

C

orporate Governance stands on four pillars namely, disclosures, RPTs, accounting and financial reporting standards and boardroom practices. Generally, pundits in the Corporate Governance area have considered it to be a three-legged stool namely, disclosures, accounting and financial reporting standards and boardroom practices. However, every Corporate Governance failure where financial misdemeanours are involved has had something to do with the RPTs. Hence, to club the RPTs with disclosures is leaving the areas of wealth management and wealth sharing ineffectively monitored and a window open for seeping out of resources. The strength of all the pillars can make the corporate edifice safe and sound, provided these pillars function in tandem and provide strength to each other. Collectively, the strength of the four pillars of Corporate Governance should be greater than the sum total of the strength of individual pillars. All the four pillars will be discussed in some detail later, but it must also be understood that all these pillars have a four-tier monitoring pyramid (graphically described in Figure 7.1):

Pillars of Corporate Governance  61

1. Management inclusive of chief compliance officer 2. Auditors—internal and statutory 3. Board subcommittees, such as: • Audit committee • Nomination and remuneration committee • Risk management committee • Stakeholders’ relationship committee 4. Board of directors Although the role and responsibility of each of the tiers will be discussed in some detail at the appropriate place in the book, it would be worthwhile to mention here that all the four tiers have the allocation of singularly different role and are not expected to replicate the role played by the other. In fact, the strength and reinforcement of each of the tiers must strengthen all the others. Figure 7.1     Edifice of Corporate Governance

REGULATOR PUBLIC SECTOR COMPLIANCE PRIVATE SECTOR – EV BOARD BOARD COMMITTEES

MANAGEMENT

BOARD ROOM PRACTICES

ACCOUNTING AND FINANCIAL REPORTING

RELATED PARTY TRANSACTIONS

DISCLOSURES

AUDITORS

62  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

It would be worthwhile to understand and appreciate why such an elaborate framework has been created over the years to enhance the quality of Corporate Governance. It is important to understand what is the role that each of the pillars of Corporate Governance is going to play. Let me begin with boardroom practices.

7.1.1. Boardroom Practices There are adequate regulatory obligations and market practices and processes which can vouch and validate disclosures, RPTs and observance of the accounting and financial reporting standards. Regulators and the markets still fail to get a clear picture of what happens in the boardroom of public companies. In quite a few cases, there is a significant amount of camouflaging by appointing persons of repute, knowledge and understanding on the boards, but the practices inside the boardroom convert them into artefacts oozing out aroma as if good governance practices subsist. Boardroom is a place where the vision, mission, values, cultures and strategic direction of the company are decided. This is a place where the performance of the management and value creation in the enterprise is evaluated. This is the place where the efficacy of management assurance and independent assurance in the financial management and reporting are evaluated. Hence, it is important that the boardroom practices make it an effective forum to efficaciously monitor (through its committees) and provide sagacious superintendence by its own appraisal. In most organizations, the real weakness lies in the boardroom practices. The rigours of the boardroom practices have been discussed in a separate chapter. It might be worthwhile to quote an instance here. When I was heading the corporate communication department of LIC, one day, I needed to meet the managing director (MD; immediate superior) for an urgent consultation on a matter of serious significance. I called up his office to seek an urgent appointment. His executive assistant informed me that he is stepping out of his office to attend the board meeting of a large-sized listed company, but will send for me as soon as he is back in office.

Pillars of Corporate Governance  63

Within half an hour, I got a call from the MD’s office to rush for the meeting (it was almost a 0.5-kilometre walk, though in the same building). I was surprised and curious to know how he could return so soon. At the end of the meeting, to quench my curiosity, I asked him how he could be back so soon. What he told me took me by surprise. He said, the board meeting of that company does not last for more than 30 minutes and the company’s office was next door; 5 minutes to go, 5 minutes to return, 10 minutes for meeting and 10 minutes for tea. He further surprised me by telling that the chairman boasts of the shortest meeting of the board. It was a very successful, profitable and blue chip company then, but eventually it got merged with another company following its becoming a sick industrial unit, to be saved from extinction. The management of the company, being under a large industrial empire, enabled that process. This incident smacks of what sometimes happens inside the boardroom. I have been sitting on the boards of companies right from the 1990s, except for a brief break of just about three years when I was the SEBI Chairman. The quality of discussions, length of meetings and contents of agenda papers have improved substantially in many cases since then. Fortunately, the era of 10-minutes board meetings held in the 1990s is over. Yet, the concerns of the boardroom practices are still there. In fact, many board meetings still do not last for more than an hour or two. There are two aspects of the boardroom practices: (a) designing of agenda and circulation of background materials (notes) to facilitate an informed decision-making and (b) quality of discussions including time spent on each of the items of the agenda of significance. More often than not, even in some of the well-known public companies, meetings are convened at short notice and the agenda of serious significance is laid on the table under the pretext of business exigencies. This leads to two kinds of situations: (a) busier amongst the board members are not able to attend; seek leave of absence and (b) even those who attend are provided inadequate information, that too at the last minute, which converts boardroom discussion into a kind of rubber stamp. The quality and context of discussions in the boardroom are more important. Even if all the necessary rituals have been gone

64  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

through but the time allotted and the quality of discussion does not engage the wisdom of the board members, the very purpose of getting them together in a boardroom is defeated. The wisdom of an individual comes out best when it is challenged. It is analogous to an athlete being challenged by someone equally or more competent when his entire physical, mental and emotional strength is unified into delivering the best within. Some of the common trends, which have been noted in the boardrooms, are as follows: 1. 2. 3. 4. 5.

Chimera of invulnerability Collective rationalization Illusion of unanimity Superfluous assessment and stereotype vision Unquestioned belief in morality of management

This book contains some of the examples of how each of these trends lead to serious Corporate Governance failures. While in two cases it lead to serious financial loss, in the other two, it appears that the board could not comprehend and direct the enterprise early enough to be able to sustain the success.

7.1.1.1. Chimera of Invulnerability Management of the most successful companies nurtures the sentiments that the company will continue to succeed and is not vulnerable to changes in the environment—macro and micro. In such organizations, risk management is a ritual which is gone through every quarter, either by the audit committee or by the risk management committee. It has to be understood that public companies and even individuals and societies are vulnerable to decline and decay. History validates the fact that the one-time most successful and largest company of the world, EIC, went down to the level of pity. Fortunately, it has emerged out of the debris of dilapidated (one-time) economic monument and has been bought by an Indian for a pittance as a matter of self-pride to acquire what once acquired India itself. Studies have revealed that out of the Fortune

Pillars of Corporate Governance  65

500 companies 25 years ago, more than 75 per cent have gone out of the list and more than 50 per cent do not exist in the original form. Even in the case of India, only two out of 30 companies are a part of Sensitive Index (SENSEX; BSE Index) now from what it was just 10 years ago. This happens when one does not re-engineer, reinvigorate and reorchestrate itself. One example that comes to the mind is that of a snake. There is a mystic myth in India that a snake lives long; in fact, it is believed that it lives for thousands of years. An old snake of such an age is said to possess ‘nagmani’, which can transform anything into prosperity and value. I am not a zoologist. Hence, I cannot confirm if a snake lives for hundreds of years, but most zoologists with whom I have interacted with confirm that the snake has a propensity of living longer and this stems out of the fact that every six months a snake goes through its reincarnation—by shedding its upper skin completely and growing a new skin. Even though the process is painful, it rejuvenates itself to take on the vagaries of the external environment and internal ageing with renewed strength and vigour. Similarly, in the case of successful companies, if there is a process and mechanism to rejuvenate itself periodically, there is a very strong possibility of its sustaining success over a long period of time. Unfortunately, however, in most boardrooms, the belief of the management is shared by the non-executive directors (NEDs) and perspectives outside of the management ethos are not considered on a regular basis. The chimera of invulnerability is shared by them all, which eventually impacts the sustainability of the company. I had the pleasure of sitting on the board of a prestigious company as a nominee director in the mid-1990s. While understanding the business and its model, it was discovered that it had serious concentration risk. When it was pointed out to the then MD and CEO in one of the board meetings, it was brushed aside. In fact, it did not evince even adequate interest of other NEDs, even though a galaxy of the top Indian business leaders was present. Since it belonged to a prestigious group, the chimera of invulnerability had overwhelmed. Eventually, it suffered from that risk going forward, and the enterprise was brought on track only with the change of CEO and the appreciation of the risks to the business model, albeit with a serious downside for several years.

66  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

Similarly, one of the India’s most valuable companies with the highest price/earnings (P/E) multiple in the related industry and which is perceived to be the paragon of Corporate Governance commenced the journey down the hill. In fact, it was going through midlife crises, which the board failed to perceive or atleast failed to address. It tried some patchwork but continued to struggle. Notwithstanding the presence of globally accomplished board members, the chimera of invulnerability seems to have engulfed the success into the whirlpool of instability. Fortunately, the entry of a new executive management team is rebuilding its image, growth and profitability.

7.1.1.2. Collective Rationalization It is a common practice in the boardroom to rationalize a decision which did not deliver the expected or bring about the consequences, leading to a setback to the company. Learning is a serious exercise and individuals, companies, countries and even societies have to continue to learn and unlearn. Learn what is new and unlearn what has become irrelevant. Failures and/or events proffer very potent potentialities for learning. In fact, failure and/or a wrong decision should be considered as an investment into learning. However, that is possible only if a comprehensive analysis is presented to the board of what happened and why, along with what could have possibly been done to anticipate what went wrong and/ or the assumption that did not turn out to be correct. Throwing away the instances and/or opportunities of failure without learning is suicidal for the growth and sustainability of the organization. The board should transit from collective rationalization to coordinated learning, which often does not happen in most boards. In another company where I had the privilege to join the board as an independent director, the decisions were leading to disastrous results. But, the lessons were not being learnt and issues were closed with rationalizing the failure to the impact of the environment. Eventually, the company went down. Of course, I resigned (out of sheer disgust) from the board of the company much before its demise.

Pillars of Corporate Governance  67

7.1.1.3. Illusion of Unanimity It has often been observed that the board members put on a mask of unanimity even though the undercurrent in the minds is often of a disagreement. While appreciating the corporate democracy, disagreement should be welcomed, considered and tolerated. Unfortunately, most people, including those who have had very successful careers, hesitate to express a divergent view in case the chairperson and/or the majority owner in the management hold a different point of view. In the context of the boardroom practices, it will be worthwhile to mention what has been observed in the case of quite a few individuals. The very fear of alienating the mind of the chairman and/or management and the probable consequences on the reelection and/or uncertainty over the direct and vicarious benefits refrain from expressing the alternate view. I still remember vividly an incident in the boardroom of a very successful financial giant in India, which had ‘who’s who’ from both India and abroad on the board. One of the board members was arguing against the swap ratio in the merger of two institutions of the same group. Even though he was able to comprehensively demolish the arguments of the three investment bankers—one each of the merged and merging institution and the third one being the arbitrator—swap ratio was not changed. Since the merger was a desirable decision, this particular director on the board did vote for the merger, but voted against the swap ratio. Interestingly, two other board members sitting right and left of the director also felt that the swap ratio needs to be realigned and whispered into the ears of the disagreed director that the management should agree to correct at least half of the change he was proposing, but they did pick up enough courage to say so themselves. In fact, even the MD and CEO, may be to please the disagreed director, during lunch break, said that the former agrees with what the latter said, but did not say so in the meeting as the chairman had already decided the ratio. To cap it all, the dissent was recorded separately but not as a part of the minutes. The chairman had the audacity to ask the director, during lunch, how the market will react. The dissenting director said, the pricing will adjust the moment the market is informed. The chairman disagreed, but that actually happened.

68  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

There are innumerable instances of this kind where some board members have a different point of view but do not express and give an impression of unanimous decision. This has two impacts: (a) the company is deprived of the benefit of voice of dissent in the decision-making and (b) it makes the board members more or less a non-contributor and thus deprives the company of the wisdom that has been collected in the boardroom.

7.1.1.4. Superfluous Assessment and Stereotype Vision In many public companies, the management takes complete charge of providing the vision and also the assessment of the performance of the company. What is often presented to the board is little less than the comprehensive analysis and the quality of discussion that takes place in the boardrooms is not indepth. The numbers are not cracked down into the genesis. The aggregation is made to look good and impressive, even though, sometimes, the disaggregate numbers speak out some of the hidden (ugly) stories. These stories often tell their tale; how one product subsidizes the other and/or one segment of the business has been vicariously supported by the other. In the absence of such an in-depth assessment, the board does not get seized with the thought of the options of developing new and rejuvenated strategic approaches to build greater profitability and de-risk the factors which are contributing negatively to the performance of the company. The superfluous assessment does not help the company and, sometimes, fuels unsustainable confidence in the business and management capability. In some of the companies, the facade of strategy session is organized, but the quality of presentation and depth of discussions leave much to be desired. Management braces ahead with predetermined direction and, eventually, the company does not continue to travel on the platform of success and sustainability. Similarly, the management abrogates the vision of the company. Even though its BoD is capable of providing the vision and

Pillars of Corporate Governance  69

better strategic directions, not enough of discussions take place in the boardroom on the subject. Consequentially, the company operates with a stereotype vision and is not able to comprehend and capture the scopes and scales of emerging opportunities and limits itself to the existing potentials.

7.1.1.5. Unquestioned Belief in the Morality of the Management Somewhere along the line, in most companies, a kind of sentiment prevails that the managers of the enterprise are honest, both financially and intellectually. The board members nurture a kind of unquestioned belief in the morality of the managers. Although there cannot be a typical auditors’ ‘blood hound’ attitude that every transaction is a suspect, it is important to understand and appreciate that an opportunity to profit and/or hide the truth is the biggest temptation. It is, therefore, important that the BoD tries to understand why of the numbers and/or of a transaction that is brought before the board, in particular the ‘balance sheet’, must be seen with incisive eyes. In one of the recent cases of Corporate Governance scandals in India, only if the independent directors had gone behind (so stated) a billion of dollar of cash having been kept in the bank deposit with incisive eyes, questions would have been raised as to why has the money been kept in low return for such a long time and even that low yield was subject to taxes, whereas alternative avenues of investment with higher yield, lower tax treatment on income and equal safety were available in the market. And, possibly, the scandal would have been prevented/unearthed earlier and the damage contained. Apparently, there was unquestioned belief in the integrity of the management and therefore such items in the ‘balance sheet’ were not questioned. The independent directors, in particular, during the boardroom discussions should be able to validate their belief in the integrity of the management, which, if seen, in the light of available temptations is not only desirable but essential.

70  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

7.1.2. Accounting and Financial Reporting Standards The performance of a company is assessed by its stakeholders on the basis of financial results published periodically. The financial statements reveal income and expenditure and their application to various purposes. Income and expenditure recognition are thus fundamental to assessing the performance of the company including its profitability and sustainability. To ensure that the income and expenditure have been appropriately recognized, accounting standards are laid down which, when applied consistently, reflect that the accounting of income and expenditure and so on have been done correctly and that the revenue account and the balance sheet reflect the true and fair picture. Their disclosure including the content and method becomes important. Hence, reporting standards have also been laid down. This is one area where shelters can be weaved for misdemeanours including self-dealings.

7.1.3. Disclosures Disclosures are intended to bring about transparency in the governance of an enterprise. It is also expected to ensure that those in the know of price-sensitive information are not able to profit from the use and/or misuse of the information. Hence, all price-sensitive information along with the changes in accounting standards (if permitted), if any, are disclosed as and when due and appropriately. Insider trading as a malaise stems from the fact that some people have access to price-sensitive information ahead of its disclosure to the market.

7.1.4. Related Party Transactions There is a strong possibility that the decision-makers in the company indulge in self-dealing and/or undertake/approve a transaction, which may benefit the decision-makers directly or indirectly. It is important that all RPTs’ decisions are taken following the required norms and procedures. The two principles which have always been guiding light are:

Pillars of Corporate Governance  71

• Arm’s length • Ordinary course of business Arm’s length, which has been explained in Chapter 10 in greater details, means fair pricing of the transactions undertaken between the two—the company and the related party. In the ordinary course of business, it means the transaction must have a direct or atleast a vicarious relationship with the business of the company. The transaction, which is completely out of the preview of ordinary course of business, will have to be dealt with separately. For undertaking those transactions, the rules are much more stringent and rigorous.

7.2. Tiers of Monitoring Pyramid The eventual outcome of all Corporate Governance practices is to ensure that an enterprise is run with a view to creating value and all value-destroying actions/transactions are checked.

7.2.1. Management The base of the edifice of Corporate Governance is the management inclusive of the chief compliance officer. This layer is supposed to provide a strong base of management assurance that all the norms of Corporate Governance have been observed and the observance has been both in letter and spirit. This layer also provides an assurance that the accounting and financial reporting standards have been scrupulously observed, disclosures have been adequately made, RPTs have been at arm’s length and in the ordinary course of business and also that the board governance practices have been orchestrated to enhancing the value and/or preventing the value destroyers of the enterprise. If the management does its job well, the quality of Corporate Governance improves and the market perceives as such and prices the valuation accordingly. However, to make sure that the management has done the job well, it is important to have an independent assessment of the strength of all the four pillars

72  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

including the compliance action by persons who are not engaged in the day-to-day management of the company. Auditors (internal and statutory) thus become the beam of strength of the edifice of Corporate Governance.

7.2.2. Auditors Auditors—internal and statutory—are expected to assess the functioning of the company with reference to the laid-down standards, called auditing standards, with a view to verify that the financials of the company reflect the true and fair picture and also that the assurances given by the management are correct and appropriate. The auditors have to provide the board and shareholders independent assurance. In the process of doing so, the auditors have to undertake an in-depth exercise of the examination of records including the financials of the company. They have to provide an independent assessment that the accounting and financial reporting standards have been scrupulously observed and consistently applied, all appropriate disclosures have been made and that too timely and that all the RPTs have been at arm’s length and in the ordinary course of business. Wherever they find any inadequacy, they have got to bring it to the notice of the oversight pillar. To ensure that the independent assurance providers are truly independent, their reporting line is to the authority, which is expected to provide the oversight, that is, audit committee and the board. The management assurance as well as independent assurance, put together create a confidence among the stakeholders on the quality of Corporate Governance of an enterprise.

7.2.3. Board and Board Committees To ensure that both the management assurance and independent assurance have been of the quality that is expected by the stakeholders, it is important to have an oversight mechanism. In the Corporate Governance structural framework, the board and its subcommittees are expected to undertake the responsibility of

Pillars of Corporate Governance  73

providing that oversight. To ensure that the two other layers are functioning efficaciously and provide adequate strength, the oversight has to be organized effectively and comprehensively. The structural framework divides the work into two parts: first, the incisive oversight, and second, the superintending oversight. The incisive oversight needs a deeper examination and understanding of the way management and independent assessors have functioned, whether their processes were potent and that adequate rigours have been applied, which includes thoroughness of diligence in undertaking their roles and responsibilities. Since, this cannot be organized by the board collectively, efficiently and requires time, the responsibilities have been subdivided between board’s committees and the board itself. The board committees are expected to devote longer and quality attention to providing oversight and reporting to the board that both management and independent assessors have by and large done their job well. The board, on the other hand, is expected to provide superintendence by monitoring the functioning of the committees and evaluating the reports received from them in a larger body where group dynamics with full collective wisdom can provide effective oversight. Summing up, the pillars are the support to each other and function in tandem along with the layers of the edifice of governance. Although the accounting and financial reporting standards, disclosures and RPTs are helpful tools, boardroom practices are to play their roles—effectively—to adjudge management and independent assurance to its appropriateness and efficacy. It is, therefore, clear from the aforesaid that each of the pillars and layers has its role cut out and there is a very effective maker-checker to ensure the quality of Corporate Governance. However, the replication of the role played or deficiency in playing the role by one or other pillars and/or tiers will directly and proportionately influence the quality of Corporate Governance. Hence, my recommendation is to ensure that the pillars and tiers of monitoring not only uphold their respective burden of responsibility but function in tandem as a team to create magnificence in Corporate Governance frame.

8 Boardroom Practices

T

he BoD is the trustee of the stakeholders’ interest and is charged with the fiduciary responsibility. The word ‘fiduciary’ as per the Webster’s dictionary means ‘unwavering’, ‘trustful’, ‘undoubting’. The fiduciary responsibility in the context of the purpose of organization—wealth creation, wealth management and wealth sharing—would include optimal management of an enterprise in the best interest of all stakeholders and its sustainability, as fiduciary owners are expected to hold it in trust even for the future generations of stakeholders. They have to be unwavering, trustful and undoubting irrespective of the temptations, coercions or undue influence. The role as also the accountability of the board flows therefrom. The corporate board is expected to provide superintendence to the functioning of the management. It is their mandate to ensure that the company and the managers operate to optimize wealth creation, wealth management and wealth sharing. At the apex level, it is also board’s remit to create institutional framework potent to check frauds and seeping out of resources and also ensure the exit of incompetence. Hence, the board has to provide a vision and direction and create systems and processes along with instrumentalities to ensure that various elements in the company operate in tandem and do not fall off the responsibility frames. Unfortunately, however, the track record of the board’s role can at best be described

Boardroom Practices  75

as mixed. Every misdemeanour in a company, fall or demise of the enterprise, is being attributed to the failure of the board, albeit vicariously in some cases. The role of the board has come into serious question in the minds of the regulators, market and the investing public at large. In the current setting, corporates (JSC) are the engine of economic growth and most important instrumentality of capitalism. The concern of the market and investing public and also that of the regulators has drawn the attention of the academics who have questioned the utility of the BoD itself and an alternative has been proposed. Stephen Bainbridge of the University of California, Los Angles and Todd Henderson of the University of Chicago, in the May 2014 edition of the Stanford Law Review, have proposed the replacement of the individual directors of the boards with professional services firms. It is not only the impression of individual fund managers like Larry Fink, boss of Black Rock, who attributed the financial crisis of 2007–2008 to the failure of Corporate Governance, it is being increasingly believed that the boards did not ask the right questions. In fact, the disease is deep rooted, and the root cause of ailment is the boardroom practices. If the institution of JSC has to live up to the expectations of the economy, Corporate Governance has to be improved first. The efficacy of governance can be built only on the bricks of boardroom practices. Creating a conducive environment can be facilitated by a number of steps and activities, which will be the subject matter of discussion in this chapter. Before I begin enumerating what needs to be done, it is important to appreciate that the CEO and the chairman, as well as individual board members, have to buy in that the processes enumerated could only be the facilitating elements and it is they who will have to make the boardroom a place where superintendence of the company is at its best. The processes can be described as the rituals (observed in every religion, in particular, Hinduism) as a preparation to work on the real act, ‘welfare of all stakeholders’ via the meditation— meaningful discussions. However, the travesty of Corporate Governance is that in most organizations it ends in rituals and even if some meditation takes place, it turns out to be elementary. This is how prescribed regulatory rituals look like tyranny

76  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

rather than facilitating processes for the fructification of the ultimate purpose.

8.1. Composition of a Board The CEO and chairman, majority shareholders and even some of the backseat drivers are accused of packing the boards with cronies. The latest example in India is the induction of a lady director. In many boards, so far, an inactive lady (housewife) in the house of the majority/controlling shareholder is being inducted in the board as compliance to the recent regulatory direction. Expecting significant contribution from such directors will be a mirage and most likely the purpose of inducting a woman on the corporate boards as a regulatory dictate will be frustrated. The journey of creating conducive boardroom practices begins with the composition of the board. Although various regulatory jurisdictions have laid down obligatory/voluntary guidance in the matter of the composition of the board including the proportion of independent and non-executive, which have to be necessarily followed, my idea of the composition of board emanates from the role of the board itself. To be able to provide effective leadership and superintendence the board must have talent, youth and maturity, men and women, courage and conviction, and dedication and integrity. I would like to strongly argue here that integrity is of two kinds—financial and intellectual. While financial integrity is important and, hence, is necessarily to be ingrained in an individual, intellectual integrity is equally important, if not more. Financial dishonesty may cause a damage which may be possible to recover, whereas intellectual dishonesty has often dealt a body blow from where even the societies are not able to recover, let alone the companies. The test is whether he will be able to stand up and be loyal to his own self, be not persuaded or cowed down by the influence of others, in particular, controlling shareholders/ management. Furthermore, on a broader frame, it is important to assess whether the prospective director is able to think strategically, will have bandwidth to apply himself—engage incisively and add value to the boardroom. It is also essential to find out whether

Boardroom Practices  77

he/she is a team player and has inclination to collaborate and stands by the discipline. ‘Get people you believe will help in value creation’, says Anand Mahindra, Chairman of Mahindra Group. The composition will also depend on the kind of business the company undertakes. It is important that the BoD comprises of persons from a variety of fields so as to assemble a diversity of skill sets in the boardroom. Diversity is of two kinds: (a) of different academic and intellectual background and (b) of different levels and kinds of experience, that is, not from operations alone. It could be in academics, policy planning or regulation. It is very difficult to define or outline the various kinds of the skills that are definitely needed in a company board. However, it is being increasingly believed that the following skills must be present in the boardroom: 1. Skills to manage the core business of the enterprise. 2. Skills to understand finance and economics. 3. Knowledge of laws and the skills to help compliance. It is absolutely necessary that every boardroom has independent director(s) who understands the business that the company/ enterprise is engaged in. This is essential for the following reasons: 1. It helps the management in bringing an outside view of the business of the enterprise and vigil to prevent tunnel vision seeping in the management of the affairs of the company. 2. It challenges the management’s assumption, efficacies of operations and efficiency levels. ‘I believe the Board should be representing various constituents of business; accounting, legal, Customer framework. Create a Board with multi-disciplinary skills and use the wisdom of Board’, says, Kishore Biyani, CEO, Future Group. The presence of such skills in the boardroom will greatly help in validating the management thinking on various underlying assumptions, propositions and impact thereof in the journey forward. In the absence of such skills, the board will not be in a position to fully appreciate the propositions of the management and the probable direction that the company may be led to. This

78  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

happened in the case of Equitable Life of UK, a one-time great life insurance company, which eventually underwent. Every enterprise functions and succeeds in the backdrop of the macro as well as micro environment in the geographies that it operates in, and also global trends. It is, therefore, important that the boardroom has person(s) who has good knowledge and understanding of the global as well as domestic environment. This is necessary to forecast various probabilities and then look at the direction and annual budgeting and so on. Knowledge and understanding of finance in the boardroom is very essential. This helps in interpreting the various financial statements and observance of the accounting standards including the treatment of various transactions and financial reporting. The lack of understanding of finance may greatly handicap the board in building confidence on the fidelity of the various financial statements as also the independent judgment of the board will be missing, which can cause a serious blow to the confidence of various stakeholders of the company. It is important to remember here that the board is ultimately responsible for the management of the affairs of the company. Hence, the ability amongst independent board members to understand and appreciate and also challenge, if needed, the authenticity of the various financial statements is imperative. Such skills are generally available amongst the persons who have the background of finance by qualification and/or experience. It helps if the board has a person who has a legal background and has experience and skills in evaluating the compliance which has assumed serious proportions. Inadequacy of the quality of compliance can bring not only regulatory onslaught but also disrepute to the company. Hence, there can never be a compromise in maintaining high standards of compliance. It, therefore, greatly benefits the company and the board if there is an independent director who is able to help the management and the board in ensuring the quality of compliance. In India, the Companies Act, 2013 enshrines the induction of a lady board member. I would even otherwise articulate that every board must have at least one lady member so that she not only brings the feminist perspective but also helps the company in targeting its customers from the segment of fair sex. It is quite

Boardroom Practices  79

possible that there can be a lady member who has skills either in the core business of the company, finance and economics, and/ or legal and compliance. Hence, it would not be necessary to have a director of those skills, which the lady director possesses. ‘We have quite a few women on our Board, have always been very helpful specially since we are marketing oriented group. They have added lot of value’, remarked Adi Godrej, Chairman, Godrej Group. I would like to argue that the position of the chairman and the CEO should not be combined. It is not only helpful but also desirable to have non-executive chairman who can provide some kind of supervision to the activities of the management led by the CEO. Ideally, the number of board members should be in the range of 10–15 because at least 10 will have enough space for getting the talent and a limit of 15 will maintain manageability. While deciding on the board members it is important not to pack the board with senior citizens, which often is the case in most geographies. It is important to have youth and energy in the board so that varied thinking and risk taking remains one of the traits of the board. It has been my experience of sitting on the boards of a variety of companies—public and private, finance, steel, cement, chemicals to realty to consumer goods and public utilities—that the most important consideration is the imminence of the persons and/or their closeness to the majority shareholders. Subjective selection of board directors builds the foundations of non- or inadequately performing boards and value creation and protection takes serious beating. In the interest of all stakeholders, the composition of the board must receive utmost focus, where objectivity must supersede all other considerations.

8.2. Sourcing of NEIDs Normally, the directors are selected from amongst the friends, relatives and known persons’ group. This obviously brings to the board familiar faces that have—either directly or indirectly,

80  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

through friends and relations—some kind of understanding, affinity and/or relationship. Selection of directors from such a pool brings in the familiarity and also the strings of subjectivity. Out of sheer respect/regard/consideration for the chairman and/or MD/CEO, they will hesitate to put across, in particular, divergent points of view eventually defeating the very purpose of having independent directors. Here are some ideas for the selection of the independent directors: 1. Persons of eminence, knowledge and skills from fields deficient in the current configuration of the board who have achieved some level of excellence or a high degree of proficiency in that field and have enough time to engage in the role of an NEID. 2. Persons known to be of independent thinking, in particular, who uphold intellectual integrity in addition to financial. 3. Persons already known or with whom some kind of relationship exists should as far as possible be avoided. 4. Drawing persons out of a database maintained either by the private parties or regulators does not serve the purpose because of the very fact that these people filing their data indicates they are seeking appointment as independent director. In fact, the situation should normally be contrary. It should generally be offered to such persons who are not prospecting for joining a board because such aspiration is always with the expectation and lands in with the limitations of free expression in the board. Here, I am reminded of an incident. Post my superannuation from the government job of SEBI Chairman, I was addressing a forum. During the question and answer session, one of the gentlemen asked why he is not being offered an independent directorship. He hastened to add that he has filed his curriculum vitae (CV) in the database maintained for the purpose and paid the entry fees as well. He also requested whether I could recommend his name. This smacks of expectation. Although to

Boardroom Practices  81

get compensated for doing the work of an independent director is fair and necessary, he should not begin with that expectation or a precondition. 5. Some companies enlist retired (a) senior civil servants and (b) top public sector enterprises’ managers. Although these people do offer a pool of skills, there should be a sagacious process of the assessment of their skills and approaches rather than just seeing their name or as a quid pro quo for past relationship. Furthermore, it has to be assessed how they keep themselves updated with the latest developments and are not rooted in the past. 6. There are agencies which specialize in the work of independent director placement. It might be helpful to engage their services, provided, however, that these agencies have a reputation of professionalism, they do not get either directly or indirectly remunerated/benefitted by the persons who they recommend for appointment as independent directors and also that they build a database on their own and do not invite people to file their CVs with them. Collecting CVs should be an exercise undertaken post initial shortlisting and possible engagement. 7. The best way would be to first identify the skill gaps in the board, prepare a list of eminent persons in the fields required to be included/replaced in the board, make a shortlist and hand it over as required by the law, now to the Nomination and Remuneration Committee, to scrutinize their candidatures, prioritize their names and the chairman of the Nomination Committee reaches out to them for consent post selection. However, before the nomination is actually recommended by the nomination of the Committee it must meet those people, have some kind of discussion to understand their attitudes and approaches so as to ensure they fit culturally and he/ she has those skills that the board needs. In fact, it is not desirable to just approach a person of eminence, ability and proficiency in the line of the skills desired and offer him the directorship. The assessment of the personality

82  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

is very necessary, also it is important for the person being assessed to build his own understanding about the enterprise, people behind the enterprise and other board members. I have insisted on doing that exercise myself wherever I have agreed to be on the boards. 8. In fact, successful CEOs, CFOs and even the presidentlevel executives of the prominent companies could be a good source of identifying talent. These people are currently beating the competition, charting out growth paths and weaving success stories in their respective companies and will have an urge to learn and play a value creation role as a board director of another company. However, while approaching an identified candidate, it has to be remembered that every successful company’s CEO, CFO or president may not be a suitable candidate for the board positions, because success is made of various elements where he might be merely a cog in the wheel. Furthermore, competent and successful amongst them would insist on being engaged so that they add to their learning and acquisition of new knowledge and skills. In fact, their employers should view this as their enrichment. ‘I think it helps to build their personality, character, vision, broad mindedness eventually better human being’, observes Deepak Parekh, Chairman, HDFC Group. Sourcing and undergoing the process of assessing their suitability is fundamental to the process of recruitment of independent directors. Hence, the entire exercise of sourcing and selection must be thorough and objective. It will be desirable to avoid persons with following attitudes: 1. Who have a negative approach to life. 2. Who are known not to function as a team member. 3. Who are/is a close family/friend of the promoters and/or the placement agencies’ managers. 4. Who do not have enough time to spare or will not provide enough commitment to this role. I have seen board

Boardroom Practices  83

directors updating themselves with the news, replying to mails or catching with an unfinished task on iPad, phone and so on in the midst of a board meeting. Such conduct expresses a lack of commitment and interest in the affairs of the company. 5. Previous experience of sitting on the board, though helpful, should not be considered as a prerequisite for selection. Narayana Murthy, Chairman, INFOSYS, says: People who do not need to be on your board, people respected by the community, people who will tell you that the decision company is trying to take is not a good decision for the company, are the people to be recruited to be on the Board.

Getting a person on the BoD is an invitation and not an offer to an application. Too eager amongst the candidates should be looked with an eye of scepticism and intentions assessed. Good candidates need persuasion, which has to be orchestrated well. I had refused one of the invitations to join the board of a prominent company because I was not very much convinced from the conversation with the chairman as to how was I going to add value. To me, it smacked of encashing more my standing than the skills and talent, which might have prompted the invitation. The entire exercise has to be organized and conducted very sagaciously to get the right talent, skill, experience and attitude on the board.

8.3. Integration of the Board Members Every board member who joins the board must be given adequate briefing about the business of the company, its vision, mission, values and cultures. He should also be briefed about the strategic approaches the company is currently pursuing and in case he joins in the middle of the financial year, he also must be educated about the budget, its contours and rational thereof. In fact, it is desirable to create some kind of a template, which will help in the induction of a new director of the company. ‘Induction into a Company Board calls for a visit to factory, presentation

84  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

of different divisions, meeting people outside Board at least 6–8 people in a large Company’, suggests Deepak Parekh, Chairman, HDFC Group. In case the company happens to be a manufacturing company, a visit to the manufacturing site(s) must be undertaken. This will enable the new entrant to understand how the manufacturing facilities are operating and in case he happens to be one who is not an expert in the core business of the company, he will get some education about what the company manufactures and how. In case it is a services company, he must be taken to some of the service outlets, so that he is able to understand the functioning of the organization. It is important that, along with the aforesaid, he is properly introduced to the heads of departments (HODs; one step down the CEO). This introduction must include who they are, whom do they report to and how do they normally operate. In fact, it will be helpful if each of the HODs makes a brief presentation about himself, job profile and from where and how he operate. This induction session should not be allowed to become a monologue. Newly recruited directors must be allowed and encouraged to ask questions and seek clarifications so that the understanding is built. Direct contact of the director with the HODs helps in validating the information provided by the CEO, which prevents CEO from presenting filtered, inadequate and/or biased information. On the positive side, it makes directors more accountable. Unfortunately, in most companies in India, there is a kind of hesitation on both the sides—CEOs and HODs. This will help the new inductees to rise up to the frequency in which the management, board and its members discuss the various agendas. In fact, this exercise of bringing up to the speed for each of the new board members is not undertaken in most of the companies, and as a result thereof the new board member slowly acquires knowledge and understanding about the company, people and its systems and processes and, oftentimes, his understanding is at variance with the understanding of the other board members. The net result is that the new board member is not able to contribute optimally and sometimes his inputs are not very relevant, in particular, to the strategic approaches that the company pursues. In fact, I have watched the new board members trying to suggest

Boardroom Practices  85

ideas and strategies which are either not relevant or have been discarded during the journey of the enterprise. I believe that this exercise should be conducted within the first two months of his joining and preferably before he starts participating in the board meetings. In one of the companies where I used to be a board member, I (despite being the director of the company for just a year then) was invited along with other newly inducted directors to the regional headquarters (HQ) of the overseas acquirer of the controlling stake for a briefing about the company, its business and the contours of its management. On reaching the office next day, we were informed that the regional head had to be away and that the briefing will be done by his deputies. The quality of the briefing took a serious knock and more so the seriousness of the exercise became a question mark. Although hospitality was appreciable, the event looked like a box ticking of the decided programme. It is important to appreciate that this induction is an enabler to enhancing the contribution of the newly inducted directors and not an exercise in completing a procedure. Hence, it has to be well planned, organized and delivered. Furthermore, the exercise of induction is over and above the training and education of the persons becoming director for the first time. Such a programme has been mandated as an obligation in some of the jurisdictions and voluntary in others. I do believe that the training and education of directors on the role, responsibility, statutory obligations and the protection and so on is a must and that every director who has not been serving on the board earlier must go through it atleast once. Fresh training will be necessary if he joins a new company, which is regulated in a different jurisdiction. There are standard courses run by several academic institutions and credible organizations and even individuals. However, in the interest of the quality of learning, it is important to attend the programme run by credible organizations and not by self-seeking individuals whose credibility to impart such a training and education is not well established. Furthermore, in the first few board meetings, new directors should be treated with greater attention and allowed to ask questions howsoever insignificant those may be and answered with

86  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

the consideration of newness. They should not be subjected to an overwhelming influence of long-standing directors. It happened so in one of the boards of eminent persons. I had to force myself—even though I was comparatively young, rather new to the role of director on the board of a fairly large company—and make my voice heard. However, every new director may not be as audacious and therefore it becomes the responsibility of the chairman to assimilate him in the team as equal. Once he gets going, he will be on his own and will surely contribute optimally.

8.3.1. Social Integration of a New Board Member It is helpful to organize, as quickly as possible, some kind of social events such as lunch/dinner, outing to break the ice and help him to open up informally as well. This social integration helps the newly inducted director to broadly understand the people and their mindsets, enabling him to proffer his inputs without any reservation. In quite a few companies, the relationship between the management and board members is formal and no occasions are provided for them to interact informally, which leaves a distance in building coherence. Immediate impact of this gap is the hesitation of the board members in reaching out to the HODs directly to seek any clarification and/or information which he/she may need to better understand the agenda items and/or cross-check the efficacy of the ideas that are brewing in their mind, which he proposes to voice in the board meeting. There is no gainsaying the fact that information, albeit full and comprehensive, is necessary for the application of mind, in particular to the ticklish issues which may have far-reaching consequences and also to think of solutions to deal with those issues. In one of the companies, where I had an occasion to sit for more than two years, which belonged to a respected business house, I did not have any occasion to socialize either with the chairman, MD and CEO and/or the HODs. This left a void of understanding between me and others. In fact, until I became the chairman of SEBI, the chairman and/or CEO never met me outside the boardroom. Whenever I asked for an appointment from the chairman’s office,

Boardroom Practices  87

I was told to wait. It is another thing that the same office would pester my office (SEBI Chairman’s office) for an appointment for their boss, the chairman (from whom I could not get an appointment), which I made sure was promptly granted. The chairman, the directors and the management have to work as a cohesive team, which cannot be enabled in the formal meetings of the board alone. Some amount of familiarity and friendship has to be rooted in, which is facilitated more by informal meetings and discussions.

8.4. Role of the Chairman The chairman of the BoD, whether executive or non-executive, has a definite, singular and important role in addition to his role as the director of the company. The role can be broadly categorized into five parts: 1. 2. 3. 4. 5.

Designing of the agenda Minutes of the meetings Conduct of the board meeting Conclusion of the board meeting Building and maintaining an environment of cordiality, commitment and contribution

The leader of the board—the chairman is the central figure in the boardroom around whom all the boardroom practices oscillate. Hence, the success of Corporate Governance effort in most cases is proportional to his abilities to manage the boardroom environment. ‘The success of a Chairman is to listen to them patiently, take their points into consideration and do what you think is right’, says Deepak Parekh, Chairman, HDFC Group. A chairman has to be a patient listener, strategic thinker, good communicator, team builder, quick segregator of content from mere sounds and fury and creator of harmony out of disagreements. Some of the qualities which enable an individual to ingrain all the previously mentioned qualities could be (a) a successful past, which imbibes both self-confidence and appreciation of others’ views and abilities, commands respect and also has the experience to handle uneven

88  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

events and situations; (b) ability to manage relationships—building cohesiveness requires personal relationships and bonding, which is so essential for a bunch of intellectual, experienced and successful people to eventually converge their differing points of views into a consensus; (c) having time and commitment, which enables him to engage the management into presenting a quality agenda and the board members (even outside the boardroom) to challenge their wisdom, skills and experience into working out strategies and solutions to intractable issues; (d) humility to share the credit equally with the management and directors and (e) being decisive enough to conclude all the debate of even divergent views on an agenda into an implementable direction to the executive management. 1. Designing of the agenda: The quality of the agenda defines the success of a board meeting. In case the agenda has not been designed well the success of the board meeting cannot be ensured. Designing of an agenda has been covered later in a section of this chapter, in which the role of the chairman in the designing and drafting of the agenda has also been outlined. It is important that the chairman assumes full responsibility in the designing of the agenda for the board meeting. 2. Minutes of the meetings: Minutes of a board meeting are a record of what actually happened in the board meeting. It is the minutes that stand the test of time and scrutiny of law as to the decisions taken in the board meeting and also the role played by various board members. It is, therefore, important that the minutes are recorded accurately and comprehensively. Although it is not necessary to record the proceedings of the board meeting verbatim, nothing important that has been discussed and decided in the board meeting should be left out. The subject of writing the minutes have been dealt with in another section of this chapter. However, it is the responsibility of the chairman, who not only authenticates but signs the accuracy of the minutes as well to ensure that the minutes are properly recorded.

Boardroom Practices  89

3. Conduct of the board meeting: The real role of a chairman comes into play during the course of the board meeting. The chairman must be able to do the following: i. Ensure the participation of each of the board members present in the meeting. ii. Every member has an opportunity to put his point of view without hesitation, disturbance and truly without rancour. iii. Ensure that there is a healthy debate. iv. Build a consensus on a decision if there are conflicting views on any item of the agenda. v. Ensure that the meetings are orderly and discussions are friendly.   The chairman should neither be very aggressive nor very docile. He must at all times be in command at the meeting. He should be in a position to not only moderate the discussions but also ensure that the discussions remain on track and do not lapse into serious digression. It does happen sometimes that some of the members of the board have a habit of fiddling with mobile phones, iPad, laptop, indulging in side talks, monopolizing the discussion or running away with the agenda. Neither of this should be allowed to happen and the chairman must politely, yet firmly, bring everybody to attention and the discussion on the tack of the items and issues on the agenda.   In any good board, some conflicting views are expected on at least some of the items of the agenda. The chairman should neither disallow nor allow a disproportionate time and attention to one kind of views. It is his duty to make sure that the various points of view are brought to the table forthrightly and in an atmosphere of understanding and goodwill, while the expression of divergent views obtains with free will. The chairman should neither become overbearing nor a mute spectator. In one of the boards, where I had the pleasure to sit, the chairman hardly allowed anyone to really discuss an item. I

90  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

once made light of the situation by remarking that this 11-member board (on that day, 11 directors were present) team has only one batsman. The board burst into laughter. In another board, the chairman hardly spoke and it used to be free for all while the chairman sat fiddling with his electronic gadgets.   A chairman must ensure that the management is in a position to present an agenda item well and provide all the information and data necessary for the consideration of the members. The management should not be prevented or short-circuited in detailing the various aspects of an agenda item, its issues or the impact thereof. However, the chairman must ensure that the management does not flood the board members with presentations, data and statistics leaving very little time for the board members to react and discuss. In fact, since the agenda would have been circulated well in advance—essential as a good governance practice—the presentation of the management must be concise to very briefly highlight the issues involved and/or the areas where the decision is to be taken. It is pertinent to mention here that I had the experience of well-known financial institution’s board meetings, where 90 per cent of the time was spent in making the presentations by the management and out of the balance 10 per cent time, the chairman did the talking. Notwithstanding, the fact that the board comprised of very eminent persons from various fields, very little discussion on most of the items was held, thus, depriving the company of the benefit of the experience, knowledge and understanding from a variety of fields of the board members present. One of the reasons was that the chairman was overbearing and most of the board members had respect for him and the Chairman did not like the directors to butt in unless specifically requested to do so. I had an experience of yet another company board, where the chairman allowed the company secretary and MD to play his role. Consequently, the board meetings became a kind of farce and very little quality discussions

Boardroom Practices  91

were ensured. A chairman must ensure that time is not a constraint for meaningful discussions, and also that time is not wasted unnecessarily.   It must be remembered that it is not only the quality of the members of the board in the boardroom and/or the quality of an agenda, which determines the quality of Corporate Governance. In fact, it is the boardroom discussions which determine the quality of governance and here the role of the chairman becomes most important. 4. Conclusion of the board meeting: It is important that the board meeting ends with clearly summarized decisions on each of the items, so that the management is left without any doubt to execute the decision. In case this summarization is not done the management will have the option and/or the confusion to interpret the decision of the board, often the way they would like, which is good neither for the company nor for the quality of Corporate Governance. It is the role of a chairman to summarize the decision taken at the end of each item of an agenda and finally at the end of the board meeting.   The chairman must also, before concluding the board meeting, invite every board member to raise any issue, if he/she likes to. This opportunity must be provided to ensure that no important item that either the management or a board member considers urgent is left to be taken up and/or no issues of serious attention and consequence are left unaddressed. This is possible only if the conclusion of the meeting is not hurried up, which often is the case in many board meetings. I have been watching the board meetings and have found that in most of the board meetings, it is the company secretary who says that the agenda is over, whereas it is the chairman who should. Having surveyed the situation and pronounced that no item is left to be covered and that no member wants to raise any issue, the meeting comes to a close.   The role of a chairman is singular and catalytic, which, if rendered inefficiently, frustrates all the efforts that

92  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

have gone into the preparation of the board meeting and regulatory directions and concludes into poor Corporate Governance and less-than-optimal value creation.

8.5. Role of a Lead Director One of the significant developments in strengthening Corporate Governance is the growing recognition of the role of a lead independent director, which is being used as a valuable mechanism for enhancing the independence and effectiveness of boards. The most significant factor driving this trend is of moving Corporate Governance to a next level of optimal value creation. The amendments in Clause 49 of the listing agreement (now transformed into regulation) in the Indian capital market, made effective by the regulator—SEBI from 1 October 2014, envisages the appointment of a lead independent director as an obligation. It is my belief that a lead independent director can play a very important role in aggregating the views of independent directors and provide a pragmatic approach to the leadership structure. In case there is an executive chairman, the significance of the lead director grows tremendously. However, even if there is a nonexecutive chairman but represents promoter group/entities, the lead director can play a significantly useful role. In fact, in every board, there are certain items which the management and the chairman are interested to discuss and debate on, while there are other items which are postponed and/or not taken up at all. In one of the recent board meetings of a company where I used to sit as an NEID, I had to effectively make a point that for the whole year the board meetings have been logged in appraising only the performance of the company, and the review and formulation of the strategy has neither been brought on the agenda nor discussed. It took some time and a bit of impolite discussions before the management could be convinced that this is essential and will be useful. However, the same was brought only once till I quit and that too perfunctorily. I had to describe to the discomfort of MD and CEO and majority shareholders’ directors as ‘work-in-progress’.

Boardroom Practices  93

Furthermore, in the absence of a lead director, no time is allocated to a free forum or what is called blue sky discussions about the business of a company and its prospects. It is my view that the institution of a lead director can enhance the engagement of NEDs and help improve the quality of the board agenda as well as the discussions. Possibly, it will enable the directors to ask better questions and the board meetings would become much more productive. Surveys conducted by various agencies have revealed that with the appointment of a lead director and his playing an effective role, the communications inside and outside the boardroom between the directors and between the management and directors have improved significantly. In fact, the institution of a lead director can prevent a management from providing a ragtag set of agenda papers and also the recommendations. It helps in better summarizing and transmitting the decisions taken. The institution of a lead director helps in the following areas: 1. Enhancing board independence: The lead director can serve as a communication link for a large body of stakeholders and provide a valuable counterweight to the chairman of the board, an effective response to the calls for greater board independence. Independently, this institution can also play the role of aggregating the views of the independent directors and add pragmatism to leadership approaches. 2. Efficacious meetings of the board: Since the lead director works with the chairman/CEO in planning the board meetings and ensuring the agenda papers, the appointment of a lead director in most cases have helped in improving the quality of an agenda and thereby improving the efficacy of the meeting. 3. Freewheeling discussions: The institution of a lead director can help in the allocation of time for freewheeling discussions about the company and its future. Some management pundits call it blue sky discussions and, according to me, this is very essential not only in looking at the new horizons but also in engaging the wisdom of the board and deciphering unfolding opportunities for the company.

94  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

It is important to identify the right person to ensure the effectiveness of a lead director. The first and foremost quality is the mindset to the task, which is to help the company to succeed and the CEO/Chairman to be the winner, and acts as a building block for a constructive relationship. The person to be chosen must care for the spirit of the board and exhibit extraordinary commitment to integrity, loyalty and equanimity. He has to be someone who performs the role with candour and makes people feel safe about asking the tough and proverbial ‘dumb’ questions. He has to possess communication and facilitation skills. He must be able to convey reservations and concerns effectively without sugarcoating tough messages, of course everything in the interest of stakeholders of the company. In fact, a lot of diplomacy is involved in the role. Globally, the following roles are being assigned to a lead independent director: 1. 2. 3. 4.

Communicating with the CEO/chairman Helping to organize board meetings better Running/NEDs sessions Evaluating the performance of the directors

Hence, it is desirable to designate one of the independent directors as the lead director.

8.6. Retirement Policy—NEDs There is a forced (statutory) retirement policy in some of the regulatory jurisdictions including India now, which has to be implemented. However, an independent policy should be crafted by a company for the ease of exit of the non-performing directors. This is very important to ensure that longevity, which breeds familiarity, does not result in a friendship that is detrimental to the independence and overall impact on the performance of the boards and, thereby, the benefit to the company. The exit/disengagement of a director is not a very pleasant event, particularly if the association has been prolonged. In India, most of the majority shareholders’ directors/representatives

Boardroom Practices  95

consider it embarrassing or impolite to not renew or request a director to quit, notwithstanding the fact that the director due or needed to retire has become ineffective because of age, health and/or not being able to keep up with times. Mr Deepak Parekh, Chairman of HDFC Group Companies, being a very polite, gentle and ebullient promoter of efficacious Corporate Governance, faces the (only) criticism of long-standing and ageing directors on his board from the global investors, in particular. Once there is a policy, the heartburn in the exit of a director will be minimal because it will be applied uniformly. For example, some boards have a policy of retirement at the age of 75, when even the owner directors and executive directors also retire. The policy must include consideration of the annual performance appraisal of the NED, which has been discussed elsewhere in the book, and in cases where performance is less than expected, retirement must be a natural concomitant. During my long association with financial markets and participation in the boards of a variety of companies, it has been observed that some of the board members have been continuing for several decades. While one may not question the wisdom or the quality of participation of long-serving NEDs on the board, it is important to appreciate the relevance of fresh thinking. The longevity of association builds rigidity, stereotype and conventional thinking. Even a fuller application of mind in the face of repetitiveness becomes a question mark in the case of longserving NEDs, which I have observed in some of the prominent company boards where I had the occasion to serve. The environment inside the company, outside in the market and in the industry as well as global environment is undergoing unremitting transformation. It is, therefore, important to ensure that the company does not get logged in the cobwebs of a tunnel vision. This can be obviated only if, periodically, persons with different thinking, skills and knowledge are inducted in the board. I am strongly of the view that after a certain period of time, which the board can specify, new directors are inducted and the long-serving directors are moved out. To undertake this process objectively, exit policy merits a serious consideration. I consider this to be a value enhancer and, therefore, must be done, albeit pragmatically.

96  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

Since the 10-year rule—two terms of five years each—has been made applicable under the Indian legislation and regulatory framework, it might be helpful to replicate the same even for the non-executive non-independent directors. Furthermore, the annual review of the performance of such directors must be much more rigorous and the exit policy must incorporate the exit for inadequate contribution. The exit policy must ensure that there is an ideal mix of risk taking proclivities—youth and maturity—experience. However, it must safeguard against risk-taking turning to adventurism and maturity into salinity. Most organizations use the tools of exit policy to manage such risks, which I consider to be significant, as it can retard the sustainability of growth and, sometimes, even threaten the survival of the enterprise.

8.7. Allocation of Role and Responsibilities Between the Board and the Management The shareholders of a company elect the BoD to manage the enterprise. It flows there from that the overall responsibility of the board is to operate and manage the business of the enterprise, create value and share with stakeholders appropriately. The board is assisted in its responsibilities by the management team led by the CEO. The board from time to time delegates responsibilities to the management to run the operations of the company on a day-to-day basis and produce the expected outcomes. This entails that the management functions at the pleasure of the BoD. However, for the management to function effectively, it is important that the delegations are properly made, documented and circulated. It has often been observed that the BoD replicates the role of the management in the conduct of the business of the enterprise. This does not bring about optimal value creation because of less than fuller and better utilization of time and talent of the management and board. Although the BoD is ultimately responsible to its stakeholders for management of the enterprise, creation and sharing of wealth, it is important that there is an efficacious allocation of responsibilities between the two pillars in building

Boardroom Practices  97

the edifice of a successful enterprise. Over a period of time, this principle of the allocation of role has been accepted across geographies and segregation of responsibilities has been evolving constantly. In fact, in most countries the regulatory frame, either through the legislation or subordinate legislation, outlines the role that the board is expected to play in managing a company. It might be worthwhile to visit some of those enunciations in the various regulatory jurisdictions. Although it might be useful to know and understand about the entire range of jurisdictions, for the reasons of keeping the elaboration less lengthy, it is proposed to mention here just about ten jurisdictions, as elaborated in the following sections. These nine jurisdictions, put together, by and large represent the world.

8.7.1. Australia As per the various regulatory guidances issued by the Australian Securities Exchange (ASX) Corporate Governance Council and the Australian Securities Commission, the board of a company in Australia is expected to provide strategic guidance, monitor operations’ performance and ensure that adequate policies and processes are in place to guarantee the quality of companies’ risk management and internal controls. The board also appoints and removes the CEO and company secretary, reviews the performance and determines their compensation. The board, with the help of the company secretary, is expected to ensure compliance with relevant laws, regulations and codes of practices and so on.

8.7.2. China In China, which has a two-tier system—BoD and supervisory boards, the BoD is accountable to shareholders and creates a framework which helps the directors to perform their obligations under the law. There is no more classification/clarity about the allocation of roles and it is possibly left to the board to decide the allocation between the BoD and the supervisory board.

98  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

8.7.3. France In case of France, the board’s mission is to define corporate strategy, decide the organizational design (i.e., whether the chairman’s and chief executive’s roles are separated or combined), appoint corporate officers, monitor the management and ensure that the shareholders receive correct and transparent information.

8.7.4. Germany In Germany too, there is a dual board system—the management board and the supervisory board. The supervisory board is compulsory and its role is governed by the general Corporate Governance board, which defines the role as follows: The supervisory board appoints, supervises and advises the management of the company. Although the supervisory board does not interfere with the day-to-day management of the business, certain categories of transactions may be subject to the supervisory board’s approval. The code calls for the supervisory board to take a more active role and to determine the level of information and reporting requirements jointly with the management board.1

In fact, the management board is primarily responsible for the executive management of the organization with all the powers of day-to-day functioning and the supervisory board, which also has a representative of workers, is concerned only with macrostrategic decisions.

8.7.5. India In India, the role of the board was outlined by the Birla Committee (appointed by SEBI) report, which states that the board ‘directs Prof Dr Theodor Baums. Corporate Governance in Germany—System and Current Developments. Universität Osnabrück. Available at: https://www.jura. uni-frankfurt.de/43029805/paper70.pdf (accessed on 30 May 2016). 1

Boardroom Practices  99

and controls the management of the company and is accountable to the stakeholders’. In the words of Birla Committee report: The board directs the company by formulating and reviewing the company’s policies, strategies, major plans of action, risk policy, annual budgets and business plans, setting performance objectives, monitoring implementation and corporate performance, and overseeing major capital expenditures, acquisitions and divestitures, change in financial control and compliance with applicable laws, taking into account the interests of stakeholders.2

The board is expected to manage the company by laying down the code of conduct, overseeing the process of disclosure and communications, ensuring that appropriate systems for financial control and reporting and monitoring risk are in place, evaluating the performance of management, chief executive, executive directors and providing checks and balances to reduce potential conflict between the specific interests of management and the wider interests of the company and shareholders including misuse of corporate assets and abuse in related party transactions.

Finally, the board is accountable to the shareholders for ‘creating, protecting and enhancing wealth and resources for the company and reporting to them on the performance in a timely and transparent manner’. It is, however, the management’s responsibility, not the board’s, to run the company everyday.

8.7.6. Italy In March 2006, the Corporate Governance Committee promoted by Borsa Italiana published a new code according to which the role of the board is defined as follows: The board examines and approves the company’s strategic, operational and financial plans, evaluates the adequacy of the company’s 2 Report of the Committee Appointed by the SEBI on Corporate Governance under the Chairmanship of Shri Kumar Mangalam Birla. Available at: http:// www.sebi.gov.in/commreport/corpgov.html (accessed on 30 June 2016).

100  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE organisational, administrative and accounting structure and internal controls, and delegates powers to executive committee, if one exists. The board also determines the remuneration of directors, monitors conflicts of interest, supervises the general performance of the company, evaluates the size, composition and performance of the board and its committees at least once a year, and issues an annual corporate governance report which, among other things, must show the related percentage attendance of each director.

The board is also responsible for examining and approving in advance the transactions that ‘have a significant impact on the company’s profitability, assets, liabilities or financial position’ (including, in particular, those involving the related parties). It is up to the BoD to establish general criteria for identifying such transactions.

8.7.7. Singapore The governance code of Singapore defined the board role as follows: [T]o provide entrepreneurial leadership, set strategic aims, and ensure that the necessary financial and human resources are in place for the company to meet its objectives; to establish a framework of prudent and effective controls that enables risk to be assessed and managed; to review management performance; to set the company’s values and standards; and to ensure that obligations to shareholders and others are understood and met.3

8.7.8. South Africa The role of the board has been outlined as follows: The board provides strategic guidance, monitors operational performance and ensures that adequate policies and processes are in place to Code of Corporate Governance (2 May 2012). Available at: http://www. mas.gov.sg/~/media/resource/fin_development/corporate_governance/ CGCRevisedCodeofCorporateGovernance3May2012.pdf (accessed on 30 May 2016). 3

Boardroom Practices  101

guarantee the quality of the company’s risk management and internal controls. The board appoints the Chief Executive Officer (CEO), as well as other executive directors, and is responsible for the CEO succession process. The board, with the guidance of the company secretary, ensures that the company complies with all the relevant laws, regulations and codes of business practice. It communicates all material company issues to the shareholders openly, promptly and usually at the annual general meeting. The board is in essence responsible for the performance and affairs of the company and any delegation of authority to board committees and/or management does not absolve it of its duties.4

8.7.9. United Kingdom According to the Combined Code (2003), the board should ‘provide entrepreneurial leadership of the Company, within a framework of prudent and effective controls which enables risk to be assessed and managed’. The board is expected to set the strategy, values and standards for the company, review the performance of management and ensure that the necessary financial and human resources are in place.

8.7.10. United States of America As per the Corporate Governance code in place in the USA, the main purposes of the board are to select, evaluate and compensate the CEO, debate and ultimately approve the company’s strategy, ensure that the company is managed in the best interest of its shareholders and to oversee the auditing process resulting in the proper disclosure of accurate financial statements. In all the jurisdictions where there are two-tier boards such as China, Germany and so on, the allocation of role between the two boards is fairly clear. The supervisory board takes decisions only on macro matters and does not indulge/interfere in the day-to-day Draft Code of Governance, Principles for South Africa – 2009, King Committee on Governance. Available at: https://www.ru.ac.za/media/rhodesuniversity/ content/erm/documents/xx.%20King%203%20-%20King%20Report.pdf (accessed on 30 May 2016). 4

102  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

management of the firm, day-to-day management is the responsibility of the management board, which is given full responsibility, coupled with adequate powers and authority to take decisions and run the company proficiently. However, the management board reports and is responsible to the supervisory board. Summarizing the aforesaid would possibly mean that while assuming the overall responsibility to stakeholders, the board’s role is to lay down vision, direction, organizational design and strategy and the management led by the CEO is expected to execute and manage day-to-day operations. It is indeed clear that the overarching responsibility of the board is the ‘management of enterprise’ and that of the CEO and his team is the ‘management of business’. The subtle distinction between the management of an enterprise and that of a business is that the management of a business maintains the health of the company in the current shape and the management of the enterprise ensures the sustainability and future well-being of the enterprise. Figure 8.1 precisely describes the role of the board. Figure 8.1    Role of the Board

Strategy Loop

Super Ordinate Goals

Direction Board of Directors

Monitoring & Control Systems

Value Creation Goal

Performance Loop

It would be noted from Figure 8.1 that there are two loops in the role of the board: strategy loop and performance loop.

Boardroom Practices  103

Strategy loop can be further subdivided into (a) superordinate goals and (b) direction. The performance loop can be segregated into (a) value creation goals and (b) monitoring and control system. If one was put in a narrative form as has been done in many regulatory jurisdictions and by various management pundits, the entire set of responsibilities can be grouped into aforesaid stated four broad parts—vision, mission, values and culture will get covered under direction. The strategy inclusive of input mobilization—resources pooling, entry and exit choices and organizational design will get aggregated into superordinate goals. The annual budgeting and work plan will get covered under value creation goals and rest of it including monitoring of performance, compliance, disclosures and so on will get aggregated under monitoring and control system. Appointment, removal and compensation and so on will also get included under value creation goals. However, a broad segregation of the role of the management and the board, as I see it, is given in Annexure 2.

8.8. Allocation of Time of the Board As mentioned earlier, the board’s responsibility can be divided into two frames: the strategy frame and the operational frame. The board should conceive, discuss and decide the strategy and the management must operationalize those to create wealth. Thus, strategy remains the bigger role of the board and managing the operations remains the prime responsibility of the management. However, the board is expected to exercise what I describe monitoring and control over the operations management. This is necessary to ensure that the management is on the right path and that the trends emerging from the performance are indicating the fructification of the vision and mission of the enterprise. Hence, the board has to allocate appropriate time to both the roles, that is, strategy formulation and operations management. Since the primary responsibility of the board remains that of providing strategy, it has to devote much more time to this aspect and much lesser time to the operations management. However, it is my experience that most boards spent, if not more, 90 per cent of the time in appraising the performance and very little or

104  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

negligible time is allocated to strategy formulation and its review. The end result of this allocation is that the board fails to govern the enterprise. In most cases, they become the replicators of the role played by the management who hardly treats the board members as more than artefacts in the boardroom. Assertive among the board members start getting frustrated and eventually give up or fall in line to enjoy the cosy environment of the boardroom. The boardroom practices will improve only if the time of the board is appropriately allocated and a significant amount of quality time is spent in building the strategy. The recommendation on the allocation of time into various stages of the company is given as follows: Time allocation Strategy

Operations

Stage 1

20

80

Stage 2

40

60

Stage 3

60

40

8.9. Business Management and Enterprise Management There is a subtle difference between the business management and enterprise management. Business management is like maintaining health in the current framework, whereas refurbishing, reorienting and re-engineering the framework along the journey to keep the enterprise well and healthy over a long duration is enterprise management. Political, social, economic, ecological, technological and business trends shape the planetary landscape. For assessing the overall impact of the trends including sub trends and their fusion, the managements have to adopt anticipatory and perceptive approach. Rising consumption in emerging markets and technology-driven products and services are expected to create new market. The companies are expected to face intense pressure to innovate, be more productive and acquire size to harness the opportunities and even survive. The profitability is shifting

Boardroom Practices  105

to idea-intensive sectors, which will make acquiring intellectual assets and inorganic growth important factors. As per Mckinsey survey, there is relatively a wide gap between the impact that the executives assign to these trends and the extent to which their companies take active steps to seize the opportunities. The survey further outlined that in their responses to questions about indicated macroeconomic, political, social, environmental and business trends, executives from different industries reveal significant differences in their assessments of the impact of the trends as well as the actions their companies are taking to address them. In fact, some of executives are not able to even decipher that their organization has or is likely to lapse into a midlife crisis. To meet the compelling challenges of the unfolding trends strategic response have to become multidimensional, which will necessitate companies moving in a range of directions. Structural changes include hiving and consolidation, erecting upstream and downstream partnerships, risk-taking and hard-nosed approach to competition. The organizational design and strategic frames will have to be visited at more frequent intervals to ensure that value drivers are not becoming value destroyers and that new value drivers are being added constantly. The challenge of sustaining corporate performance over a period of time, which I call enterprise management, has long exercised the minds of the executives and management pundits. Yet corporate management and the BoD of the companies still find it hard to shift their attention away from the next set of quarterly results and today’s stock prices. Anticipating—deciphering threats and opportunities emerging out of those trends and husbanding—for growth, profitability and sustainability is an integral part of an enterprise management. The enterprise management helps companies to harness emerging trends without jeopardizing the core business. The enterprise management will seek to ensure the longterm health of the organization by fostering a variety of attributes such as: • Building broader mental mind fields which open up strategic vision hot spots.

106  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

• Architecting enterprise resilience to handle known– unknown and unknown–unknown changes. • Building the competences of ‘strategic think’, particularly amongst the members of the senior management team. • Shifting the focus of acquisition to intellectual assets and idea-creating organization and business designs. • Building execution capabilities along with abilities of efficacious decision-making, forecasting and well-orchestrated responsibility and accountability frames. • Reorienting the organization so that the vision connects every stakeholder, in particular employees, with an elaborate process of shared identity and values coupled with equal concern for the interest of all stakeholders. Post a robust framework of compliance with the laws and rules and best practices, and business model the board of the company should focus more on the enterprise management, which will include in addition to the aforementioned, organizational behaviour, group dynamics, balance of power and decision-making processes and will leave business management to the executives, of course with a focused oversight. This is required if it is essential for the company to grow, organically and inorganically. Even otherwise, unless the company acquires a reasonable size of strong built, it will be difficult to wrestle in the industry ring of disproportionately burly pehlwans (wrestlers). Greater focus on the strategy loop is the way forward. This is how the board will add value and the tyranny of Corporate Governance will turn it into the triumph of the enterprise.

8.10. Designing the Agenda for the Board Meeting The success of a board meeting depends substantially on the design of the agenda. In most companies, the design and drafting of the agenda is left to the company secretary who routinely lists out the items which he considers are necessary from the regulatory perspective and includes usual items such as confirmation

Boardroom Practices  107

of the minutes, review of the performance, approval of quarterly results and so on. If the HOD happens to send him an item by himself, the company secretary assesses the relevance and if he thinks it to be fit and appropriate he includes it in the list prepared by him. In fact, some of the long-serving company secretaries become overbearing and the HODs hardly challenge their discretion. However, some of the articulate company secretaries send a mail/memo and invite items from the HODs to be included in the agenda of the forthcoming board meeting. And this is all done just about a few days before the date of the meeting. Most often, the chairman of the board hardly gets involved; at best, the CEO is shown the list who cursorily goes through it and adds an item or two and returns the papers to the company secretary. I remember having once asked the CEO of one the companies where I happened to be the non-executive chairman whether he has perused the agenda which is being circulated to the board members. He was frank enough to admit he has not and added that this is being handled by the company secretary. In fact, in most cases where the chairman is a non-executive, he gets the agenda along with other directors pinned over the notes, which exhibits the casualness of the approach and inadequacy of the contribution of the chairman. It is important that both the CEO and the chairman not only get involved but also give a direction to the formulation of the agenda. The agenda determines the flow of the board’s meeting and decision-making process. The procedure for drafting the agenda for better results should be as follows. The company secretary should, at least a month in advance of the date of the board meeting, send a mail/memo to all the HODs and also the CEO to send their items which they would like to be included. The response time for the HODs and the CEO should be at best three days. The company secretary should, on receipt of their response, consolidate the items with those he has listed, inclusive of those that need to be presented to the board as per statutory requirements. Having prepared the list, he should approach the CEO for the clearance of the list when the latter gets the opportunity to get the areas he wants to be discussed in the board included and/or excluded. This will make the management’s list complete, which should then be sent to the chairman.

108  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

A date should be fixed when the chairman, the CEO and the company secretary sit together physically or through video/audio conference and finalize the tentative agenda. In the meantime, after having received the management’s list, the chairman should talk to either the lead director or all the non-executive/independent directors about the items they would like to include in the agenda of the next board meeting. Even though most of the time independent directors may have no item, this approach builds a sense of participation and, of course, if they have one, the same is included. Three of them then finalize the list of items to be included for discussions and decisions in the next board meeting. The discussion will also deliberate on the types of data, information and analysis that will need to be collected by the HODs to prepare the background notes which are comprehensive and facilitate decision-making. Such an elaborate exercise makes way for the comprehensive preparation of the board meeting and leaves very little scope for table items, which should always be few and far between. It must be clearly understood that a board meeting is one of the, if not the most, important event in a quarter of an enterprise and preparations for leveraging the wisdom of the board has to be comprehensive. Senior management is always bugged with routine and preparation of the board meetings, most often goes by the default, which does not deliver the expected results in the board meetings and does not augur well for the good of Corporate Governance either. The agenda of a board meeting should normally have the following four broad sections: 1. Items for information and noting. 2. Items for routine approval such as minutes of the last board meeting and so on. 3. Operational matters. 4. Strategic issues. Such a segregation helps in quickly running through the easy items during the meeting, which hardly require discussions, leaving enough time and adequate attention for the important

Boardroom Practices  109

items to concentrate on. It has been observed in quite a few board meetings that most of the time is spent on routine items and the important items which deserve much deeper discussions and considerations are passed quickly. In some boards, I have observed that a significant time is spent in discussing the language, grammar and punctuations in the minutes. This may suit some of the CEOs and other senior executives, but is suicidal for the success and sustainability of the company. The operational matters should further be segregated into (a) regular items such as approval of quarterly, half yearly and/or annual results and the accounts and performance evaluation of the company since the last board meeting and (b) other items where board’s approval/attention is needed. While items in (a) entails supervisory jurisdiction of the board of monitoring the performance and its evaluation and, therefore, will have to be reviewed critically, these items are most often approved at the conclusion of the presentation by the CEO and the CFO with little or no discussion. Such items afford an opportunity to the board to understand how the present of the company is moving forward. It is also an occassion for the board to offer suggestion/ideas for improving the performance. Simultaneously, it helps the board in evaluating the performance of the CEO, the CFO and other board-level executives and others, which is necessary for deciding their compensation and continuance in the company. The strategic matters will have two parts: (a) evaluation of the effectiveness of the strategic approaches being pursued as to their efficacy and delivery of the expected outcomes and (b) new strategic moves. Both these matters require much more attention of the board, as this is their primary task. Once the items of the agenda have been decided, these should be circulated to the HODs for the collection of relevant information, data and preparation of analytical background notes specifying various alternatives and also the perceived impacts of the alternative choices. The diligence in preparation of notes cannot be compromised in the interest of the quality of decisionmaking. It requires time and attention for the job to be done well. Hence, the early start of the preparation of the agenda becomes

110  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

necessary. The agenda must be ready and circulated to the board members at least 10 days ahead of the board meeting date, which will give enough time to the board members to read, apply their mind and come prepared to deliberate in the board meeting. In fact, the preparation for the strategic items will begin much earlier because the kind of information and/or analysis that is required may not be possible to organize in two to three weeks. Cost implications, alternative uses of the resources and data of the impact of the strategic moves taken earlier is a time-consuming process. Hence, just bringing the item without adequate preparation does not offer a fulsome opportunity to the board members to give their best. Often, the board members are told how we can find a strategic matter in every board meeting. The following is a tentatively illustrative list which can be considered. 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11.

Management of HR Marketing strategies and validity of those being pursued Management of financial resources Production efficiencies Management of environment—macro and micro Emerging trends in the business line and messages for consideration Efficacy of product basket Optimization of physical resources Inorganic growth opportunities and our space Succession planning Evaluation of strategies in action

The list can be endless and the contribution of the board can be enormous, provided these subjects are brought before the board and enough time is allocated for discussion thereof.

8.11. Drafting of the Board Notes It is important that the board notes are comprehensively drafted, so as to help the board members to take the decision. It is important that these notes are divided into four parts.

Boardroom Practices  111

1. State the issues that need attention of the board and consequential decision-making to address those issues. In case framing of the issues is not appropriate, the rest of the work will not have appropriate linkages. Hence, various members of the management team must devote enough time and attention to identify the issues. Quite often, the symptoms are confused as issues, for example, if a product is not selling, one has to identify the issue, lack of sale or inadequate sale of a product is only a symptom. There could be defects in the design of the product, lack of competitive advantage in the product, predatory pricing by the competitors, poor post sales services and so on. In case none or inadequate sale of products is treated as an issue, the simple solution would be to propose a few incentives either to customers and/or to sales persons and heighten the advertising. These cannot bring the results. Sometimes, some flicker of growth as a consequence of such incentives does occur, but that uptrend subsides once the incentives are over and/or absorbed. In case the issue is competitive positioning and so on, it has to be dealt with as such and the solutions would be far different. Hence, the effort of the management has to be to diagnose the disease/ issues stemming out of the symptoms. 2. Once the issue(s) has been diagnosed, the management must propose various options/choices to deal with them. Since there cannot be only one solution to deal with the issue(s), alternative choices have to be thought and proposed. The details of the alternate choices must form part of the note. All the choices have to be supported by the need of resources and the value creation. 3. The third part of the note would be the probable impact of the alternative choices, in short, medium and long term, on the revenue, health and sustainability of the company. This is very important for the management as well as for the board to be able to weigh various options and then take a considered decision of selecting the best option available. 4. The concluding part of the note should be the management’s recommendations, and if that is accepted, what

112  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

would be the execution process(s). Clearly, delineating the milestones of the journey will help them to review the progress at quick intervals as to the effectiveness of the choice(s) made and/or need for re-engineering, abdication and so on. The notes have to be supplemented with statistics relevant to the issues, choices, impacts and also the experiences of the execution of similar choices in the past by the organization itself and/or by others domestically and/or internationally. It is important to note here that every decision is an expense, both in terms of the resources used and time spent in executing the decision. In case a decision does not turn out to be correct, it would amount to a loss of revenue/resources of the company. Although it is impossible to determine at the time of taking the decision whether the decision will actually turn out to be the right decision, application of mind has to be facilitated by enough of data and analysis. It is my belief that in case the wisdom of the board is marshalled with due consideration of all the necessary information, data and analysis there is a stronger possibility of a decision turning out to be right or near right. In case, however, such a process is not undergone, the possibility of those decisions turning out to be right is rather remote. This exercise has, necessarily, to be undergone for the strategic decision-making, in particular where ‘blue ocean strategy’ is sought to be pursued. In the matter of the review of the performance it has often been observed that what facilitated the performance, what did not help in the performance, what were the impediments in achieving a better performance and/or what signals this performance is throwing up are not brought before the board. In fact, in most cases, such an in-depth analysis of the periodical results, be it monthly, quarterly, half-yearly or yearly, is done. In the absence thereof, discussions in the boardroom become a kind of replication of the exercise, which has already been undertaken by the management and no better light emerges in the process. Thus, the role of the board in monitoring the performance is less than fulfilled. I would like to state that the aforementioned is just a small description of an item. Every item of the board agenda has to be

Boardroom Practices  113

dealt with similarly. The board undertakes the review of the health check of the business in the current form but also meet to review and decide what needs to be done to help ensure the sustainability of the success of the enterprise. In case the enterprise is going through some pains, board meeting is the right forum to discuss and decide what needs to be done. Early takes prevent regrets later. Hence, the preparation of board notes becomes a very critical part of the boardroom practices. During our consultancy projects, we examined the board notes of the clients and found that in most cases, the notes put up before the board were perfunctory in nature. It has to be well understood that the board is the ultimate authority of management in the journey of an enterprise, and if that exercise of management is not undertaken in depth, ‘God save the King’ is a famous proverb that would become applicable.

8.12. Minutes of the Board and Committees’ Meetings The minutes are expected to be the mirror image of the discussions and decisions taken in the meetings of the BoD and its committees. It must be remembered that whenever the need arises to find out what actually happened and/or what decisions were taken in a particular meeting, and also what factors were considered, what arguments were advanced and what information/documents were relied upon while taking those decisions, the minutes are the only document which is relied upon by the regulators, courts, investigating agencies, any other person and/or authority. Even if the company’s executives want to know, understand or analyse what and why a decision was taken, the minutes become a relevant document. Hence, it is necessary and important that the minutes are properly and elaborately recorded. Go through the minutes of any of the companies, even the ones perceived to be good governed companies, it can be observed that in most cases, the recording of the minutes is very sloppy. The chairman and the CEO do not devote enough attention and time to this important aspect of the functioning of the board and committees. In one of the companies where I happened to be the non-executive chairman, the CEO never bothered to check what has been

114  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

recorded in the minutes. He relied completely on the company secretary and the chairman. When I refused to clear the minutes until these were perused by him, the clearance of the minutes started getting delayed as he accorded the least priority to this job. Routine always overtook him. This is the case of a CEO who was hard working, conscientious and successful. One of the prestigious companies in the financial services sector had a practise of recording dissent separately and not as a part of the minutes. Of course, dissent itself in that company were few and far between mainly because of the overbearing persona of the chairman. In fact, the minutes of some of the companies just record the decisions and do not record a gist of discussions including various points of view expressed. In some cases, some phrases such as ‘after discussions’, ‘after detailed discussions’, ‘after some discussions’ the board/committee accorded the approval are used, which is highly irregular. Such a recording denotes that either the discussions did not take place at all or were without depth. The situation in either case is undesirable. It can be appreciated that for items such as approval of the minutes and so on, if the recording is proper and are circulated well in advance, very minimal discussion would be required in the next meeting. However, matters either of strategic nature or even the operational performance cannot be approved by the board/committees without full-length discussions even if everything is excellent because in that case, the discussions should centre around how that could be achieved and how sustainable it is. What are the learnings that need to be documented and what are the threats to the excellent performance going forward. Such items of the agenda, being passed without discussions, may give an impression of a lack of application by the members of the board and/or the committees. The moot questions that, therefore, emerge are, What is all that needs to be recorded and how the recording should take place? Here are some thoughts in this direction. First, the best way to ensure that every important point brought out during the discussions is recorded by tape recording the proceedings, which is then used by the company secretary to finalize the draft of the minutes. This will have multiple benefits: (a) all the recording will be factually correct, (b) as many details can be recorded as may be

Boardroom Practices  115

felt necessary and (c) it will leave little scope for the members to point out the inaccuracies and incompleteness. At the best, what will require correction would be the language so that the recordings make sense as to what was meant when the directors made those observations and what was actually decided. This may look to be a painful process and may make the directors, particularly noncontributing, uninvolved or those participating unprepared in the meetings, uncomfortable, but will eventually be in the interest of the company and also the directors. In any case with the provision in the Indian Companies Act, 2013 permitting video conferencing, the recording of the discussion will be a legal requirement. The following things definitely need to be recorded as a part of the record of proceeding: 1. Management submission on the agenda item either culled out of the note and/or what the management’s representative says in the meeting as a matter of clarification and so on. 2. Queries raised by the directors. It might be useful to mention the name of the director who raises the query and/or makes the point. However, if the directors feel strongly against the recording of names, conscientiousness needs to be built against it. What is important is the full and factual recording. Building perception of efficacious Corporate Governance warrants that the names are recorded. Eventually, this will also build a kind of record of the level of participation of the individual directors and the quality of each director’s contributions, which will be useful in evaluating the performance of the NEDs for their continuance and/or remuneration, if the varying level of compensation is sought to be given. 3. Various points of views expressed, whether for or against the proposals. 4. Impact of the points of views on the outcome of the decision taken/suggested to be taken. 5. Replies given by the management to each of those queries. The recording of the discussions needs to be brief and precise but must render full elaboration of the points made. Verbatim recording

116  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

need not be done. It should be done only if it is felt necessary or the concerned director who makes the point desires so, because a verbatim recording will make the minutes too bulky and real points may get lost in the text somewhere. However, it must be made sure that nothing important that needs to be recorded is left out. Once the draft is ready, it should be sent to the chairman of the board/committee who should vet the draft and suggest changes, if any necessary. It would be desirable for the HODs and the CEO to review it before the company secretary readies it as a draft and forwards to the chairman. Once the chairman has cleared the draft, the same should be circulated to all the directors who should be given at best a week’s time to suggest additions, deletions and/or changes, if any. It is important that the draft of the minutes is circulated within a week of the conclusion of the board/committee meeting. This will ensure that the directors are able to recall the discussions and decisions. Longer the time taken in circulating the draft of the minutes, greater are the chances of the memory of the directors fading away. This will incidentally ensure that the approval of the minutes in the meeting takes very little or no time at all. In one of the boards where I sat as an independent director, another director who was a solicitor by profession would read the minutes in the flight taking him to the town of the board meeting and would take hell out of the company secretary and the CEO eventually, wasting half the time of the meeting in the approval of the minutes. He would like even the grammar to be corrected. Although the drafting of the minutes certainly need substantial improvement, the problem could be solved if the minutes were circulated within seven days with an agreement that corrections/modifications to be suggested must be received by the company secretary within seven days of circulation. This would result in better quality of the minutes, utilization of the board’s time for more substantive issues and relieve the directors from the torture of haggling and bargaining in the board meeting. This is what I did in another board where I was the chairman to rein in the recalcitrant director of wasting the board’s time in the approval of the minutes. The quality of the minutes is of utmost importance. Writing or making use thereof while writing history will be greatly facilitated by good quality minutes. Hence, it is essential that the minutes are recorded and kept not only for statutory reasons but more so for their use for a variety of purposes.

Boardroom Practices  117

8.13. Action Taken Report (ATR) The confirmation of the minutes has to be followed by an ATR as the next item in the board agenda. While in some of the companies this is not done at all, in others the ATR is sloppy. Either it does not contain the information on all the decisions/direction given in the board meeting or the ATR is not complete with facts of what has actually been done. In fact, ATR helps the board members to know what actually happened to the implementation of the decision. It might be helpful and desirable to outline the timeline for the implementation of the decision/direction in the meeting in which such a decision is taken or a direction is given, and the management must ensure that the timeline is adhered to scrupulously. In case the timeline cannot be adhered to, the management must specify in the ATR why and also when will the implementation be completed. The management is generally happy to skip the presentation of ATR, however, the board cannot afford that. In fact, it is an obligation of the management and necessary for the welfare of the enterprise that the decisions of the board are implemented as planned. The best way it can be ensured is by the submission of a comprehensive report in the form of an ATR and unless the decision is fully implemented, it is carried as an open item until done along with the date of decision and progress made, if any so far. This will also help in revisiting the decisions/directions of the board, if those are not implemented or needs re-engineering.

8.14. Vision and Direction In the allocation of roles between the executive management and the board, it has been clearly delineated across jurisdictions that the board will have primary responsibilities of providing the vision and direction to the company in its tryst with future. While different management pundits have defined vision differently, it can be summed up that ‘vision is a distant dream difficult to achieve but realisable’. In fact, it indicates the place that the company would like to carve out for itself in the economic horizon of the planet Earth. The formulation of vision will

118  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

necessarily involve people at all levels in the organization and in the consideration of the environment—macro and micro, globally and domestically and the business line it is pursuing, so that it is able to clearly specify the purpose of its incorporation and existence. It should also be able to help all the stakeholders to identify whom it is going to serve, how will its journey of success pan out, how will it create value and wealth and how will derisking programme including beating competition pan out, what specific attributes will help and how it is going to manage itself in an environment which is undergoing unremitting transformation constantly. Vision must have the spark of a larger lofty theme, which enthuses the stakeholders to rally around it. There is no gainsaying the fact that vision, the central theme of the existence of the company, will be supported by the mission that it will craft and the vehicles of the strategy that it will architect. In fact, it has to be complemented by the organizational values and cultures, which will be the guiding lights in its tryst with triumph. Hence, the board will have to not only finalize, decide and articulate the vision, but also outline the mission, strategies and organizational values and cultures. As mentioned earlier, in the formulation of all the above, there has to be a very involved debate in the organization, and unedited views and opinions of the whole organization have to be placed before the board along with the supporting information, data, analysis and the research that would have been conducted in-house and/or with the help of outside agency. In most companies’ executive management, may be a few of the shareholders’, director decide the vision and present to the board for rubber-stamping. It happened in one of the companies where I was an NEID. I was dumbfounded when the approval of vision, mission, values and cultures was passed over like minutes of the meeting. Nobody said anything. Before I could recover from the shock, the chairman had moved to another item, making my intervention as if irrelevant. Of course, I had to threaten him with my exit to compel him for an hour-long discussion that followed. Since I was the lone respondent of the discussion, it got summed up quickly, albeit with modifications. As the time passed, the CEO thanked me twice as the changes helped him to diversify, and new

Boardroom Practices  119

business lines are now dictating the sustainability of the company, even though I am out of the board. Greater acceptability by the stakeholders commandeers experiencing a sentiment that the vision has emerged out of several options that were weighed. The board cannot delegate these responsibilities to the executive management and ask them to come up with the finalized preposition, and deliberate briefly to approve it. The exercise in the board has to be of designing—of course, with the help and support of the inputs from the executive management. Undertaking such an exercise by the board may not be possible in one of the routine board meetings. This will have to be done in a separate meeting called for the purpose, preferably offsite, so that the executive management which is expected to participate in this exercise is not disturbed by the pressures of operations’ management. The offsite meeting will also help in building thoughts during the informal interactions—over the breakfast, lunch and/ or dinner tables. An environment has to be necessarily created for engaging the minds of all the board members and executive management. As a preparation for the meeting, sufficient data work would have to be done to facilitate a meaningful exercise. Once the vision, mission, strategies, organizational values and cultures have been decided, these need to be articulated so that these are understood by all those who are going to make use and execute. The success will depend on the understanding that is built within the organization and the level of ownership that is cultivated. Without the ownership, execution will be a mirage. The board will have to periodically review the execution and, if necessary, initiate steps to ensure greater effectiveness. Notwithstanding the above, annually, the board will have to review the basic theme of the vision along with the mission and strategies as to their relevance and effectiveness for the sustainable success of the organization. While undertaking the review exercise, its appeal to all stakeholders will have to be assessed in-depth, as their support is essential all the way for fructification. The whole idea is to evaluate the value creation capabilities of the vision, which will emerge out of the advantages that the company has over the competitors, and how it is managing and mitigating the risks along the journey.

120  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

Any organization without a definite vision, which is pragmatic and executable, cannot sustain success. It becomes like a rudderless boat, which either flows along the current and finds shores by the direction of winds or just drifts. It cannot navigate the adversities of the rough waters and weathers. While action plans will be made by the management, the fundamental strategy, which can broadly be categorized into (a) market choices and (b) competitive edge, has to be decided by the board. The market choices have to be delineated further into entry and exit options. Similarly, competitive edge has to be organized through products offering and pricing options. Vision must be capable of being translated into marketable products and services, which is facilitated by strategies. I have the experience of sitting on a number of boards—private and public companies and different sectors from financial services to infrastructure—and I have observed that the designing and articulation of the vision, if at all done, are left to the CEO. It is only when I became the executive chairman of a large public corporation that I made board devote some time to this very important role of the board, but even then, the participation of the individual board members was marginal. Unfortunately, even at boards I chair now, I find it difficult to push my way through the board and the executive management to get this agenda onto the forefront of the role of the board. As stated earlier, there is clear-cut segregation in the roles of the executive management and the board. Executive management should be charged with the management of business, whereas the board should be more concerned with the management of enterprise. Business management is like maintaining the health of the enterprise in the current framework. Refurbishing, reorienting and re-engineering the framework along the journey to keep the enterprise well and healthy over a long duration are called the management of an enterprise. This can be achieved only by outlining the vision, mission, strategies and organizational values and cultures. As said earlier, since the environment is dynamic, all these pillars of enterprise management have to be kept on a dynamic platform. This is possible with the clarity of direction given to the management by the board.

Boardroom Practices  121

8.15. Barrier to Broader Debate in the Boardroom A boardroom is a forum where broader debate on issues, challenges and opportunities must ensue. This is where expertise should collide with the wisdom of generalists to explore, innovate and experiment with unique prepositions, philosophical underpinning and out-ofbox thinking. Incisive exercises in this forum can prevent tunnel vision, which often is the case, if specialist abrogates the decisionmaking without inciting a robust debate on ideas and thinking of the generalist. In an HRB article (January–February 2015 issue), academicians Martin Ihrig and Ian MacMillan propound, ‘Largescale, sustainable growth is generally made possible when people take insight from one knowledge domain and apply to another…’. I have watched in the board meetings, so-called experts in the line run riot with the agenda item without even giving a chance to unconventional ideas being considered in the formulation of the course of action. In the absence of such an exercise, the enterprise is deprived of the benefits of collective wisdom and leveraging of skills, experience and learnings that obtain in the boardroom. There is something called finding correlation between inside out and outside in, which includes expertise militating with generality and full-time executives debating with NEDs. This is what takes out of the tunnel vision. In one of the boards where I was the only experienced person (could be called an expert) with domain knowledge, I tried to excite a broader debate with a view to help the enterprise benefiting from the nonexperts’ unconventional thinking. I was told by the CEO that the matter will be discussed with me separately. I visualized the barrier to the broader debate and withdrew immediately from the discussions in the meeting, and eventually from the board itself. Although, in most boards, the agenda is closed with the run up to the routine items, wherever some debates take place on strategy or direction, the depth is missing. Maybe there are a few selected boards where this ensues with alacrity, concern and coordination, but those are the companies which are excellent performers too. There are a number of barriers to the broader debate in the boardroom, such as:

122  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

1. Reluctance of the CEO and/or chairman for such a debate in the absence realization of the benefits thereof. 2. Insecurity of the CEO, in particular about his position in the organization, albeit a challenge to his performance/ understanding/wisdom. 3. Absence of comprehensive data, analysis, framing of issues and so on. 4. Insufficiency of time allocation. 5. Discouragement to independent thinkers, contributors and collaborators.

8.16. Focus on Strategy A Mckinsey survey of more than 1,000 directors outlines that many board members are frustrated by their companies’ excessive focus on short-term financial performance and prefer not to devote more time to long-term issues, such as strategy and leadership development. The findings further add that directors sometimes lack the information needed for sound decision-making and may not understand the set of objectives and risks for their companies. Such surveys pitchfork the deficit of governance in harnessing the skills of the board in building and enhancing the capabilities of the organization. In Section 8.1, Composition of the Board, a compelling case has been made out to collect wisdom, variety of skills and tons of experience. However, the utilization of the talent in the board cannot be limited to the monitoring of the performance of the management, albeit replicating of what they do. Greater utilization has to be found in the role delineated to the board as outlined in the relevant chapter. I believe that the strategy is at the heart of the board’s work. The board should, therefore, be more focused on designing and regularly reviewing and rewriting strategy—medium and long term—for ensuring that the organization progresses in developing the essential capabilities to deal with the future challenges. Another study reveals that the boards and leading companies are making strategy review a consistent part of every board meeting. Of course, it is important to watch how quickly boards

Boardroom Practices  123

acclimatize to their new focus, dynamics and the chemistry in the boardroom in order to tackle strategic agenda effectively. Let me dwell briefly on how this agenda can be furthered in the board. Within the definition of strategy, which I have elaborated earlier, the board, with the support of the management, should identify the value drivers. These value drivers, although may relate to an industry, are specific to a company, which could be, say, ‘market growth rate’, ‘pricing strategy’, ‘competitive landscape’ and so on. This identification has to be supported by the data and information on how the value drivers are panning out. The board has to engage its attention on the threats to the value drivers along with the predictability of profitability and sustainability. Once that is done, the debate has to shift to de-risking those along with other value destroyer or eroder. The board has to engage its mind on how the competitive scenario is unfolding and how it will impact the strategy frame of the company along with its value drivers. The board should also discuss how the strategy execution is shaping. Are the value drivers emerging as envisaged in the strategy and also whether sprouting of value destroyers, if any, discernible? The board has to evaluate whether the compensation strategy being pursued by the company is value enhancer or long-term wealth destroyer. Effectiveness of the entire strategic weaponry should be the agenda of debates in the board meetings. However, before understanding the review processes as mentioned earlier, the board has to formulate its strategy for the realization of the ultimate goal—wealth creation through the medium of its vision. The idea of writing this narrative is only to suggest the threads which can help the board contributing optimally its part in the value creation by the enterprise. What management will do will be complementary and supplementary to the contribution of the board, and reflection thereof will be seen in the arithmetic presented to the board by the management as quarterly, half yearly and yearly financials. This will also be adjusted by the market in the valuation it will accord to the enterprise. In fact, with the compliance of regulatory obligations behind, the board should focus on more substantive mission, with increased company’s dependence on their BoD for insight and guidance on the big picture issues that can contribute mightily to

124  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

the company’s success and long-term sustainability. The annual offsite meeting of the board, which, I understand, are being organized in most companies, should outline the focus on the strategy loop for the rest of the year. Furthermore, the board oversight will get significantly enhanced if the directors can develop comprehensive pictures of the performance of their companies and learn to participate more deeply in discussions about strategy and leadership. The company should not be depriving itself of the value of the wisdom and experience of a very accomplished BoD.

8.16.1. Organizational Design Every company architects an organizational design to ensure the smooth conduct of operations and value creation. In fact, in good companies, organizational design is so weaved that every part of the design creates value and prevents seeping in of any value eroding viruses. This is organized through a variety of tools and techniques. The effectiveness of tools and techniques has a direct and proportionate relationship with the organizational design. Over a period of time, the tools and techniques become blunt and, therefore, have to be sharpened or changed altogether. This cannot be organized without reviewing the organizational design periodically. Furthermore, with the change in the macro and/or micro environment, tools and techniques become ineffective and/or irrelevant, so becomes the organizational design. It is, therefore, important to periodically assess whether the organizational design and its attendant tools and techniques are still delivering value optimally and whether they are able to effectively check value destruction. It might be relevant to note here that the organizational design of insurance industry companies—more particularly of life insurance companies—in India has become value eroder as a consequence of transformed regulatory stance and market developments. Unfortunately, the boards and managements of the companies are unable to comprehend the desirability of innovating new (which I have just done for academics) model and keep complaining about the market competition. Manufacturing margins are being eaten by the distribution excesses.

Boardroom Practices  125

Manufacturing margins emerge from the surplus generated by the lower actual mortality of the assured lives over the expected mortality of the assured lives, the excess of investment income actually earned over the expected returns on the investments of a life insurance company and lower actual expenses of management over the expected (estimated) expenses. Thus, the manufacturing margin is an aggregate of the surpluses from the three aforesaid segments. The expenses of management include distribution–sales and marketing expenses. It is expected that actual expenses will be lower than the expected (estimated) expenses. Unfortunately, in the case of private life insurance companies in India, the actual of sales and marketing expenses are much higher than the expected expenses. Oftentimes, these expenses are 150–200 per cent of the expected and factored in pricing the products, which eats away the manufacturing margins generated by other segments namely, mortality ratio and average mean yield on investments. An example is given in Table 8.1. It can be seen from the table that the manufacturing margins being delivered by 1, 2 and 3(b) are being eaten by 3(a), and the company lands in losses. Sagacity demands casting off irrelevance, but the impulse of control is persuading the management to keep hugging the dead child like a monkey; possibly the wait will end when the stink of erosion becomes difficult to bear. This happens because organizational design combines manufacturing with marketing and sales, which need to be separated. Hence, annual strategy formulation must include review, refurbishing, re-engineering of organizational design. Most boards do not Table 8.1    Calculation of Surplus In Life Insurance Companies Expected Actual 1. Mortality experience

100

90

Surplus –10

2. Average mean yield (%)

7.5

8

0.5

3. Expenses of management

100

175

+75

(a) Distribution–sales and marketing expenses

75

155 

+80

(b) Other expenses

25

20 

–5



126  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

realize the significance of the review of the organizational design, and, ignorantly enough, become part of less-than-optimal value creation. The Corporate Governance is all about value creation, and the collective wisdom in the board as a governance practice should be marshalled to enhance value. Of course, for review and organizational redesign, the board can seek the help of outside agency/experts who can provide suggestions, recommendations and useful inputs. However, it will eventually remain the board’s responsibility to ensure that the organizational design remains efficacious at all times.

8.16.2. Strategy Audit It is my view that the primary responsibility of the board is to provide strategy and vision. Executive management is charged to convert that strategy and vision into operational reality. Directors who represent stakeholders are expected to evaluate how companies’ returns compare with those of other investment opportunities in the backdrop of strategy pursued. The ownership of the execution of the strategy remains firmly in the hands of the chief executive and his team, and for good reasons. In fact, every company requires a clear and unambiguous strategy and vision, and also confidence that its top management has the authority and ability to carry it out. Efficacious oversight of the strategy can visualize the bottle­ necks and demonstrate to stakeholders that the board and CEO have a joint commitment to the effective and orderly operationalization of strategy and vision. I would recommend a low-key, behind-the-scene strategy audit, designed to lend credibility to the strategy and vision of the board and management’s leadership to operationalize and not undermine it. The process could confer the leadership of strategy oversight in the hands of independent directors and provide them with the authority to establish both the criteria and the methods. The criteria should be the optimality of value creation through the measurement of the input–output ratio, compared with the alternative uses of resources channelized in the implementation of the strategy. The method has to be objective and the process should be numerical. The performance review of the company should be jointly undertaken by the board and

Boardroom Practices  127

management, which would signal to the investing public that the board and management accept the board’s authority and responsibility for active and ongoing strategy oversight. Such a strategy audit mechanism can certainly prevent value erosion and turn out to be a value creator.

8.17. Budgeting Exercise The budgeting exercise of an enterprise is an incisive process. It must take into account various factors which directly or indirectly affect the functioning and fructification of the targets. Sagacious approaches pursued by most dynamic enterprises consist of the following steps: (a) scenario building, (b) targets setting, (c) strategy formulation, (d) action plan fabrication, (e) activity listing, (f) sensitivity analysis, (g) risk management, (h) mid-term review and (i) value creation goals. Each of these steps can be briefly described as follows: 1. Scenario building: An enterprise comes into being, achieves and sustains its success, with reference to macro and microenvironment. While macro-environment relates to the overall setting—domestically and globally, the micro-environment relates to the industry with which the enterprise is bracketed and environment within. Macro-environment has three components: (a) economic, (b) political and (c) social. The micro-environment, as mentioned earlier, has two components: (a) environment within the industry—relates to product, pricing and competition and so on and (b) environment inside the enterprise—fiscal, physical and human.   In fact, the macro- and micro-environmental factors, taken together, become a kind of matrix and influence the performance of the enterprise. It is, therefore, important for the designers of the budget to get some realistic assessment of the kind of environment, both macro and micro, that will be unfolding, and how will that influence the industry in general and the enterprise, in particular. Not to consider, these factors will be designing the budget in isolation as if the enterprise

128  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

was operating in an island by itself and/or is capable of creating the environment as it suits. Unfortunately, for the planners of the budget, both macro- and microenvironmental factors cannot be orchestrated. These factors have actually to be managed to the advantage of the enterprise for delivering a superior performance compared to the peer group.   Hence, information and data should be collected on, in particular, the macro and micro-environment and how the fusion of these factors will impact—favourably, unfavourably and/or neutrally. Fortunately, we live in an information age where data is just a click away. 2. Targets setting: This part will contain the numbers which will be sought to be achieved during the year. The targets to be achieved will have a reference to the vision and mission of the organization, past performance and possible mobilization of resources. The ambition to perform better, be more competitive and profitable will have to be the approach. Although top line is important, bottom is more significant. Top line is a beauty to be admired, but bottom line is ecstasy to be experienced. The long- and medium-term perspective cannot be sacrificed at the altar of the short-term perspective because the financial year under planning is only a year in the journey of success of an enterprise.   This will also have a list of assumptions of the variety of factors that have been considered while arriving at the numbers. 3. Strategy formulation: Oftentimes, managers confuse strategies with an action plan and activities. It is, therefore, important to have clarity as to what is the strategy, what is an action plan and how it is different from the activities. Strategies can be described as the broad approach which, when perused, will lead to fructification of the budget. The strategies can broadly be classified into following parts: (a) entry and exit, (b) market choices (c) pricing proposition and (d) product basket and so on. Hence, while budgeting, the management has to look at what

Boardroom Practices  129

kind of strategic approach it will pursue during the year and what kind of linkages it will have with the journey covered and the journey proposed to be covered. 4. Action plan fabrication: Action plans are like the wheels of the vehicle of the strategies, and activities are the steps or movement that the vehicle undertakes. Action plan converts the strategies into a goal post, for example, if entry into a new market is decided as a strategy, what kind of action plan will be created to enter the market. Just to illustrate the point whether the entry would be direct, through a subsidiary and/or through dealership network. It will also be decided where production facilities will be located—will it be located in the market place to benefit from near sourcing or will it be shipped from the existing production facilities and/or new facilities will be created somewhere else to reap the benefit of scale, skills scope and/or facilitation, tax advantage, ready infrastructure and so on.   Activities will be how direct, subsidiary and/or dealership network marshalling, whatever chosen, will be approached and how monitoring and performance will be facilitated. 5. Activity listing: As mentioned earlier, the activities would be the movement of the vehicle or the actual steps to be taken. However, it has also to be listed what kind of arithmetic the activities will generate. The aggregate of arithmetic of activities must total up to the expected outcome of the action plan. The activities would also mean detailing of every step along with the monitoring process, impact analysis and re-engineering process(s). 6. Sensitivity analysis: Along with the aforesaid will also be presented sensitivity to various assumptions and how will the numbers emerge as a consequence of the impact of changes in environmental factors on those assumption turning out to be true, partially true or playing out adversely. In some progressive organizations, three broad frames are presented. • Best case • Most likely case • Worst case

130  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

  I would suggest drawing up multiple frames so that impact on the significant assumptions is analysed during the mid-term review for the course correction of strategy, action plan, activities or the resultant numbers itself. 7. Mid-term review: The budget must also incorporate the periodicity of the review of the activities, action plan, strategies and final achievement of targets. While the period for the review of activities will be shorter—mostly weekly, fortnightly and/or monthly, quarterly, in case of action plan and strategies, if necessary, the reconfiguration of the activities, re-engineering of the action plan and refurbishing of the strategies would be a part of the midterm review. However, need-based mid-course correction will be a continuous exercise. 8. Risk management: While undertaking the budgeting exercise, certain assumptions are made. Every assumption has a propensity of it turning out to be correct, partially correct and/or incorrect. These assumptions relate to macro and micro-environment, impact of strategies, action plan and activities. Creating a hedge against all these is called risk management, which has two components: (a) enterprise risk management and (b) budget achievement risk management. The risk management exercise is undertaken via the following steps: (a) risk assessment, (b) risk avoidance, (c) risk management, (d) risk mitigation and (e) risk impact—short, medium and long term.   The enterprise which does not undertake the risk management exercise is like a driver on a highway without steering wheel and brakes. Most organizations undertake the exercise of enterprise risk management but do not undertake budget achievement risk management. Both are important because both affect short-, medium- and longterm performance and sustainability of the organization. Some organizations combine the two frames, which often blunts the sharpness of armoury to manage different kinds of risk, because each risk will need a different weapon. 9. Value creation goals: Carrying out the budgeting exercise without clearly delineating ‘value creation goals’ is like

Boardroom Practices  131

charting out a voyage without pre-identifying the ports to dock. In fact, for the board to be able to assess whether the performance during the year is progressing well or not is with reference to reviewing movement in ‘value creation goals’. The budgeting exercise, to be complete, must run its full course (briefly described earlier). Before it is presented to the board, the board must issue beforehand the broad direction of the approach that the management has to pursue while crafting the budget. If the budget is so drawn, then the approval process in the board can become a meaningful exercise. In the absence thereof, a ragtag presentation will end up in rubber-stamping some numbers, which, if achieved, will evoke praise for management and if not, the collective rationalization will move on to the similar exercise next year.

8.18. Evaluation of the Performance of Executive Directors It is common in all the companies to assess the performance of the executive directors on a clearly defined objective criteria, in consonance with the companies’ policy. Generally, the performance evaluation is data-oriented for each of the spheres of the responsibility. Performance is measured against commitment (annual operating plan; AoP) and best-in-class performance benchmarks. In some of the companies, performance appraisal of the executive directors provides an alignment of director’s target with those of the company through a ‘balance score card’ framework. Generally, the CEO and executive directors have four key roles namely, leadership, strategy execution, value creation and governance. In fact, a set of performance matrix has to be created for each of the position of executive directors. The performance matrix will have a relationship with each of the four broad elements. The assignment of weightage to each of the elements will differ depending upon the focus that a company needs to gear up, although a broad brush of a robust company could be as under:

132  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

1. 2. 3. 4.

Leadership: Governance: Strategy execution: Value creation:

30 per cent 15 per cent 20 per cent 35 per cent

In fact, in most boards, the exercise of evaluating the performance of the executive directors is undertaken rather casually. The perception about the performance has to be substantiated by the systematic, formal and rational evaluation with reference to the agreed objective/key result areas (KRAs) (in the beginning of the year). I have tried to push the thought in the boardrooms and I must admit that, notwithstanding the tremendous goodwill and regard that I enjoy, I have not succeeded enough in most companies. Generally, the MD/CEO, by default, undertakes this important exercise in respect of other executive directors.

8.18.1. Performance Evaluation of CEO CEO is the nucleus around whom the entire organization revolves. He reports directly to the board. Hence, it is the board which has the responsibility of evaluating his performance. Inefficacious evaluation and treatment of the assessment of performance sends wrong signals to the organizations at large. Hence, this process has to be not only very incisive and objective, but also perceived by the organizations to be so. High performers or enviable performance of the enterprise evokes comfort and inadequacy of thoroughness ensues. Some of the long-serving CEOs assume larger-than-life image and become overbearing, and the board members hesitate to point out deficiencies (considering them to be demigods) in the performance even when apparent. Such situations become value eroders and eventually engulf the sustainability of the growth of the organization. I have seen several such organizations both in India and other markets. In some such cases, CEOs had a painful parting, which hurt the organizations as well. This is one of the important governance pillars which stakeholders, analysts and the market watches very carefully, and the board cannot abdicate its responsibility and/or miss the comprehensiveness by default.

Boardroom Practices  133

Often, the board fails to fully appreciate the significance and also that the lack of rigour in evaluating the performance steadily builds the risk of non-performance and even of non-challenge amongst the CEO and other executive directors. Sudden exit, forced or otherwise, is often caused by this lapse on the part of the board. In any case, the board is deprived of the early warning signals of the quality of leadership and the garbage that is often accumulated in the backyard of long-term performance of the company. The best way would be to assign the preliminary work to the nomination and remuneration committee. This committee should design the process, get it approved by the board and assess the performance of all the executive directors including CEO at least once in six months. Once that is done, this should be a formal agenda item of the board meeting on a six-monthly basis, where all the board members have an opportunity to provide the benefit of their wisdom. The thoroughness of the work of the nomination and remuneration committee will reveal many things, which will be very useful in defining the direction of the company by the board.

8.19. Evaluation of the Performance of NEDs Even though most companies periodically assess, albeit as an item on the agenda for increase in their remuneration, the performance of the executive directors, the percentage of companies reviewing the performance of its NEDs is still not very large. Fairly an old survey commissioned by Russell Reynolds Associates found that the quality of companies’ board and its performance has now become an important evaluation factor for the investment by the institutional investors. Another survey of directors of Fortune 1,000 Companies conducted in 1996 by Korl/Ferry International indicated that the assessment of the performance of the NEDs was done only in 16 per cent of the companies. However, ever since the major Corporate Governance failures, particularly across Atlantic, the focus on the performance evaluation of the NEDs has increased tremendously. I guess over 85 per cent of Standard & Poor’s (S&P) companies review the performance of NED. Recently, in India, the review of the performance of NEDs, either internally or by

134  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

an external agency, has been made compulsory by a notification by the exchanges for the listed companies. It is mandatory for other companies too in terms of the provisions of Companies Act, 2013. The investors want to distinguish boards with competent and contributing directors from old boys club, of friends and friends’ friend. Performance evaluation methodologies are varied, which include: • Outside consultants • Self-review • Peer review However, the most accepted methodology is that of peer review. In this process, each of the NEDs presents before the board on ‘how they have performed/added value to the company’. Each board member then evaluates each of the other NEDs, preferably on a scale of 1 to 10, based on performance indicators. I suggest the following as the performance criteria for the NEDs: 1. Attendance 2. Preparedness for the board meeting 3. Contribution in the boardroom using expertise and knowledge and experience and wisdom 4. Independence of views and judgment 5. Interpersonal relationship 6. Safeguarding minority shareholders’ interest 7. Facilitating best Corporate Governance practices 8. Ownership of value building These should be assessed with reference to the ability to contribute via active participation, commitment to enterprise success and the significance generated in the process of the Corporate Governance. However, before the evaluation process is put in place, the criteria, measuring standards and process must be placed before the board for consideration and approval. It might be useful to seek the benefit of advice from an expert consulting agency to determine the criteria, measuring standard and the process before placing before the board for approval. This is suggested to establish objectivity, because lack of it may build disenchantment

Boardroom Practices  135

amongst the directors, which may hurt the image of the company. Adverse image of the company can choke the pipeline of good candidates for future inclusion in the board. If the underpinning of the evaluation exercise is to enhance the contribution of the individual board members, greater objectivity and its acceptability by the board will have to be ensured. A method has to be found to make that underpinning apparent; the preamble of the programme may have the purpose defined as follows: The collective responsibility of the Board is the optimal wealth creation and its most efficacious sharing. Individual Directors have the ability to enhance the outcome by increasing their own valuable contribution. Frame of reference of the evaluation exercise is to enhance that contribution individually and collectively.

Every board has some non-contributing or dysfunctional directors. Let me mention here three different situations. 1. One of the directors is past his prime, has become old and partially infirm. The only contribution is 100 per cent attendance. 2. One of the directors—maybe because of age or lack of interest/commitment—doses off during the currency of the board meeting. 3. One of the directors hardly opens his mouth, and if ever he says something, it is certainly not relevant to the agenda being discussed. Since all these directors have a glorious past, the controlling shareholders and professional managers, out of sheer respect and regard, are hesitant to get them out. I am a witness to all the three situations in three different companies’ boards. The company is a great looser if this process is not carried out either seriously or thoroughly. It will continue to suffer from the burden of non-contributing, suboptimally contributing or negatively contributing director(s). The firm will also be deprived of the induction of fresh talent on the board and their contribution. Some of the companies appoint retired civil servants who are not adequately briefed. Consequently, even to their own frustration, they become a decoration in the boardroom. Once the

136  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

evaluation process is organized, it will become apparent why they are not contributing. Intelligent as they are, learning is possible. Hence, opportunities must be created to learn and unlearn, and, if thereafter also contribution does not improve, the change should become inevitable in the best interests of all the stakeholders, which can be facilitated by the objective evaluation of performance. The fundamental purpose of the evaluation of the performance of NEDs is to enhance the performance of the individual directors and, thereby, the board. Forcing the exit of a director should be the last resort. The institution of lead director can play a very important role in this process.

8.20. Evaluation of Performance of the Board There is a regulatory obligation (in some jurisdictions) and voluntary effort (in others) to evaluate the performance of the executive directors and NEDs. However, serious thought is not given to the evaluation of the performance of the board as a team. I would strongly advocate that the evaluation of the performance of the board as a team by the board itself be made an integral part of the performance evaluation process annually. However, it is the outcome-substance of the performance of the board which is more important. This evaluation process will assess what the enterprise, as a whole, has achieved during the year in terms of short-, medium- as well as long-term objectives. The reference points will be the objectives that the board will set to be achieved by the enterprise as an entity in one year (short term), three years (medium term) and five years and above (long term). The reference points will emerge out of the vision of wealth creation, wealth management and wealth sharing charted by the board. Even though the performances of the individual directors, executive and non-executive, will have a bearing on the performance of the board, it cannot be an aggregation of the performances of these persons. It will be like the outcome of a cricket match—victory, defeat or draw—where individual players might have well bated, bowled or fielded, yet the aggregate may fall short of the expected. The enterprise’s objectives, in addition to usual areas such as top line, bottom line, margins, capacity and competency building

Boardroom Practices  137

and enhancements and so on, should also include enterprise value enhancement, creation and protection of value drivers, risk management, with reference to the tolerance level set by the board, execution of succession planning and so on. In fact, currently, I am developing a matrix each for the evaluation of the performance of executive directors, NEDs and board as a team. The factors that are vying in mind are environment management—macro and micro, handling of issues including crisis management, opportunity sizing, input mobilization, creation and utilization of weapons of competitive warfare and securing global position and so on in the overarching philosophical underpinning of wealth creation, wealth management and wealth sharing. However, all the factors to be considered will have a bearing of the size of the enterprise, area/ space it operates, level of the market development and so on. The criterion will be objective, mostly numerical, so that subjectivity is minimized. The standards of comparison will be published data and/or data, which can be authenticated. The agency to do the evaluation will be a team created from amongst the BoD. Let us consider what is often missed out of the responsibility frame of the board: fiduciary responsibility—‘to hold the enterprise in trust for the future generation of stakeholders’. Most of the legal enunciations encompass the aspects of loyalty with reference to fiduciary responsibility. • Keeping company’s interest over one’s own interest and prudence. • Applying skills optimally to company’s decision-making. I always like to add to this, building brighter perspectives in the run up to the onward journey, albeit my concept of enterprise management. This can be achieved only if the performance of the board as a team is assessed.

8.21. Succession Planning One of the most important measures of success of the board is how well the succession issues are handled. The facets of a potent succession plan include the suitability of the candidates,

138  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

elimination of time gap in the occupation of the position on vacation and smoothness of the transition. Some of the general abilities which organizations seek in the candidates for the senior positions are performance focus, listening skills, personal stability, ethical standards and ability to articulate vision, put up with pressures and manage transition. In most companies, a formal and meaningful, well-orchestrated succession planning does not exist. The sudden exit of managers in senior positions including CEO can cause a serious setback to the profitability and sustainability of the enterprise. I, therefore, recommend the board seizing the issue to lay down an appropriate succession planning structure. Succession planning is the role of the board. More often than not, this goes by default, and a sudden flurry of activity starts as and when some critical resource exits or is about to exit. A broad frame of succession planning could be as follows: 1. Mapping of all the critical positions in the company. 2. Examining the manning of those positions. 3. Reviewing the assessment of the persons and the performance of those positions. 4. Finding out the likelihood of the possible exits including sudden or forced. 5. Mapping up the time gap required to fill up the positions. 6. Lining up the second line of defence and time required to groom for him to be in full command. Succession planning is a bit of specialized function. Hence, help of outside experts can always be taken.

8.21.1 CEO Recruitment and Succession The CEO is the leader of the executive management team. I need not elaborate here what CEO and the team led by him are expected to do and deliver. Even though almost all the jurisdictions obligate that the CEO, CFO and few other positions will be filled by the board on the recommendations of the nominations

Boardroom Practices  139

and/or audit committee, in many cases, it is the controlling shareholders who decide the candidate, and a farcical exercise is undertaken in the nomination committee to recommend and the board to approve the appointment. CEO and such other designated positions are critical for the company and the interest of its stakeholders. Hence, the exercise of such rights by the controlling shareholders is unethical, if not and illegal, and must stop. The ultimate responsibility (including fiduciary) to all the stakeholders devolves on the BoD and, therefore, absolute and not the formal authority must rest with the board alone. Nevertheless, for the purpose of the board, I would recommend the board to assume full responsibility, and even if any legally vetted agreement subsists, maximum space the board can concede is to receive a panel of at least three names with a right to reject all of them. If the board does not exercise its right, it will tantamount to the deficit of governance, and value creation will most probably be impaired/lopsided. This responsibility has been entrusted to the board by the regulators out of experiences of misdemeanours, governance failures and inadequacy of performance. Here are a few thoughts on the broader frame for assessing the stability of the CEO and other positions, where the board has the responsibility and authority to appoint: 1. 2. 3. 4. 5. 6.

Integrity—financial and intellectual Team builder and player Good communicator Ambitious Humility Abilities related to the industry/jobs and skills

The rigours of performance can hold out a picture of likely continuance/exit in the foreseeable future. Portends should be deciphered and early steps to plan the succession must be taken. Delays can cause irreparable damage to the enterprise. The board must assume full responsibility of de-risking the setback to the company, in particular, by the sudden exit of a critical resource.

140  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

8.22. Constant Communication and Consultation The best out of the skills of the board members, whether in the board meeting or on other occasions, can be facilitated through the instrumentality of constant communication. Directors ought to be briefed on the expectations from them and requested, albeit persuaded, to contribute optimally. This is possible only by providing them all the necessary information, which will help them to proffer a considered opinion. The information sharing cannot be peripheral. It has to be in-depth and full, which warrants reposing trust in the board members. In many boards, the CEO and the top management feel that sharing information with the board members ingrains a possibility of its being leaked and/or misused, which can be eliminated by briefing them on the importance of the exclusiveness and confidentiality of the information and data provided. In fact, whenever the strategic agenda is taken up by the board, it must be preceded by full and detailed information that can help a board member to understand and appreciate the strategy that is sought to be discussed and the impact thereof on the short-, medium- and long-term performance of the company. It is important for the board members to feel that they are being genuinely consulted in the decision-making, and also that whenever any issue is voiced, referred to or brought before the board, it is not a mere formality. This can happen only if the CEO and chairman together are able to reflect how valuable their opinion and ideas are. It is not important that all the ideas that are proffered or the views that are expressed by a board member are accepted. However, what is significant is the importance that is attached to those views. Such an approach will instil the confidence in the board members that the purpose of the exercise is to really ascertain their opinion and thinking, and the contribution will eventually flow. A graphical picture is presented in Figure 8.2. Figure 8.2 shows the team of senior executives forming an outside ring of information and knowledge sharing. In many

Boardroom Practices  141

Figure 8.2    Senior Executives Helping Board

boards, I have observed that the openness of the CEO and/or the chairman if he happens to be an executive chairman, is limited to a few board members. Many of the board members are not fully briefed. In case the management feels that either they do not enjoy their trust or do not have confidence in their skills or maintaining the confidentiality of the information, it is desirable that an appropriate action, either to bring the board member on to the same wavelength or make his exit possible, is taken, but there can be no substitute to a board member being kept in constant communication and consultation on all major matters. I sit on the board of a company where the chairman is articulate enough to bounce all the major ideas beforehand (and by beforehand I mean even before these are brought to the board), so that the directors are able to think through the idea, and when the board meeting takes place or decision-making process is energized, they proffer their opinion with their comprehensive perspective. I believe such an exercise needs to be conducted by all the boards to be able to derive optimal benefits out of the skills/talent of the board.

9 Accounting and Financial Reporting Standards

T

he relationship of the stakeholders with a company is built on trust, and the value creation propensities are proportional to that trust. The public trust sustains, strengthens and flowers with the availability of complete and credible information about the performance of the company. The credibility is architected on the back of standards applied consistently. The accounting and financial reporting standards specified for application by the standard setters/regulators across geographies are expected to facilitate the stakeholders to understand and interpret the financials with confidence on the reliability and their application consistently quarter on quarter. The expectations of stakeholders on the ‘reliability’ delineate the Corporate Governance pillar of accounting and financial reporting standards. In my view, there are four pillars of building ‘reliability’, graphically depicted in Figure 9.1. It is, therefore, essential that companies, accounting firms (auditors), standard setters and the regulators commit to architecting that ‘reliability’ by the instrumentalities of establishing, observing and re-engineering of the standards.

Accounting and Financial Reporting Standards  143

Figure 9.1    Pillars of Reliability

QUALITY ASSURANCE

MANAGEMENT ASSURANCE

STANDARD SETTERS

INDEPENDENT ASSURANCE

STATUTORY ASSURANCE

AUDITORS

BOARD

AUDIT COMMITTEE

MANAGEMENT

MARKET

REGULATORS

STATUTORY

SROEXCHANGES

9.1. Quality Assurance Standard setters are obligated to lay down a framework which is potent to serve the fundamental purpose of the application of accounting and financial reporting standards—in effect, deliver quality information about the performance of the company. The barometers of the quality are (a) reliability and (b) usefulness. Reliability emanates from the reflection of the clearer picture of the value of the enterprise. The dust of the raging debate on selecting the underpinning of the various standards between ‘historical cost model’ and ‘fair value model’, which was kicked off following the unravelling of corporate scandals such as Enron and so on, is yet to settle down. Here, it may be relevant to record that capital markets price the enterprise on the strength of the underlying value, which, in many cases, is not captured in the ‘historical cost value model’. Furthermore, the ever-increasing complexities of businesses, where

144  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

intangibles, in many cases, ingrain higher value than tangible assets, undermine the relevance of ‘historical cost model’. It is being increasingly believed that the historical balance sheet captures only about 30–40 per cent of the market value of the enterprise and the balance inhabits in the intangible assets and non-financial value drivers. On the liabilities sides are off balance sheet financing, unrecorded options, rights and obligations. The critics of fair value preposition raise the issues of the objective (arithmetically) measurability of intangibles such as brand value, customer loyalty and so on. In fact, in one of the conversations with experts on accounting and financial reporting standards, I was reminded the realizable value of the brand of an airline in India, which went belly down. The airline brand was valued at about US$ 1 billion. Similarly, there are numerous stances where the value of intangibles was overestimated. It is the belief of the opponents of the fair value model that the factors that are considered for arriving at the fair value of intangibles are dynamic and keep oscillating with the change in the environment, technology and so on. Hence, it is desirable to continue to pursue the historical cost value model. However, the most ardent supporters cannot deny the volatility and the element of a bit of subjectivity in adopting fair value preposition. Frankly speaking, the real battle is between ‘rule’ and ‘principle’ approach, and which is better will continue to be debated for some more time to come. Since it is not the remit of this treatise to dwell on standards setting, it is suffice to say that standard setters have to dynamize the approach and traverse the journey of re-engineering of stan­ dards with the philosophy of capturing the true value of enterprise. Insofar as the thesis of Corporate Governance is concerned, rigorous and religious conformance to prescribed standards is the call. The ultimate test is the reliability of the information to adjudge the real performance of the company. The usefulness of information is assessed from the availability of the same information from multiple sources and the ease with which technology tools can be employed to analyse. In substance, the cost involved in accessing and consuming the information. It is this perspective which adds relevance of dissemination of information using tools such as Internet-enabled platform known as extensible business reporting language (XBRL) and so

Accounting and Financial Reporting Standards  145

on. XBRL has the potential to tag along even the non-financial information—company- and industry-specific—and can facilitate collection and collation of information from outside the company as well. Such ability proffers previously unattainable fruits in the corporate reporting value chain and helps, in particular, researchers and fund managers to assess the value of the enterprise better. There are standards setters in every regulatory jurisdiction charged with the responsibility of laying down relevant and enforceable standards in tune with the domestic environment inclusive of company structures, market and business practices and so on. Some of the standards of a jurisdiction differ significantly from the corresponding standards of other jurisdictions. Globalization of market, in particular, financial, where companies travel around for ease and economizing the cost of resources, reaping the potentials for marketing products and services, and even developing/manufacturing products and services, makes a compelling case for building and applying global standards namely International Financial Reporting Standards (IFRS). Although the transition to global standards entails costs and consequences, for emerging economies and small- and medium-sized companies in particular, the eventual economics of business merits faster integration.

9.2. Management Assurance The management assurance is centred on the faithful and consistent observance of relevant standards. It has three layers: (a) executive management, (b) audit committee and (c) board. Each of these layers is expected to render distinctive yet complementary roles. The executive management is expected to record and aggregate all the transactions and present them in the specified format, applying relevant standards for each kind of transaction. However, it is not a straight line walk. The company transacts millions, even billions, of transactions, depending upon the size on daily, monthly, quarterly and yearly basis. Although the technology can facilitate correct recording and aggregation, ambiguity in the treatment of some of the transactions, which is high in case of some of the standards, adds to complications. Hence,

146  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

the treatment of transactions vis-à-vis the application of standards becomes a matter of judgement. In many companies, this judgement is exercised by more than one executive, which makes uniformity an issue. Such judgement choices open up the minefields of temptations. Furthermore, occasions do arise in the life of the company when the accounting treatment of a few transactions can convert loss into profit for the company. Here comes the role of standard operating procedures (SOP), delegation of authority (DOA) and internal checks and controls. Every company is obligated to set up a comprehensive framework of all the three. The internal checks and controls must be potent to ensure that every transaction gets recorded correctly and appropriately leaving little or no scope for discretion. If discretions are built, and exercised, the exception reporting mechanism must get triggered automatically. The exceptions reporting must be complemented with a review system to assess the efficacy of discretion exercised and whether review of SOP and/or DOA is called far. The internal audit is expected to play a sterling role in assessing the efficacy of SOP, DOA and internal checks and controls. It is important to state here that efficacy has to be validated periodically (at least once in three years), preferably by an outside agency— unrelated to internal and statutory audit entities. In the context of fast-changing macro- and micro-environment, company structure, business model and product line, no system, however effective, remains potent, and re-engineering becomes necessary. Since the board, management, CFO and CEO have to sign off not only on the financials, accuracy thereof on the strength of external checks and controls, but also the adequacy of internal checks and controls, the importance cannot be over-emphasized. Then, there are temptations of playing the earnings game and beating the market expectations quater on quater in the mistaken belief of enhancing shareholders value. It is relevant to mention here that the relevance of earnings as a reflector of future value has been reducing, albeit gradually eventually making the P/E ratios as only one of the motivators of investors. Instances of companies holding on to market valuation even when profit turned into a loss and/or sudden decline in the P/E ratio even when the same level of profit was reported are not far to seek in any market. Of

Accounting and Financial Reporting Standards  147

course, if the loss becomes a story rather than an isolated instance, the valuation does take a serious beating. Furthermore, executive compensations aligned to earnings game are not being kindly perceived by the shareholders, and sustainable real value creators is becoming a more reliable indicator. ‘Prevention is better than cure’ so goes the adage. Seeping of temptations into financial reporting can be arrested by the following cultural interventions: 1. Accountability: Accountability of the persons charged with the responsibility of the observance of accounting and financial reporting standards must be clearly delineated. Ambiguity at any level of any kind can disturb the equilibrium. Hence, the responsibility frame should include recording, aggregating, reporting and answering the queries, and those responsible must be held accountable. 2. Intellectual integrity: Many corporate scandals have taken birth in the womb of intellectual dishonesty. Executing instruction/advice not in conformity with the accepted principles even without personal benefit is intellectual dishonesty. It is possible to salvage an institution from the debris of financial loss, but not from the loss of credibility and trust. Doing what is expected cannot be compromised even under the guise of creating value for stakeholders, which may eventually betray their trust. Hence, organizations must become intolerant of dishonesty—financial as well as intellectual. 3. Alignment of compensation packages with value creation: It is important that the executive compensation is aligned with sustainable value creation, rather short-term performance. Hence, back-ended and deferred compensations are gradually, yet steadily, becoming the order of the day. 4. Enforceability of culture: The sustainability of any cultural ethos, however potent, depends on its enforcement. Zero in-tolerance drives fear down the spine of all concerned. The audit committee is charged with the responsibility of providing an effective oversight to the functioning of the management in this respect. It has the benefit of the independent assurance (will

148  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

be discussed later) proffered by the auditors to judge the quality of the work of executive management in the discharge of its role and obligations. Since the audit committee has been given the benefit of relying on the work of auditors, it has been legislatively empowered to recommend the appointment and remuneration of both internal and statutory auditors. While exercising its right to recommend the appointment and remuneration of auditors, the audit committee has to consider the following essential qualifications: 1. Independence—free from any other motivation, influence and so on. 2. Skills and competence to be able to undertake the responsibility, and a record of having displayed full accountability. 3. Required engagement—time and quality of attention. 4. Impeccable reputation of integrity. Unfortunately, in most companies, this right is not exercised with due caution and judgement, which, to my mind, is fundamental to their support system to validate managements’ certification. In fact, in quite a few companies, it is left to the CEO and/or options are not provided. Furthermore, the board also does not really get involved in the appraisal of the recommendations of the audit committee. This deficit in the governance process is fraught with serious risk of endangering the quality of independent assurance. The audit committee has to evaluate whether systems, processes, control mechanism and maker-checker are in place and efficaciously applied. Exceptions, if any, are reported and reviewed as to their desirability of use and impact on the overall financials and reporting. Furthermore, the need of the disclosure of exception has also to be evaluated and acted upon, if felt that disclosure is warranted in the light of its impact. In effect, the audit committee, while providing effective oversight capable of preventing executive management falling into temptations, adds credibility to the quality of management assurance. This is the rationale behind most regulators laying down an obligatory direction that the chairman of the audit committee must be well versed in accounting rules and regulations

Accounting and Financial Reporting Standards  149

and in understanding and interpretations of financial statements. Other members of the audit committee are also expected to be financially literate. In one of the companies, I know of, none of the members of the audit committee had the ability to appraise financial statements, and the MD and CEO were happy, glibly making statements such as ‘No more dramas in my audit committee meetings’. The stakeholders will be the ultimate sufferers, whereas the MD and CEO can enjoy the unquestioned presentations of financials. Hence, the board has to exercise its judgement while nominating its members on the audit committee. Even though the management, auditors, board as well as standard setters and regulators hold the collective responsibility of delivering credible information in the financial statements, the journey in an enterprise begins with the board. It is the commitment of the company to scrupulous application of standards that leads the path. It is the board which has to direct the application of accounting and financial reporting standards. If and when allowed to change, the application of new standard has also to be decided by the board. Hence, the board becomes the guardian of the application of standards. The superintendence of the board is facilitated by the following: 1. Direction to CFO and his team 2. Verification and confirmation of application by the auditors–internal and statutory 3. Monitoring by the audit committee of the board The superintendence of the board should ensure that potent systems, processes, control mechanism, maker-checker and risk management are in place and the application thereof is checked by the auditors and the audit committee. The board must unleash the cultures of accountability and integrity (mentioned earlier) and ensure that the executive management compensations are appropriately aligned. The board and its members should not only lay down, but also commit and scrupulously observe those standards of accountability and integrity, which they expect the executive management to adhere to. The board must provide the directions and get the implementations of those directions vouched at various levels with thoroughness and intensity.

150  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

I have observed that in most board meetings, not even a simple enquiry is made from the chairman of the audit committee, who briefs the board on the deliberations of the audit committee; and even in the audit committee no enquiry is made from the auditors whether the observance of accounting and financial reporting standards has been verified, and no exceptions have been reported/observed. In fact, it might be useful for the audit committee to formulate and use certain accounting standards’ applications measuring tests and insist on the auditors to give a report of their having tested the observance on the platform of those tests. Rigor and lapse in financial reporting can result in value creation or destruction, respectively. What separates a management and the board of a company from the other is one who identifies, measures and faithfully reports to all the stakeholders both the real value drivers and value destroyers in the same breath, of course, with a plan how these would be derisked. This is the difference that good Corporate Governance can make, which is built on the pillars of integrity, accountability and transparency. The financial reporting must also include, inter alia, the measurement of results on the platform of the pursued strategies. This sends the signals of lasting trust as the stakeholders appreciate the management’s own appraisal of both successes and failures becoming a public knowledge. What is often done is to publish the achievements alone. Consequently, a wave of mistrust sweeps across the market stemming out of inadequate reporting. The efficacy of management assurance is adjudged from the scrupulous compliance of the applicable standards, consistency of approach, clarity and comprehensiveness of the information with explanations on value drivers/destroyers, risks and uncertainties, judgement calls on significant estimations, strategies to preserve/enhance value, quality of controls and its method of relay to all the stakeholders including regulators. In fact, most progressive companies have crafted value reporting framework. Infosys—an Indian information technology (IT) company—has it on its website. Such reporting presents fuller and truer picture of the performance of the company and builds a greater trust in the management and its ability to navigate the rough weathers.

Accounting and Financial Reporting Standards  151

9.3. Independent Assurance Independent auditors have a distinctive role of rendering ‘independent assurance’ about the accuracy and quality of financials and its reporting. They owe it to the stakeholders of the enterprise who appoint and compensate to provide them an objective assessment, free from any external factor or motivation. A broader view of all the major corporate misdemeanours reverberates the assessment that the auditors had not done their job well in many cases if they were not complicit. The audit firms, their partners and the supporting staff too have to imbibe the culture of accountability and ‘integrity’, and should not fall prey to temptations. The relationship with the firm that they consent to provide independent assurance should be limited to auditing and on a fair and reasonable compensation. Delinquent behaviour, inadequate application of mind and even the lack of integrity have prompted some of the jurisdictions to create an independent regulator for auditors. This function was hither to before, and, even currently, in most jurisdictions, is handled by the professional body of accountants. Sarbanes–Oxley Act (2000) USA has brought in existence Public Company Accounting Oversight Board (PCAOB) to oversee and supervise the audit of public companies, in effect to regulate the audit function. PCAOB has been conferred wide-ranging powers, which includes imposition of penalties and suspension and revocation of registration itself of accounting firms. In India also, the Companies Act, 2013 provides for setting up of a similar body, ‘National Financial Reporting Authority’ (NFRA) to monitor and enforce the compliance of the standards in addition to setting of the standards itself. The NFRA is proposed to have a significant role including powers to investigate probable misconduct by a firm of chartered accountants and advise the government on auditing standards to be laid down. Eventually, NFRA may emerge as the big daddy to the accounting and auditing profession in India. The underpinning of creating one more agency is to ensure the efficacy of independent assurance. The auditors have to play the role of ‘watch dogs’ enshrined in the basic principles of auditing. The professional bodies of accountants have laid down the ‘auditing standards’ to help the professionals to architect a broad frame of uniformity. However,

152  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

they have to develop efficacious approaches to deal with the ambiguity, which is a growing phenomenon in the complex business environment. The auditors should not seek refuse under the shadow of rules to forsake the robe of accountability. The deeply embedded culture of accountability will help the stakeholders to get ‘the best’, rather than ‘marginally acceptable’, treatment of transactions. This will also help in bridging the expectation gap. In one of the companies where I used to sit on the board, a few issues led the auditors to take an extreme view and began with the threat of ‘declaration of not being able to render an opinion’ out of sheer scare of possible devolving responsibility, if ever. It took months of deeper scrutiny, discussions and delays, causing serious anxieties in the minds of investing public. Eventually, the auditors rendered the opinion ‘true and fair picture’ (subject to the following), albeit qualified opinion, which is what executive management and the board were agreeable to right at the beginning in the light of issues involved. Such an approach emanates from extreme caution and building safeguard around ‘accountability’, a clever way to de-risk converts the independent auditors from ‘watch dogs’ into ‘blood hound’. Having been a capital market regulator, it might be useful for the readers to know that the de-risking cover is easily blown over when the ‘application of best judgement’ is questioned, which is what I was arguing with the auditors of that company. The stakeholders of the firms expect from the ‘independent assurance’ rendered by auditors the best and not merely legalistically acceptable accounting treatment of transactions. The auditors do run the risk of being questioned, and what will stand in good stead for them is not the cover but the integrity of approach. Wellintentioned, honest decision is pardoned, but not the games played on the pitch of accountability. Yes, there is a risk in providing ‘independent assurance’, but that is inherent in the profession as in any other activity undertaken, which is supposed to have been purchased while consenting to undertake the engagement. The barometer of the auditor’s performance would be to assist the management in discharging its role efficaciously and highlighting the inadequacies—errors of omission and commissions, insensitivities to value creation and/or destruction and insensitiveness to the interest of the stakeholders.

Accounting and Financial Reporting Standards  153

9.4. Statutory Assurance The orderliness in a society is ensured by laying down the rules of the game and appointing ‘high priests’—regulators—to adjudge the behaviour with reference to those rules. The capital market is no different. The ‘economic agents’ ingrain the greater propensities of profiting from the possibilities including those they cannot harness ethically. Their enlightened self-interests often ride roughshod on the interests of the investing community. Hence, a comprehensive framework has evolved (and continues to evolve) to rein in such motivations of the economic agents. This according to the author is the ‘statutory assurance’ provided to the investing public that the market, in general, and the company, in particular, are on track. Misdemeanours, if any, are being noted and dealt with effectively to sustain the confidence. Regulators are often angry and feel aggrieved when they come under public scrutiny for failure to curb and prevent the misdemeanours. Their defence is that they did lay down the framework and kept a watchful eye and if something still has happened, why blame regulators? What is often forgotten in such situations is that the frame of reference is ‘collective responsibility’. Hence, some part of accountability, albeit much less in degree, has to be shared by the regulators. Regulators assurance is both qualitative and quantitative. The quantitative assurance is reflected in the adjustment to the valuation by the market when it factors in the financial reporting. This is instant and moves with the speed of light. It is a pity that some of the managements rationalize it to market sentiments, ignoring the fact that this is the verdict of the market. There are a number of instances where valuations have taken a knock on account of deficit in the application of accounting standards. Such erosion in the value of an enterprise is much higher than the decline on account of lower profits in a quarter or two. The statutory assurance is provided by the regulators, which, in most markets, consists of two tiers. The first tier is called SRO, which, in most markets, is the exchange that has independent arm/department to undertake the task of review of financial reporting and also recommend to the statutory regulators to keep re-engineering the ground rules from time to time with a view

154  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

to reinforce the robustness of the framework. The second tier is the statutory regulator who lays down the framework and has the ultimate responsibility of it being followed scrupulously. The barometer of the success of ‘statutory assurance’ is the minimality of the cases of misdemeanours and expeditious and effective cognisance of the noticed cases which unleashes a wave of deterrence.

9.5. Conclusion The collective responsibility frame has been erected in all jurisdictions, as the impact of misinformation is multidimensional. It impacts the company and its stakeholder directly and the capital market and, at times, even economy as whole vicariously. The analysis of Asian meltdown published as ‘The IMF’s Response to the Asian Crisis: A Factsheet’ in 1999, inter alia, reported, ‘Although private sector expenditure and financing decisions led to the crises, it was made worse by governance issues, notably government involvement in private sector and lack of transparency in Corporate and fiscal accounting and the provision of financial and economic data.’1 Every instance dents the confidence of the investing public. However, instances of blatant disregard of the rules and regulations, which smacks of governance failures, build 1 International Monetary Fund (1999). Available at: https://books.google. co.in/books?id=nVJ_AgAAQBAJ&pg=PA77&lpg=PA77&dq=imf+although+pr ivate+sector+expenditure+and+financing+decisions+led+to+the+crises,+it+wa s+made+worse+by+governance+issues,+notably+government+involvement+in +private+sector+and+lack+of+transparency+in+Corporate+and+fiscal+accoun ting+and+the+provision+of+financial+and+economic+data&source=bl&ots=a bi47ZG0jx&sig=AjJBn8WhWe47dxxN-quzU_T3aO8&hl=en&sa=X&ved=0ah UKEwi3nYO_8e_MAhVMo48KHee_C8MQ6AEIITAC#v=onepage&q=imf%20 although%20private%20sector%20expenditure%20and%20financing% 20decisions%20led%20to%20the%20crises%2C%20it%20was%20made%20 worse%20by%20governance%20issues%2C%20notably%20government%20 involvement%20in%20private%20sector%20and%20lack%20of% 20transparency%20in%20Corporate%20and%20fiscal%20accounting%20 and%20the%20provision%20of%20financial%20and%20economic%20 data&f=false (accessed on 30 May 2016).

Accounting and Financial Reporting Standards  155

fissures and often wreck the confidence in allocation efficiency of the capital market and trust in entrepreneurship. This is what happened when a series of misdemeanours unfolded in the North America and the regulators and governments across geographies had to sit up and take notice. What followed was knee-jerk reactions and excessive regulatory framework which eventually enhanced the ‘agency costs’. The ultimate sufferer has been the investing public and entrepreneurial spirit, and the eventual wealth creation and the extension of the sufferings of deprived masses in the concerned societies are caused by the lower/negative growth of economies. Hence, the responsibility and accountability is cast on all the assurance providers not to treat an instance in isolation, but look at the impact on the larger interests. However, so far, as the Corporate Governance is concerned, it is the ‘management assurance’ and ‘independence assurance’ which have to be truthful and really assuring. If the society thrives, companies will deliver better results and all the stakeholders including economic agents will prosper. The call is to rise above narrow self-aggrandizement and deliver quality financial reporting to strengthen the confidence in the corporate democracy. The quality financial reporting is one which is complete, accurate, trustworthy and timely. Hence, the frame actually has to work where all the factors are interwoven to provide confidence to the investing public (see Figure 9.2). Figure 9.2   Stakeholders QUALITY ASSURANCE

STAKEHOLDERS INDEPENDENT ASSURANCE

MANAGEMENT ASSURANCE

STATUTORY ASSURANCE

156  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE Figure 9.3    Pyramid of Accounting and Financial Reporting HIGH PRIEST CAPITAL MARKET REGULATORS

BOARD AUDIT COMMITTEE OF BOARD AUDITORS INTERNAL AND STATUTORY MANAGEMENT STANDARD SETTERS

The deliberate act of providing false assurance by the management and independent auditors of Satyam Computers of India not only shook the confidence of the shareholders of Satyam and witnessed immediate erosion in their wealth, but also had its impact on the community of shareholders at large. It gave a fillip to the sentiment that connivance in providing management and independent assurances disrupting the efficacy of the market itself do happen. In substance, the pyramid of accounting and financial reporting works as shown in Figure 9.3, in terms of responsibility frame.

10 Related Party Transactions

T

he market economy commandeers the ingenuity of the management to build economics of operations. RPTs do provide the scope for lowering the costs of capital, HR, goods and services and tax savings and so on. One does not have to look beyond the nose to exemplify benefits from RPTs. Often used transactions include: 1. Supply of goods (including raw material) and services— especially as an element of backward or forward integration. 2. Licensing or leasing agreement between holding and subsidiary companies, particularly in multinational organizations. 3. Intercompany loans and guarantees from holding to subsidiary and vice versa. 4. Leveraging of receivables via a special purpose vehicle and so on. 5. Compensation to executive members on the board as well as NEDs. 6. Transfer of property, right or obligation and so on. 7. Leasing of accommodation: property, vehicle, equipment and so on.

158  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

However, RPTs have been an issue of serious concern amongst the shareholders and regulators alike. The prospect of undermining the interest of some by the other emerges from the underlying factor that the individuals/entities in control of decision-making process have interest in themselves and/or other entities too, which proffers the propensities of profiting from the RPTs. And, human nature is self-serving and susceptible to temptations. Many a Corporate Governance failures and corporate misdemeanours have been attributed to the RPTs. It is, therefore, important that every RPT is undertaken in a manner, and by a method, which not only is fair, but also appears to be fair to all concerned and delivers an economic benefit to the company. The pendulum of approach to regulating RPTs has swung from one side to another. US law once prohibited RPTs involving managers and directors. The Indian Companies Act, 2013 has procedurally made RPTs a very difficult preposition. However, despite conceding that value diversion builds significant agency costs, prohibiting RPT cannot provide assurance to protect minority interests, while delineating wealth optimizing and scoping equitable approaches in enterprises. Hence, globally, the burden of direction has shifted to designing the regulatory framework to prevent, albeit minimize, the conflict of interest, and whatever is done reflects fairness and economic profit at least vicariously to the enterprise. Transparency has been conceived to be the hallmark of fairness. It is not easy to define RPTs as one may think. Any transaction in the course of the management of an enterprise is broadly described as RPTs, if decision-makers or their dependents and associates have interest, direct or indirect, in that transaction. Regulators across geographies have listed related parties that have to be reckoned with while dealing with the issue of RPTs. However, the following are the broad categories of related parties which fall within the preview of related party in all regulatory jurisdictions, and transactions related to these parties become RPTs. 1. Holding, parent, associate and subsidiary companies. 2. Subsidiaries of a common parent.

Related Party Transactions  159

3. 4. 5. 6. 7.

Trusts and entities for the benefit of employees. Management inclusive of directors. Employees. Immediate family members of those mentioned in 4 and 5. Affiliates of those in 4, 5 and 6.

10.1. What Is an RPT A transaction regardless of whether or not market price is the consideration—through which the ownership/benefit/right of monetary value (current and/or future) is sought to be transferred to another entity/individual that is related to the original owner/decision-maker—is termed as the RPT. Since the decisionmakers have an interest in the transferee, conflict of interest comes into play. Some of the examples of RPTs have been quoted in the first paragraph. These transactions could also be entered into with other related parties inclusive of directors, their dependents and the entities fully or partially owned by the related parties.

10.2. Why RPTs Are an Issue of Significance Ordinarily, if the asset/right/benefit changes the ownership for the appropriate price, there could be no issue. However, oftentimes, the ownership changes hands at a price, which is not commensurate with the fair value. Sometimes, it is observed that although a fair price is agreed to be paid, the mechanism/ instrumentality of the payment of consideration, when delved deep, reflects that what is on the surface is actually a facade and covers the reality of under/over-payment, which is detrimental to the interest of the stakeholders of one or the other entities. This is done through the process called ‘financial engineering’, although no pragmatic analyser of such transactions can have a quarrel with the finance professional’s ingenuity—financial

160  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

engineering, so long as it is legal, enforceable and fair. However, oftentimes, financial engineering is undertaken to camouflage the actual consideration amount. In case the ownership pattern of current and future owners is exactly the same and not likely to change over time, there can hardly be an antagonism to the RPT. But, most often, that is not the case. Sometimes, the equity structure of the two entities is so weaved that even though on a given date it looks the same, it changes substantially over a period of time by the inbuilt propensities of the future capital structure. This causes financial hurt to the owners of one entity and benefits the owners of the other. I have had the occasions to watch the consolidation and split and again consolidation of businesses, which at the end of tunnel resulted in change in ownership structure in favour of promoters and/or decision-makers. This is often not noticed by the stakeholders, in particular, if the time gap is considered, though incisive market participants get a hang of it easily and discount the valuation. And, all the stakeholders suffer but the hurt to silent majority is greater. Solution: We are in a dynamic environment where changes are taking place at the speed of thought, which calls for an appropriate strategy response to remain competitive, profitable and a step ahead of others. The strategy response can take various forms including mergers and demergers, hive and hire, slice and dice and so on of the asset, input mobilization and/or supply chain management. The fairness demands that such activity, which may also result in RPTs, is undertaken in a manner and method which not only is fair, but also is perceived to be fair. This is made possible by laying down the process and outlining the procedure. The process and procedure should have the following basic ingredients: • Establishing indisputable necessity to undertake the transaction. • Independent assessment of the value of the asset/right/ benefit sought to be transferred. • Well-laid out justification of how the value has been arrived at.

Related Party Transactions  161

• Matching of the amount of price/consideration for the transfer of the asset/right/benefit with the actual value to be transferred. • Scrupulous adherence to law in letter and spirit. • The transaction stands the scrutiny not only of law, but also the public analysis about equity to all concerned. • The procedure outlines proper disclosure giving all the necessary data for the people to assess the efficacy of the transaction(s).

10.3. RPTs, Auditors and the Audit Committee Auditors and the audit committee in that order have the primary responsibility towards stakeholders of ensuring that all RPTs are done at arm’s length, in the ordinary course of business and transparently. Arm’s length will include fair market price as the consideration for the transaction. The problems for the auditors and the audit committee in providing effective superintendence arise not only from the complexity of transactions, but also from material misstatement—deliberate or by default. Auditors generally employ a range of audit processes to identify and evaluate RPTs and work as an effective support system for the audit committee. However, our suggestion is to collect information about delegation—whether formal or not—control over activities, responsibilities of various layers of management and arrangement with various components of the company. This might help to uncover the managerial ethos of profiting from the openings of RPTs. Sensitizing the organization about the agency costs, value evaporation and consequential cognisance by the stakeholders and/or regulatory authorities is the role that the auditors will have to play. The audit committee has to, inter alia, monitor the effectiveness and independence of the auditors, specifically in the matter of RPTs. The audit committee will also have to apply its mind to reassure that the RPTs are at arm’s length, transparent and in the ordinary course of business, and the procedure outlined has been scrupulously adhered to.

162  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

10.4. Board and the RPTs It is the responsibility of the BoD to ensure that a sense of fair play and equity is apparent in all the RPTs. The board relies on the assessment of the investment bankers, auditors and the audit committee. While their assessment should be an important consideration for approving the decision, the board has to apply its mind, use its wisdom and assess whether equity and fair play exist in full measure. The fundamental principles have been graphically depicted in Figure 10.1 It is a three-legged stool which makes instability inherent. Any of the legs becoming weak or not providing enough strength or sharing the weight makes the RPT a questionable transaction. The executive management, auditors and the audit committee must remain watchful of not allowing the weakness creeping in any of the legs and rather ensure that their scrutiny adds strength and stability. It might be useful to delve briefly into what the three principles are all about. 1. Ordinary Course of Business: The why of RPT entails reflecting the usefulness and necessity of the transaction for the business of the enterprise. Economic benefit must be established. This can happen only if it is desirable Figure 10.1     Fundamental Principles of Approving RPT

ORDINARY COURSE OF BUSINESS

TRANSPARENCY

ARMS LENGTH

RELATED PARTY TRANSACTION

Related Party Transactions  163

in the ordinary course of business. Hence, the relationship of RPTs with the business of the enterprise must be established normally directly, but must be clearly visible to discernible eyes if it is indirectly related to the business of the enterprise. 2. Arm’s Length: Arm’s length envisages that the related parties are not influencing the decision-making. Hence, the pricing of the transaction has to be at the fair market price. Any transaction, which is not fairly priced, cannot be considered to be at arm’s length. How to arrive at the fair price has been described in Section 10.6. 3. Transparency: It is important that the stakeholders are fully informed of all the RPTs so as to help them evaluate that the related parties in the management are not indulging in self-dealing, in particular, as a determent to their interests. The disclosure must incorporate the methodology used. The confidence of the stakeholders in fairness increases if there is a board-approved RPT policy which is made public. This will help them to evaluate the efficacy of transaction with reference to established policy.

10.5. RPT Policy Every company must frame an RPT policy, which should be approved by the board. The policy must provide broad frame under which the RPT will be undertaken. This should be made public, and comments from the stakeholders, if any, must be used to modify. A sample of draft policy is given in Annexure 4.

10.6. RPT Procedure I recommend the following procedure for all RPTs: 1. Letter of intent • A formal communication of intent should be submitted to the audit committee and board before entering

164  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

2.

3. 4.

5.

6. 7.

into an RPT. The purpose of the communication of intent is the pre-examination of the need to enter into such RPTs as also pre-approval by the audit committee as is mandatory in some jurisdictions including India. Valuation • Two or more valuers should be appointed for deciding on the appropriate price. Also, it is recommended that the services of different valuers should be utilized for different transactions instead of repeating the same valuer every time. This will help in establishing greater authenticity and transparency in the RPTs and/or • Competitive quotations should be obtained from more than one party. Pricing • The basis adopted by the valuer to decide transfer pricing should be elaborated. Payment term • If any credit/settlement period is given for realizing the consideration, the matching of transfer price and payment should be done. The company should ensure that the present value of the consideration to be received in future matches with the transfer price decided by the valuers. Sunset clause • When entering into long-term contracts, care should be taken that the contract remains fair at all times. Accordingly, a sunset clause should be incorporated in the contracts so that the contract does not become uncompetitive in the long run. Disclosure • All RPTs should be disclosed in full. Oversight mechanism • The robustness of the oversight mechanism of the auditors, validation by the audit committee and authentication by the board of the RPTs should be strengthened.

Related Party Transactions  165

Following such an elaborate framework of policy and procedure may appear to the managers of the enterprise tyranny. However, it must be remembered that this is one area which has the propensities to wreck the trust of the stakeholders. In any case the market perceives that the RPTs are not above board and/or are undertaken except in the interest of the business and transparently, the valuation is significantly discounted. Pursuing an elaborate approach which is subjected to incisive security by independent auditors and the audit committee and transparency will receive the appreciation all around and protect the valuation. Hence, it is an advisable approach.

10.7. Conclusion ‘RPT destroys your own wealth because, if the perception is wrong then you would lose couple of percentages of multiples’, says Narayana Murthy, chairman emeritus of Infosys. Although the management, monitoring and superintendence of the RPT cannot be allowed to deprive the enterprise of value creation opportunities, it has to be clearly understood that inefficacious handling can dent the reputation, which eventually destroys the value—the basic purpose of its existence, ‘wealth creation’. The market forces, in addition to regulators, are at work, more so with increasing shareholders activism. Damaged reputation will have serious repercussion on the enterprise valuation. The trade-off, even for the entrepreneur-driven companies, may be adverse economics. Hence, a deeper approach to protecting minority interest, increased transparency and greater shareholder involvement in decision-making may benefit substantially. The Indian Companies Act, 2013 has laid down very comprehensive guidelines in the matter of RPTs. The observance of these guidelines in letter and spirit would certainly strengthen the Corporate Governance of the firms in India.

11 Disclosures 11.1. Introduction

T

he invention of the institution of JSC has separated ownership from the management. The small minority of controlling shareholders and/or the professionals manage the interest of a large majority of silent and passive stakeholders. The ‘trust factor’ cements the relationship. The world has transited from the ‘merit-based’ to the ‘disclosure-based’ regime. In the meritbased regime, someone acting from a corner office of a regulatory structure decides who can raise financial resources, when and at what price. In the disclosure-based regime, the entrepreneurs/ management have to disclose their intentions to raising resources coupled with methodology and pricing, along with all the information that will help a prospective investor to take an informed decision. Howard Schultz, the head of Starbucks, observed some time back, ‘The currency of leadership is transparency’. Narayana Murthy, the chairman of Infosys, says, ‘We have to insure there is no asymmetry of information between owner/manager, who we are and community of our shareholders. And the only way we can do is through leading its disclosures’. He adds, ‘Good disclosures are needed to enhance the trust of stakeholders at large’. The decisions taken by the managers of the enterprise have economic consequences, which, in capital market terminology, are called ‘price-sensitive’. The decision-maker becomes privy to

Disclosures  167

price-sensitive information and knowledge of its impact before it becomes public. The propensity to encash such information ahead of its becoming public and profit therefrom is inherent. Such encashment is called ‘insider trading’. It is, therefore, incumbent on all such persons who, by virtue of their position, get information ahead of others to disclose it immediately in a manner and method that makes it a public knowledge and, until then, do not make use of such information directly or indirectly to benefit therefrom. Furthermore, the stakeholders including investors, in risk capital, need certain information to begin with and on an ongoing basis, which helps them to assess the current health of the company and its future prospects so as to decide whether to engage, continue to engage or disengage from the relationship with the company. They also need to assess the quality of the management, which helps them to extrapolate forward valuations. An old Global Investors Opinion Survey (2002), conducted by McKinsey & Company, revealed that 71 per cent of investors gave weightage to accounting disclosures while taking an investment decision. This explains why companies in the same industry with nearly the same P/E ratio are priced with varying multiplies. In fact, one vicarious advantage of market valuation based on disclosures is its near truthful verdict on the performance of the company and future prospects. Thus, information becomes the prime mover of the capital markets. The enlightened management and board should use market verdict to shed the garb of complacency and gear up the organization to the heights of excellence. The strides of corporatization have brought into sharper focus the significance of transparency in decision-making, which has made disclosures an important part of the Corporate Governance. Since it is neither feasible nor necessary to disclose every corporate decision, regulators, as good Corporate Governance norms, have made it imperative to disclose certain (specified) important decisions and information. In any scheme of disclosures, the significance has to be on quality. One of the purposes served by the disclosures is the impact of decision on the profitability and sustainability of the business as well as the enterprise. Hence, if the information provided does not throw enough light on its impact, it is irrelevant.

168  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

It has been observed that sometimes, recourse to legal opinion is taken to decide whether decision/information needs to be disclosed. In my opinion, good Corporate Governance warrants ‘when in doubt, better disclose’ rather than ‘look for the umbrella of legal opinion to hide’. Such an approach will enhance transparency and build credibility of the management, which will eventually augment the perception about the quality of Corporate Governance. However, the underpinning of the disclosures is transparency, greater transparency and still greater transparency. Hence, a ‘culture of transparency’ had to be ingrained in all concerned in the company right from grass roots to the level of the board. In fact, a procedure needs to be outlined so as to ensure that whenever occasions arise, disclosure happens. This can be organized by building trigger points based on the parameters outlined and the philosophy of the Corporate Governance moving from mere form to substance. The system should be so orchestrated that the trigger points get activated whenever the eventuality of disclosure arises. The responsibility of disclosures falls squarely on the shoulders of the BoDs. Corporate Governance codes around the world including International Corporate Governance Network (ICGN), OECD, Commonwealth Association for Corporate Governance (CACG) guidelines, and, in addition, the regulators mandate that the BoD provides all the stakeholders credible information to help them take a call on the continuance of the relationship. Figure 11.1      Pyramid of Disclosures

BOARD AUDIT COMMITTEE AUDITORS CHIEF COMPLIANCE OFFICER CFO AND HIS TEAM

Disclosures  169

Even though the ultimate responsibility of disclosures rests with the board, there is pyramidical structure which supports the board in the discharge of its obligation (see Figure 11.1). At the base is the CFO and his team, who have the primary responsibility to disclose what is expected of a company in terms of regulatory framework and desirability for enhancing the transparency, thereby strengthening the trust factor. The chief compliance officer has to ensure that rules are complied with in this respect as well and that the manner of disclosure is as prescribed. Thus, he acts as a kind of check on the performance of the base line champions of disclosures. The auditors are expected to provide an independent assurance that all the necessary and needful disclosures have been made, and timely, as also that the quality of information provided is appropriate. They are expected to carry out a scrutiny of disclosures while undertaking the audit of financials, internal checks and controls and so on to fulfil their obligation. They are obligated to provide the certification to that effect as well. The audit committee, which provides oversight to the functioning of the CFO and his team and also that auditors are effectively playing the role as an independent agency, has to evaluate the quality of work done by these layers. Additionally, it has to insist upon the existence of systems to ensure that the disclosures happen as a matter of organized process and let up the surface, if any, before it is too late. The board is charged with the responsibility of providing superintendence to the functioning of the various layers of the pyramid through the review of the working of the audit committee. It would thus be observed that each of the layers has a singular responsibility and lends support to keep the pyramid of transparency solid and strong. However, at the top of the pyramid sits the regulators who prescribe and continue to reconfigure the prescription of disclosures based on the expectations of the investing community—nationally and globally—and the lesson learnt in the journey of regulating the market. The prescribed standards must lay down principles and rules which enable disclosures to become useful and reliable. Regulators have also the responsibility to ensure that all the aforesaid layers of the pyramid render their role optimally and that

170  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

the enforcement mechanism creates a fear of God and draws the management to chanting the mantra of full transparency. Today’s investors expect ever-greater transparency not from companies alone; their aspiration extends to independent auditors and even regulatory design. This pitchforks the frame of collective responsibility. As the chairman of SEBI, when I was being criticized for my overdrive on enhancing disclosures, I used to take solace in the frame of collective responsibility. The central focus thus turns to what I call intellectual integrity to building, maintaining and sustaining ‘stakeholders’ trust’, a necessary condition to creating and retaining the efficacy and belief in the virtue of the capital markets. In most companies, disclosures centre around merely financial disclosures. It is imperative to remind anything material which can influence the price of its stock, albeit market valuation and/or the decision of the stakeholder needs to be disclosed. Even the state of the health of the CEO becomes important. Every company has to rigorously conform to regulatory direction in the matter of disclosure, and here is a broad frame of reference: 1. Financial Disclosures: Information on financial and operating results should be potent enough to help, understand and appreciate the nature of business, current state of affairs, performance during the quarter/half/year and how would the enterprise shape up going forward. The quality of financial disclosures has a direct relationship with the robustness of financial reporting standards or observance of the accounting standards’ use in the preparation of the financial statements. Although the observance of accounting and financial reporting standards is a subject matter of another chapter, it is suffice to state here that the authenticity of use thereof is of prime concern. Financial disclosures, therefore, must be accompanied by the management’s discussions and analyses (MDA). MDA would include inherent risks and estimates used in the preparations and reporting of the financial results. The information disclosed must include ‘value drivers’ as well as ‘value destroyers’ and how the management is going to leverage and/or de-risk all those in the forward journey. This disclosure will be insufficient if the strategies that will be marshalled are not outlined. Furthermore, disclosure must also incorporate company’s compensation policies, statement on the robustness of

Disclosures  171

internal control systems, compliance procedure and company’s commitment to serving the interest of all the stakeholders rather than shareholders alone. The process followed by the board in approving the accounts must also be disclosed. In fact, it might be helpful to disclose the board’s obligation of the superintendence of the process of preparations of financial statements. Along with the financial results, the company must also disclose all significant RPTs as well as related party relationships where control exists, even though there may not be any RPT. Adding to disclosures, RPT’s decision-making process is greatly appreciated. 2. Non-financial Disclosures: The following is the list of nonfinancial disclosures: • Company objectives, charges, if any • Management structure: directors and key executives • Ownership control structure along with how shareholders exercise their control rights—through voting and/or seat on the board and so on • Changes in control along with the process/transaction that brought about • Governance policies and structures inclusive of board committees and their charters • Processes of dealing with the conflict of interest • Performance evaluation process for the board members and key management personnel • Compensation to board members and key management personnel • Disclosure about auditors—statutory and internal—and briefly how their work is organized • Matters about the AGM and EGM • Whistle blower policy • RPTs and procedure This is not a comprehensive list and should not be used as a reference. The guiding principle has to be to keep the stakeholders fully informed of all that they would want to know or must know or will be useful to them in their decision-making. The more is disclosed, the more transparency gets strengthened.

172  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

11.2. Means, Methods and Manner of Disclosures The following means are generally used by the companies for disclosures: 1. Annual report 2. Website 3. Statutory filing: periodically with • the exchange where company is listed • regulator(s) 4. Newspapers 5. Communication to shareholders Most regulators now permit electronic circulation/dissemination/ filing of the information. The companies should switch, if not already done, to an electronic method. This will save the cost and speed up the receipt of the information/disclosure, which can be even personalized if so desired and helpful. Most companies now use Internet-based XBRL-like platform to facilitate the ease of access and analysis of the information. In any scheme of disclosures, the most significant part is the manner. It should be precise and candid. It should convey what is sought to be conveyed. Hence, the focus has to be on the quality and timeliness of the disclosure. Delay or inadequate disclosures open up space for insider trading as also speculation, which has to be necessarily obviated. Researchers form a considered opinion, and investors take informed decision based on the information so disclosed and the opinion of researchers. It has, therefore, to be ensured by the board that disclosure is timely, is done in a manner and a method that it is noted and understood by all those to whom disclosures is intended and is understood by the public in general as by the management itself. The quality of disclosures plays a significant role in building perception about the quality of governance and has, therefore, to be handled with sagacity, pragmatism and urgency. A number of concerns have been expressed by the managements of the company on (excessive) disclosures. While, as a regulator of the Indian capital market, I was traversing, albeit fast-paced, on the

Disclosures  173

platform of modernizing the market and dynamizing the disclosure standards, I had to deal with those concerns sagaciously. The two most talked-about concerns were: (a) cost of disclosures and (b) compromise to the competitive position of the company. Although my answer to beating the cost by standardization of systems and use of technology was acceptable, I was not able to convince them on the issue of compromise to the competitive positions, particularly vis-à-vis an unlisted company. However, it had been my belief then, and continues to strengthen with every passing misdemeanour, that all the economic costs are taken care of by the higher valuation of the enterprise by the market proffered to companies with very high standards of disclosures. Transparency begets trust, and trust endures the loyalty of the stakeholders, which may be difficult to ensure as much by other means and methods, involving expenditure including in investor relations’ management. I am aware of the cost involved in building investor relations. Although investor relations are limited to providing assurance on good governance, world-class disclosure standards go beyond to enhancing valuation. The global financial meltdown of 2007 has brought transparency of the corporate to centre stage and the lack of it threatens sustainability. The governance has become more active. Even the pressure groups such as non-government organizations (NGOs), shareholders and so on and investigative journalist organizations have become focused. Transparency International (TI), which now reports on corporate transparency as well, has, in a recent study, revealed that 80 per cent of the firms surveyed scored less than 5 on a scale of 10, and that the record of Asian companies is much poorer.1 One of the three important areas surveyed was financial reporting. Inadequate, incorrect or unclear disclosures adversely impact the perception about the quality of Corporate Governance, which has a direct and proportionate bearing on the valuation. Institutional investors generally apply lower discounting rates 1 ‘Corporate Transparency: The Openness Revolution’. (2014, 13 December). The Economist. Available at http://www.economist.com/news/business/21636070multinationals-are-forced-reveal-more-about-themselves-where-should-limits (accessed on 30 May 2016).

174  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

while arriving at the valuation of Asian companies compared to US and European companies, in general; of course, transparent companies in all jurisdiction get their valuation near right. Deficit in the disclosure may invite regulatory onslaught, which can destroy/diminish the enterprise value. In a recent case of nondisclosure (of Delhi Land & Finance (DLF)—the largest listed Indian reality company), SEBI, India’s securities market regulator, prohibited the company and the three promoter directors, CFO and so on from dealing in securities market for a period of three years, which shaved off nearly 20 per cent of the enterprise value in one day. The decision was challenged before the Securities Appellate Tribunal (SAT), which overturned the decision of SEBI. SEBI has since appealed to the Supreme Court against the order of SAT. Irrespective of the outcome, the irreparable damage to both the value of the enterprise and ‘trust factor’ has been done. At a time when even capital markets have gone global, alignment with global standards and the integrity of disclosures has become an important element of enhancing economic growth of a country. Regular surveys are being conducted by the credit rating agencies, investment bankers and even large active institutional investors such as CALPERS to assess the quality of disclosures. Since sharing of truthful information is bound to open up platforms of broader market investors, every regulatory jurisdiction is now committing to global standards of disclosures while weaving the local needs. In fact, the phenomenon of ‘civic duty’ to leak information, if their employer is shady and secretive, is also spreading. Hence, the deficit in disclosure will not only harm the firm and lower its enterprise value, but also, albeit vicariously, adversely impact the economic growth of the country, because its conduct will impact the efficacy of the capital market itself. Professor George Serafeim of Harvard Business School, based on the evidence, observed, ‘It boosts the share price because of the demonstration by the management of its efforts to handling hidden risks’. Hence, in the interest of the firm, the market and also the larger economic interests of the jurisdiction it operates, it is important that the board, executive management, auditors and regulators collectively address the issue of disclosures and make the functioning of the firm transparent. The reputational benefits of openness will be greater than any other gain that can be achieved by the managers of the firm by the lack of it.

12 Risk Management

‘T

he revolutionary idea that defines the boundary between modern times and the past is the mastery of risk: the notion that the future is more than a whim of the Gods and that man and women are not passive before nature’, writes Peter L. Bernstein in the introduction of his world famous book, Against the Gods: The Remarkable Story of Risk.1 And, to my understanding, the fast-paced unremitting transformation of the environment makes a year gone by as past. Obsolescence and irrelevance have a new definition of the longevity of organizational design, products, systems or processes. The ability to map the future—year, two years or five years—decipher risks and draw up a matrix of risk management, risk mitigation and risk avoidance tools are the hallmark of sustainable success of individuals, corporations and even societies. This transformation in approach distinguishes pragmatism from conventional wisdom. If the definition of success extends beyond a quarter or year, risk management has to occupy the front seat in the strategy formulation. While granting that all risk management failed to perceive and map out the onset 1 Bernstein, P. (1996). Available at: https://books.google.co.in/books?id= uTje6PYAijUC&printsec=frontcover&source=gbs_ge_summary_ r&cad=0#v=onepage&q=the%20notion%20that%20the%20future%20is%20 more%20than%20a%20whim%20of%20the%20Gods%20&f=false (accessed on 30 May 2016).

176  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

of 2007 global economic meltdown, I would still forcefully advocate risk management to be at the top of the agenda. I consider risk management as one of the important processes in building excellence in Corporate Governance. In most boards, risk management is relegated as an appendage to the oversight of the audit committee which focuses and rightly so on the financials and its reporting, and the risk management is discussed once in a while and often casually. Pragmatic managements architect risk management within the broader framework of strategy and operations’ management, but with clearly defined goals and process. The theme of this book is the triumph of Corporate Governance. Hence, I suggest risk management as one of the fundamental enabling processes. It is the process which will help protect value drivers and de-risk value destroyers. Although I will discuss the actual process while detailing the role of the risk management committee (RMC), the focus here is what the board should be doing in this area. I strongly recommend constitution of a separate RMC. A draft charter of RMC inclusive of the role is given in Annexure 5. First and foremost is the coordinated, concerted and continuous focus on risk management, rather than mere conformance with regulatory directive of setting up RMC or allocating the responsibility to the audit committee. The journey will begin with identifying the value drivers as also the value destroyers, which will have to be reviewed every quarter. This will be in addition to the detailed work of identifying the business risks, their management and mitigation. The following, which are often ignored and/or not considered, will have to be definitely incorporated in the framework. The board must design a pragmatic risk management policy and craft risk management framework with the help of RMC. The scope of the risk horizons is of prime importance. Scope: The risk management framework often excludes risks arising out of macro- and micro-socio-politico-economic factors. In the current dynamic setting, macro- and micro-factors emerging in any part of geography can influence the business environment in other parts of the planet. Just to explain the point, the impact of the growth of Chinese economy or slow down of

Risk Management  177

investments in infrastructure in China can influence not only the pricing and production capacities, prices of commodities, but even the new investments opportunities in different industries in India as anywhere else. The Arab spring and the consequential political and social disquiet in Middle East and North African (MENA) countries affected the economics and businesses globally, consequenced by their impact on the production of oil. Hence, the macro- and micro-environmental risks have to be scoped to mitigate and manage the impact thereof on the business of the enterprise. Regulatory Risk: Regulatory stance about the business, product, compliance and so on travels on a dynamic platform and undergoes transformation depending upon the macro, micro and even the market environment, company compliance and misconduct. The change in regulatory stance often alters the frame of reference, which may eventually make the organizational design, business model, strategic approach and even the product basket irrelevant or counterproductive. Furthermore, any letup in the obligated compliance can invoke regulatory cognisance and consequential action. This may result in financial loss and lead to the erosion of the value of the enterprise. Hence, regulatory risks have to be an inescapable part of the risk management framework. The propensity of regulatory risks is greater in case the regulator is on a learning curve or the market is at an evolutionary stage. Life Insurance industry in India during the years 2008–2013 is a witness to the severe impact on the growth and profitability caused by the unhedged regulatory risk. Most boards do not recognize regulatory risk and are surprised when the onslaught of regulatory overtones wrecks the financials and/or enterprise value. Opportunity Loss: This is also a risk which may not necessarily impact the profitability of the current business and even sustainability of the enterprise, but can certainly impede encashing the propensities of profiting from the unfolding of opportunities, albeit far in the horizon, as a consequence of new perspectives and possible changes in social, economic and political environment across geographies. An illustration: Change in the preference to mud structure over concrete even for additional housing by well-to-do

178  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE Figure 12.1      Risk Management Grid Executives’ Risk Management Committee

RMC of Board

BoD

Value Protection

Enterprise Risk Vision, Mission and Cultures

Organizational Design Risks

Business Risks*

Regulatory Risk

Opportunity Loss Risks

Micro Environment Risks: Industry-specific Risks Macro Environments Risk: Political, Social and Economic

Note: * denotes strategic, operational, financial risks and so on.

families can throw up a new set of opportunities to encash, particularly in a fast-growing large emerging economy like India. Organizational Design: With the change in environment, the relevance and usefulness of organizational design become a question mark. This has to be reviewed at least once in a year, so as to ensure that the organizational design is capable of delivering value optimally and has not become irrelevant and/or value destroyer which is a serious risk. Vision, Mission, Values and Cultures: Similarly, the vision, mission, values and cultures in the organization need to be revisited. These also do pose risks for the continued success of the organization. In any case, their relevance and validity have to be tested on the platform of (dynamic) environment. Figure 12.1 shows the grid of an efficacious risk management.

12.1. Risk Management Process The RMC of the board has to be assisted by a committee of executives. Let us call it executives’ RMC (ERMC). The structure has to be further supported by the shop floor-level committees and risk champions. Most boards are happy with the detailing of 10/15/20 big risks and management thereof. I would suggest the detailing

Risk Management  179

of all the possible risks at the commencement of the financial year into the following buckets: 1. Environment risks: macro and micro 2. Business risks • Strategy • Operations inclusive of financial • Systems and processes and so on • Value drivers at risk • Emerging value destroyers 3. Regulatory risks 4. Opportunity loss risks Once such a detailing is complete, all the risks must be graded into major and minor risks. Thereafter, the possible impact of all the risks must be assessed. After such detailing works, the measures to mitigate, manage and sidestepping risks must be formulated. The entire strategic plan will be complete with naming the risks owners and scripting the monitoring plan, which will include when the various forums of structures will meet and what kind of information, data and analysis, success and failures statements will be presented in the meetings for incisive debates in those forums. Every quarter, the board should get a comprehensive feedback on how the risk management function is working and suggest/direct changes in the approaches wherever needed. Organization-wide education/awareness of risk and the imperatives of managing these will have to be an ongoing exercise. The role of the risk champions and risk owners will be singular in the exercise. At the end of the year, a comprehensive stock taking must be undertaken to assess the successes and failures as also the lessons learnt along the journey for re-engineering the frame for the next year. The most important aspect to remember is whether the mechanism of orchestrated reviews includes the business risks as well as enterprise risks. Organizational design, vision, mission, values and cultures do have the relevance with the management of the enterprise and, therefore, will have to be reviewed and the relevant aspects de-risked. To judge whether the risk management

180  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

has been sagacious, the board must make a reverse journey and look into the financials to assess whether the enterprise value has been enhanced, maintained or reduced. The board can also assess whether the risk management model can sustain the value in future. Erosion in the profitability or the value must be investigated as to why RMC failed to de-risk that. Let us remember that the overall performance of the enterprise has a direct and proportionate relationship with the quality of risk management. In fact, the ability to visualize how environment and the market scene is going to unfold and choose amongst the possible alternative strategy response is at the heart of risk management. I strongly advocate the defining of multiple scenarios and designing of multiple alternative strategy responses. Even if the actual turns out to be at variance with all the defined scenarios, there is a strong possibility of divergence not being far from one of the visualized scenarios. One amongst the multiple choices designed can easily and quickly be customized to challenge the risks of unfolded scenario. In the absence of such an exercise, the time gap in drafting the strategy response may prove to be expensive. The concept is summed up in the philosophy of the scientist, Arthur Rudolph who developed the Saturn 5 that launched the first Apollo Mission to the moon. He spelled out (reported in the obituary published New York Times, 3 January 1996), ‘You want a valve that does not leak and you try everything possible to develop one. But the real world provides you with a leaky valve. You have to determine how much leaking you can tolerate’.2 If there is a ready-to-launch strategy response, the tolerance level of the damage assessed quickly and the lowest denominator can be applied. Since risk management has developed as science by itself and neither it is the remit of the book to help develop and design risk management plan nor am I an expert in risk management, I would like to conclude that risk management superintendence should remain in the sharp focus of the board at all times. This will convert the regulatory direction of obligatory risk management action into value preservation and creation process. Available at: http://www.nytimes.com/1996/01/03/us/arthur-rudolph-89developer-of-rocket-in-first-apollo-flight.html (accessed on 30 May 2016). 2

13 Building Ethos: Ecosystem

E

nvironment influences individuals and, in aggregate, the enterprise. The quality of Corporate Governance, in particular, is influenced by the organizational ethos or the ecosystem that is created by the management under the direction of the board. In case a company seeks to architect excellence in Corporate Governance, it is essential that an ecosystem is created where every action of all those who are associated with the enterprise, including those who participate from the outside, reverberate against the ecosystem and less than excellence bounces back to the undertaker of those act. Building of an ecosystem has broadly three main frames: 1. Configuration of the board and the board committees, senior management team and the engagement philosophy with the HR in the organization as also the suppliers of goods, services and financial capital. 2. Systems, processes and practices (SPP): The platform on which business of the company is transacted. 3. Democracy: Where expression of views and opinions as also suggestions and recommendations is open and welcome.

182  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

It would be desirable to elaborate, albeit briefly, on all the three frames of the ecosystem. 1. Configuration: It is important that all the people who are invited to be associated or with whom the people in the enterprise transact the business carry a reputation of professionalism and integrity. The integrity connotes both financial and intellectual. It may be very difficult for any enterprise to obtain character certificates from the people whom the enterprise proposes to engage about professionalism and integrity. However, a bit of diligence to find out whether something negative about their professionalism and integrity is floating in the environment should be undertaken. This may not be a very difficult process, in particular, because of the information explosion. Today, it is very difficult for an individual to hide known debilities most importantly, relating to integrity. The private lives of individuals have since become the public information.   Such diligence must begin with the appointment of the board members, extending to the senior management team and travelling down to the last level of the human capital in the organization. There must be a written code in the organization, in the matter of recruitment of individuals at any level in the organization, that the lack of adequate professionalism and impeccable integrity is unwelcome and will not be tolerated. It is quite possible that while recruiting people at the lower level, the adequacy of professionalism may become a challenge. In such a situation, at least some understanding of the mindset of the individual as to whether he will be willing and capable of developing a professional approach will have to be engrained; testing the abilities as also debilities of learning and unlearning. Psychometric tests are available to organize such a testing.   Post recruitment, the induction of people in the organization must be done through a formal exercise. During

Building Ethos: Ecosystem  183

that exercise, it must be made and be clearly understood that individuals with professionalism and integrity alone can flourish in the organization, albeit continue. This one-time exercise of induction has to be repeated off and on, both by organized activities and the behaviour of the organization in taking cognizance of lack of it observed any time during the currency of the relationship. And if it is established through a process of inquiry and examination that there was, in particular, deliberate attempt to be less than professional and/or honest, the exit door must be shown.   While building relationships with suppliers of goods, services and financial capital, whether through debt or equity (bulk), some kind of diligence must be undertaken to ensure that the people sought to be associated with do not have a record of dishonesty. It might be worthwhile at least in the long run not to pursue and/or promote relationship with people/organization without honesty because it is bound to affect, one time or the other, the quality of governance in the organization.   Although the approach suggested earlier may appear to be utopian, it may cause difficulties in building organization, people and relationships. However, the emerging focus on the quality of Corporate Governance warrants the building of an ecosystem where there is a tendency to move forward in ensuring the observance of the highest standard of Corporate Governance. And, the journey has to begin at the beginning.   It is quite possible that the enterprise may be deprived of some of the growth opportunities, and/or the growth trajectory may have slowed down. However, in the long run, it will sustain the growth path and enhance value creation. The short-sighted approach of quick gains has to be traded with the long-term sustainability, profitability and growth value. 2. Systems, Processes and Practices: Human beings are captive of the SPP. These are used to bring about uniformity

184  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

and authenticity of the output—goods, services or data and statements. Loopholes and lacunas in SPP can lead to disaster/ruin of the enterprise. Hence, it has to be ensured while developing, operating and re-engineering SPP that these help professionalism and leave no scope for dishonesty. It is well appreciated that human ingenuity is unlimited. An evil mind can always create distortions to organize the misdeeds and profit there from. It has happened to the organizations of even great repute. However, the safety lies in organizing continuous evaluation through a programmed approach and the involvement of outsiders (different people/organization at different times) in undertaking the examination and evaluation of the robustness of SPP.   Anyone found distorting SPP must be called to question. Although building exceptions to the observance of SPP may sometime become essential, close scrutiny and monitoring will be the safeguard against such exceptions, which, in any case, have to be permitted sparingly and not as a matter of routine. Organizations loosening their grip on the SPP, and/or the exception reporting and monitoring eventually, lapse into disaster. A question may arise in some minds as to how SPP are related with building excellence in Corporate Governance. I believe it to be elementary, as SPP is the basic foundation on which everything whether it is an RPT, disclosure, observance of accounting standard, risk management or even conduct of business operations, happens. There is an element of Corporate Governance in everything. The quality and authentication of observance of the laid down norms can be ensured only through the robustness of the SPP. Thus, building SPP in the process of architecturing excellence in Corporate Governance must remain in focus at all times. 3. Democracy: Democracy is often used only with reference to the governance of a nation and/or a society. I believe that democracy is essential in all walks of life including management of personal life and the enterprises. It

Building Ethos: Ecosystem  185

might be useful to explain what democracy means with reference to the management of an enterprise and/or the Corporate Governance. Democracy means freedom to speak, opportunity to participate in decision-making and authority to evaluate the consequences of the decisions.   In most organizations, it is only boss’s speak. There is very little space for individuals in the team, whether it is the boardroom, committees of the board, management, departmental meetings and/or shop floor discussions. It is recognized in democracy that the leader has the authority to take decisions. However, that authority confers on him the responsibility of delivering efficacious decisions. The efficacy of a decision is tested only with reference to the views of the people involved in the decision-making process. Restricting the voice of a dissent does greatest harm to an individual and also to the enterprises. It is in this context that in a parliamentary democracy, not only opposition, but also its leader is recognized. The leader of opposition has a status and a statutory right to be heard. Even if the dissent cannot be accepted, it propels the decision-maker to think of the safeguards and precautions to be taken while implementing the decisions, so that the propensity of success of the decision is greatly enhanced. The dissent must be respected and given full consideration. Such an approach does great good to the organization and protects from many risks, in particular, the lack of commitment in the implementation of the decision.   It is quite possible that most people toe the line of the leader and do not open up. It, thus, becomes the responsibility of the leader to invite, encourage and even exhort the people to come out with their opinion and views. I cannot forget an instance when the then minister of finance of India had made up his mind to take a decision on an issue and wanted to cross-check with me about my own opinion on that. Having being told earlier by the finance secretary of his having made up his mind, I said it is ok, even though I did see some risk but not the disaster.

186  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

However, the minister insisted on expressing my views on the matter by saying that he always respected my views and, therefore, would like frankness in this matter as well. I told him about my reservation as also explained fairly in depth the reasons thereof. It must be added to his grace that he realized the potential risk of the proposed decision and changed his mind. This helped him in modifying his earlier decision and de-risking the potential risks. It is our belief that the flourishing of democracy in the organization is the foundation of creating an ecosystem for architecting excellence in Corporate Governance. Just to conclude, building and maintaining an appropriate ecosystem is a perquisite for delivering excellence in Corporate Governance. And, it is the primary responsibility of the board to architect that and sustain it all through.

14 Building Enablers of Good Corporate Governance

B

uilding excellence in Corporate Governance demands that certain facilitating enablers are inbuilt in the system, which must eventually lead to greater understanding in the organization and larger accountability and transparency. Some of the enablers, which are mandated by the regulators, either as obligatory or voluntary, need to be firmly in place.

14.1. Code of Conduct Building excellence in Corporate Governance cannot be organized in the boardroom alone. It has got to envelop the entire organization. Involvement of the employees at all levels is facilitated by designing and implementing enabling processes. In fact, an appropriate setting has to be architected, which governs the approach and behaviour of the organization. Organizational behaviour is the sum total of the approach and behaviour of all the employees in the organization. Hence, a three-pronged approach, outlined as follows, has to be pursued.

188  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

1. Designing code of conduct 2. Communication 3. Monitoring of conduct A comprehensive code of conduct has to be drafted. The code of conduct should broadly lay down a framework with reference to which the employees at all levels would address their roles, responsibility and accountability frames. In fact, a code of conduct is about how they will operate on a day-to-day basis. The overarching theme of the code of conduct would be (a) integrity—financial and intellectual, (b) commitment to scrupulous compliance of the rules, regulations, guidance and direction and so on, (c) protecting and enhancing the enterprise value—guarding interest of all the stakeholders and (d) total commitment to the delegated responsibilities and devolved accountability—professionalism. Designing the code of conduct is a very involved and evolutionary process, and the organization must seek views and opinion at all levels. Once the draft of the code of conduct is finalized, it should be placed before the board for approval. Some kind of model code of conduct is a part of Annexure 4. The code should be subjected to a periodical review, preferably yearly, with reference to experiences gained during the journey of its implementations. The code, once finalized, should be widely circulated. It must be uploaded on the website so that the employees can refer to it as and when required. In fact, the communication should not be restricted to the circulation of code. Maybe through the town hall meetings, why the code must be instilled, which would enthuse them to follow religiously. Examples should be enumerated of how the observance of the code is going to enhance or protect the value of the enterprise and consequences thereof on their own welfare. Communication relating to code cannot be a onetime affair. It has to be reinforced periodically. In fact, it might be useful to organize a cadre of champions who would keep the dialogue ongoing. It is not only important that an organization has a code of conduct, but it has to have a mechanism to enforce it as well. Any deviation from the code of conduct must be taken cognisance

Building Enablers of Good Corporate Governance  189

of and dealt with appropriately. In acts of serious delinquency, exemplary action must be taken. The whole process of the code of conduct must work tridimensionally: 1. Educative 2. Preventive 3. Prescriptive Education would mean instiling in the minds and heart, why and how of strict conformance to the code of conduct: how will it benefit the organization and in turn the people in the organization. Prevention would envisage motivating people to observe the code of conduct in both letter and spirit. The exemplary punishment must deter the employees from venturing into misconduct, and misadventure is but one motivation, although real motivation follows from benefits that flow with full compliance. This can be a factor in monetary compensation as well as for rise in hierarchy. The board must create processes by which it is able to review the observance of the code of conduct and also direct, wherever necessary, to ensure that the organization is deeply involved in reaping the benefits of institutionalizing the code of conduct. Prescription would entail exemplary punishment to defaulters in non-observance of the code, which should send shivers down the spine of those on the sidelines of less than full compliance with the code of conduct. This can be organized through the erection of a system of monitoring of compliance of code. In the absence of monitoring, which should include dealing with delinquencies, the very purpose of setting up code would be defeated. Excellence in Corporate Governance cannot be built without a pragmatic and sagacious code of conduct and robust monitoring mechanism of its implementation.

14.2. Whistle Blower Policy For effective Corporate Governance, companies are urged to concentrate on two areas: first, to create a strong ethical compass

190  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

to guide the organization—the code of conduct and second, to establish a comprehensive framework of internal controls to foster a culture of accountability. Ernst Young’s one of the annual surveys of global fraud has rated whistle blowing mechanism (WBM) above external audits as the second most effective means of detecting corruption. People are now prepared to acknowledge that whistle blowing is about good corporate citizenship. Whistle blower policy provides employees, customers and vendors an avenue to raise concerns, in line with the commitment to the highest possible standards of ethical, moral and legal in business conduct. It also provides necessary safeguards for the protection of employees from reprisals or victimization, for whistle blowing in good faith. Most regulators across the geographies have enshrined in the regulations the setting up of a whistle blower policy as an obligation. The SEBI in its latest amendment to Clause 49 of the listing agreement, which has now become a regulation by name SEBI (Listing Obligations and Disclosure Requirements) Regulations 2015 and issued as SEBI/LAD-NRO/GN/2015-16/013, has made whistle blower policy compulsory, which states: The company may establish a mechanism for the employees to report to the management concerns about unethical behaviour, actual or suspected fraud or violation of company’s code of conduct or ethics policy. This mechanism could also provide for adequate safeguards against victimization of employees who avail of the mechanism and also provide for direct access to the Chairman of the Audit Committee in case needed. Once established, the existence of the mechanism may be appropriately communicated within the organization.1

This suggests that, primarily, whistle blower’s allegation should be placed before the management and can be brought before the audit committee wherever needed. I suggest similar formation, while making audit committee’s door always open to approach with or without contacting/communicating to management. 1 Section 4(2)(d)(iv). Available at: http://www.sebi.gov.in/cms/sebi_data/ attachdocs/1441284401427.pdf (accessed on 30 May 2016).

Building Enablers of Good Corporate Governance  191

So does the Indian Companies Act incorporate? It is the duty of the board through the audit committee to design and approve whistle blower policy—a policy which is potent and encourages employees to bring to the notice of the audit committee serious financial irregularities that occur in the organization. Although the formulation and approval of whistle blower policy is easier, its implementation and, in particular, encouraging employees to fearlessly bring to the notice of the audit committee and the board any dealings that are not ethical and affect the financial soundness of the company and/or alienate the interest of stakeholders, must be systematically encouraged. It is desirable to outline the procedure for dealing with complaints in the policy. The section of the protection of whistle blower should also be specified along with how false and frivolous complaints will be dealt. More important, however, is the use of this mechanism to get feedback from the ground level in the organization to plug loopholes in the systems and processes. There is a possibility that disgruntled employees will use this as a handle to create an atmosphere of ill will and disturbance. Hence, it has to be ensured that while all genuine complaints are dealt with effectively and people behind those complaints are protected, the incidence of irrelevant, biased and motivated complaints is reduced to the minimum, if not eliminated altogether. To make it happen, the audit committee and the board will have to get involved in the process little more deeply and make sure that this does not lead to the organization being disadvantaged because anything which is not correct but getting pitchforked will bring alienation in the organization. This is what happens in the public sector undertakings (PSUs) or state-owned enterprises (SOEs) and even the government departments. Finding the right balance is a very difficult task. However, it can be achieved substantially by the involvement and attention of the audit committee and the board. However, the inevitability and robustness of this process cannot be underscored in any way. It is my belief that the WBM if used well can be a value and credibility enhancer. A suggested draft of whistle blower policy is given in Annexure 4.

192  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

14.3. Website Transparency is the biggest defence against misdemeanours and incorrect reporting. Even though most of the companies in India and in other countries do have a website, in many cases, it is neither updated nor user-friendly. It is important that the website contains all the possible information and data that any investor, analyst, customer or employee would like to know and it can be made public. Whatever informations and/or communications are sent to SXs and regulatory bodies must be simultaneously uploaded on the website. Storing the data in an organized manner is essential so that it becomes user-friendly. By a click, of course, a right click, anyone wanting to have the information should be able to see, download or print it. It might be useful for companies to take the help of the professionals to do the website.

14.4. Board and Committee Meeting Protocols It is important that the company creates a set of protocols for holding board meetings and the meetings of the committees of the board. These protocols begin with the way the notices of the meeting will be issued and agendas will be prepared and circulated. It will also include broadly the people who can attend the meetings, what kind of instruments and gadgets will be used in the meeting and how an atmosphere will be created for an undisturbed flow of discussions. I had occasions to attend board meetings where every five minutes, somebody or the other was entering the boardroom either bringing tea, coffee or snacks, papers, getting signatures of the executive directors on documents or even consultations. The board and committee meetings must be in an environment where nobody, unless invited by the chairman of the meeting, enters the room. All arrangements of refreshment, paper submission, etc. must be completed beforehand. This is important not only for maintaining decorum and facilitating undisturbed discussions, but also for the reasons of secrecy. A set of protocols, which I consider will be helpful, have been incorporated in Annexure 3.

Building Enablers of Good Corporate Governance  193

14.5. Compliance Culture It is the legislative responsibility of the capital market regulator, sector regulator and any other authority, such as in the case of India, Ministry of Company Affairs, Government of India, to regulate the market and protect the interest of the investors. In the case of Indian capital market, regulators such as SEBI and other financial regulators have added the responsibility of developing the respective markets. To discharge their obligations, every regulator including SROs issue legislations, rules, regulations, directions and guidance, compliance of some of which is obligatory and some other discretionary. In the case of listed companies in India, the Corporate Governance norms have been specified as conditions in the listing agreement for continued listing in addition to what is specified in the Companies Act. The Indian Companies Act has been comprehensively revised in 2013, and most of the provisions have been made applicable from 1 April 2014. In addition, the SXs have issued guidelines for compliance. Every company has to necessarily comply with all the applicable clauses of legislations, regulations, rules, directions and guidance. Any lapse in the compliance is taken note of and dealt with appropriately. To ensure that the company undertakes the job fully and faithfully, it has to develop a culture which envelops the entire organization. There are a number of companies which are using software developed by some consulting accounting and legal firms. Many of the users feel that it serves them well. However, there is no substitute to creating a culture of compliance in letter and spirit and effective monitoring of the compliance. In fact, there is a need to create an environment where all the three formats—proactive, co-active and reactive—work so that compliance does not become the casualty of confusion and fragmented/ distributed ownership. In most jurisdictions, the company secretary has been designated to be the chief compliance officer for Corporate Governance compliance. However, the ultimate responsibility of compliance devolves on the shoulders of the BoD. Even otherwise, to leave the compliance completely to company secretary without an effective oversight of the board is dangerous. Unfortunately, this is what is

194  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

happening in most boards, and complete reliance is placed only on the certificate presented to the board. It is imperative for the board to lay down the systems and processes as to how compliance will be ensured. In the case of need, expert advice can be sought. These systems and processes must be reviewed at least once in a year by the governance committee of the board. In addition, it should also be discussed in the board. Non-compliance is a reputational risk in addition to the penalties by the regulators. Furthermore, the substance of compliance of Corporate Governance norms pave the way for building excellence in Corporate Governance. Moreover, this routine exercise can be converted into value-enhancing process. This may not be a comprehensive list of building enablers for good Corporate Governance. Hence, the board and its committees have to watch out to include whatever else can help in its journey of building excellence.

15 Monitoring Pyramid

T

he architecture for building excellence in Corporate Governance may be ready and implemented rigorously. However, it is important to create a very effective monitoring mechanism to (a) ensure compliance with the regulatory directions both in letter and in spirit and (b) create, enhance and maintain enterprise value. The regulatory direction in most jurisdictions has an inbuilt monitoring mechanism. These mechanisms begin with the auditors and end with the evaluation of the compliance by the regulators. In between the two function the management, the BoD and the committees of the BoD (some of which have necessarily to be constituted as a regulatory obligation, such as the audit committee, the stakeholders committee and the nomination and remuneration committee). However, the effectiveness of the mechanism is not determined by the pillars of the building but by the role they play in discharging the assigned responsibilities. In fact, in all the stances of Corporate Governance failures, one or more of the pillars had failed to provide strength and effectiveness in monitoring the quality of the Corporate Governance. Hence, it is important that the effectiveness of the monitoring of the Corporate Governance is built on very sound footing, and coordinated, concerted and continuous attempts are made to provide periodical reinforcement. This reinforcement is possible only if the different pillars

196  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

cooperate and lend each others’ strength for strengthening the other. Building such a process is the responsibility of the board, which it should not seek to delegate to any other agency. In the following, I have tried to narrate some ideas and methods of how monitoring mechanism can be made more effective. In fact, in my opinion, monitoring mechanism cannot be created in the frame of the different pillars of a building because these pillars are generally separated and the distribution of the load becomes the philosophical underpinning, which may be difficult to shift from one pillar to another even for marginal adjustment. Hence, I recommend a pyramidical structure. Figure 15.1 shows the design of the monitoring pyramid.

Figure 15.1      Monitoring Pyramid

REGULATORS

PUBLIC SECTOR Capital Market Sector Regulator

PRIVATE SECTOR SRO Capital Market

BOARD Sterling Role of Independent Directors BOARD COMMITTEES Audit , Nomination & Remuneration, Risk Management, Stakeholders AUDITORS Internal & Statutory COMPLIANCE Code of Conduct Whistle Blower Mechanism Compliance Certificate

Monitoring Pyramid  197

15.1. Compliance At the base of the pyramid has to be what I would like to describe as the ‘eternal vigilance’. This eternal vigilance has to be provided by one and all in the organization at whatever level, whatever field and in whatever relationship they might be operating. It shapes up with three frames: (a) compliance certificate, (b) code of conduct and (c) WBM.

15.1.1. Compliance Certificate Although the preparation, filing and review of compliance certificate is a kind of box-ticking process, it has to be gone through periodically (in most jurisdictions, it is envisaged as quarterly) and rigorously. Such a box ticking, even if done mechanically, would ensure that all the pieces, obligated and/or voluntary, are in place. However, it is the responsibility of the company secretary to ensure that it does not become a purely mechanical exercise. He has to periodically dive deep into the process of this box ticking to ascertain the depth of the application of the mind of the people involved in this process. Such an exercise, if not possible quarterly, has to be organized at least once in six months. This periodical review by the company secretary and his team will ensure that the people involved in the process are conscious of a kind of audit, which will be undertaken by a person other than their own supervisor, and, therefore, serious attention will willy-nilly be provided by them. It must also be provided that in case this process is not undertaken either religiously or vigorously, there is the correcting mechanism—educative, preventive and prescriptive—to bring and/or keep the process on track. The lack of taking serious cognisance of the delinquency in this area can result in lapses, which may eventually cause damage to the reputation and value of the company. The review by the company secretary has been suggested mainly because, in most jurisdictions, particularly in India, the company secretary is supposed to be the chief compliance officer of the Corporate Governance. He can discharge his responsibility

198  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

proficiently only if he ensures that the process of the issue of compliance certificate is thorough.

15.1.2. Whistle Blower Mechanism The robustness of WBM, the details of which on design have been stated somewhere else in the book, will encourage the employees at different levels to bring to the notice of the audit committee the brewing and/or happening of misdemeanours. Its robustness will also work as a prevention of the evil minds to bloom. They will be deterred by the possibility of its being unearthed by one of their colleagues with dire consequences to him. It is the duty of the audit committee, the chairman of the audit committee, in particular, to review periodically, most certainly every six months, the robustness of the WBM. This review must aim to achieve the free flow of information—appropriate and correct with documentary evidence, if possible—and also to make sure that the disgruntled and/or biased employees are not encouraged to derail the functioning of the organization by preferring malicious complaints without any basis or facts. The WBM functions as the base on which the entire monitoring pyramid would stand. In case this is not on firm grounds, the monitoring pyramid cannot be solid and safe. It is, therefore, important for the board to find out, help and assist that these blocks in the foundation of the pyramid are strengthened on an ongoing basis. Obviously, this would command periodical review by the board, maybe once in a year. It might be useful to get this mechanism audited at least once in three years from an external agency to find out how the whole processes are working, lacunas, if any, and the need for re-engineering. This alone can ensure the effectiveness of this layer, which will provide strength to all the other layers upward.

15.1.3. Code of Conduct Similarly, the code of conduct should propel the employees at all levels to behave ethically and follow the norms scrupulously. Rigorous enforcement will solidify the foundation of good

Monitoring Pyramid  199

governance right down to the last level in the organization. Since the subject of the code of conduct has been dealt with earlier, I would like to conclude with the suggestion for the board to review the observance of the code of conduct at least once in a year.

15.2. Auditors Every regulatory jurisdiction envisages the appointment of independent auditors to do what is statutorily required, the audit of financials. Hence, such auditors are also called statutory auditors. In addition, most regulatory jurisdictions enshrine that there should be internal audit as well, which can be done either by the in-house team or an external agency. Between these two auditors, it has to be ensured that 100 per cent of the SPPs are audited, or substantially if not 100 per cent of the operations. While there are some areas, such as the revenue account, balance sheet, RPTs and observance of accounting standard and so on, which have necessarily to be done by both, certain other works are also allocated between the two sets of auditors. Between these two agencies, it has to be ensured that all the financial transactions are above board and the reporting is truthful and complete. The independence of both these agencies has to be ensured. Hence, it is provided in most jurisdictions that the appointment of statutory and internal auditors including the in-house team is subject to the approval of the audit committee, board and the shareholders. Similarly, their remuneration has also to be approved by the audit committee, board and the shareholders. However, it is not the appointment and/or the functioning of these auditors which, per se, ensures the quality of governance and/or the efficacy of the accounts. The following factors determine the quality of the work of the auditors: (a) independence, (b) skills, (c) value system and (d) involvement and commitment. The independence and skills have to be evaluated by the audit committee, whereas, while their appointment is considered, the quality of involvement and commitment is ensured by providing effective oversight. Oftentimes, it is observed that the appointment of statutory auditors, in particular, is decided on the basis of the

200  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

size of the firm—number of people working in that organization and the length of its existence. Actually, in most companies, one of the big fours are preferred. Although one cannot quarrel with the underpinning that a large and well-known firm is better, in particular, because of the deep knowledge base, it has necessarily to be ensured that the auditors are independent and, without caring for their revenue and/or the engagement, they would forthrightly put across their points of view without fear or fervour. All the major Corporate Governance failures around the globe have created an impression that all the big firms have compromised their independence and integrity one time or the other. Hence, the work of the audit committee would be to do a bit of due diligence on the partner who will engage his value system and also the team that he would put in place to do the detail work. Unless care is taken by the audit committee and board during the course of appointment, the effectiveness of this mechanism cannot be guaranteed. While doing the assessment about the independence, one must get a fair idea of the skills of the partner of the audit firm who would be responsible for the audit of the company. It might be useful to find out how many audits this partner is handling, because that would determine how much of time he can spare for this audit. It is well appreciated that it is not the number of hours devoted to the audit that determines the use of his skills, but his own involvement with the engagement that decides the quality of the audit. Having got the set of auditors, it is important to evaluate periodically the kind and quality of manpower that is allocated by the audit firm and also the time they are spending in doing the work. Most firms are happy to rely on the work done by the internal auditors and/or the submissions made by the management and do not go deep into most of the matters. Some kind of vigilance is necessary. A question may arise in some minds: Is the audit committee going to be a day-to-day supervisor of auditors? Certainly not. However, it is the duty and responsibility of the audit committee to ensure the allocation of resources by the audit firm, the quality of their work and commitment. In fact, if someone goes deeper into the cases of corporate misgovernance, one can easily decipher that thoroughness was missing in the work of

Monitoring Pyramid  201

the auditors and the depth of supervision by the audit committee on the work of auditors was conspicuously absent. Auditors sit just above the base of the pyramid and are expected to provide independent assurance about the quality of accounts, observance of the accounting and financial reporting standards, disclosures and the manner in which the RPTs are undertaken—in effect, the efficacy of the work done by the management team in maintaining and managing the financials of the company—and they are qualified to do it. In case this layer of the pyramid is weak or has holes, crumbling of the entire pyramid of monitoring is inevitable.

15.3. Board Committees Since the oversight and control of the enterprise is a big enough job and cannot be organized efficaciously in just the board meetings, it has been envisaged by the regulatory bodies that the board must constitute subcommittees consisting of directors and also, if thought fit and appropriate, experts from the related fields. Accordingly, most boards constitute a number of committees. The following committees are statutorily required to be constituted: 1. Audit committee 2. Shareholders/stakeholders committee 3. Remuneration and nomination committee However, in many companies, several other committees also function like the following: 1. Risk management committee (taking away the function from the audit committee) 2. Strategy committee 3. Finance committee 4. Customer relations’ committee 5. Board governance and ethics committee and so on

202  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

To derive the optimal value out of this layer of the monitoring pyramid, it is essential that these committees function effectively. To facilitate, it is essential that each of the committee has its charter. A model charter for all the statutory committees namely the audit, shareholder and nomination and remuneration committee as also risk management committee is given in Annexure 5. Although it might be useful to discuss the role of each of these committees separately, it will make the narration very lengthy. Hence, some broad principles on which these committees must be constituted and function have been suggested as follows: 1. The constitution of the committee is done by matching the skill needs of the committee and the availability of those skills in the board. In many boards, such an exercise is not undertaken. This is missed out, and the directors with less-than-deeper understanding of the financials are appointed on the audit committee. Outside talent must be drawn if felt necessary. 2. Every committee must have a potent charter which serves at the base for the functioning of the committee. 3. Holding meetings of these committees should be regular and not a formality. Meetings of these committees should be de-linked at least with the day of the board meeting. Meetings should be held either on different dates or at least a day prior to the board meeting. Along with the date, the circulation of the notice, agenda, notes and so on must be taken care of. 4. The chairman of each committee must own the responsibility of ensuring that the substantive issues are discussed and the directors apply their mind on each of the items. This can happen only if the agenda is circulated in advance and full data/information is provided in the notes. 5. The minutes of the committee meeting are well drafted and provide specific recommendations and/or approvals. 6. The committees must take the responsibility of providing effective oversight to the work of the agencies—internal or external—who undertake the task related to the areas of interest to the committee, for example, in the case of the

Monitoring Pyramid  203

audit committee, it should provide effective supervision to the work of auditors, or the RMCs to provide effective monitoring of executive-level subcommittees. 7. Much would, however, depend on the way the work of the committees is perceived and undertaken by its members including the chairman. It must be noted here that the board’s subcommittees are supposed to help the board by going into the depth of all the matters that are brought before it, cull out the important points/issues and seek answers from the management and/or the agencies assisting the committees and formulate a view which is proffered to the board, for example, in the case of nomination and remuneration committee, it must undertake the exercise in depth of nomination or recommendation of the remuneration of the executive directors and so on and make a specific recommendation considering all the aspects of the issue. Just dittoing the views/recommendations of the management does not serve the purpose for which these committees are sought to be constituted. It must be remembered that like the auditors, board committees are a step above the layer of the monitoring pyramid to ensure excellence in Corporate Governance. This has to be accepted and acted upon by the committee. 8. Review of the work of the committees by the board must be an annual exercise, wherein the chairmen of the respective committees makes a presentation on the work done during the year, which is debated and light is thrown on the way forward.

15.4. Board The BoD has the ultimate responsibility of the functioning of the organization, its conformance with various rules, regulations, guidance, advice and laws and also of creating value. The board has the powers of the shareholders to manage the enterprise. In the case of Corporate Governance, therefore, the board has become the ultimate owner of the responsibility of creating excellence. Since it

204  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

is a pyramidical structure, it sits above the various layers described earlier in this book. All the layers are supposed to support and help the board in the discharge of its accountability frame. It is, therefore, important that the board understands its role and places a great value on the role played by other layers of the pyramid. Non-compliance with any direction/regulatory diktat is a value destroyer. Creating excellence in Corporate Governance is value enhancing. This can be delivered by the board only if (a) it does not replicate the role played by the management and/ or other layers of the monitoring pyramid and (b) it plays the role of superintending and direction efficaciously to ensure that the layer-over-layer strength increases. This can be organized only if the board is able to decipher where the weaknesses exist and/or growing and has the will to effectively deal with them by taking decisions and issuing directions. It has been discussed somewhere else in the book, what and how the board will play its role in the discharge of its responsibilities, but it cannot let go this responsibility of monitoring excellence in Corporate Governance either by delegating to the other layers of the pyramid or by allowing it to go by default. It has to assume full responsibility and, therefore, has to discuss and deliberate on the issues of building excellence in Corporate Governance in every aspect.

15.6. Regulators Regulators, as a part of monitoring, sit outside the pyramid and play a different kind of role—a watch dog. Before I discuss the role that the regulators play, it might be useful to segregate them into two parts: public sector regulators and private sector regulators. It is the responsibility of the public sector regulators to ensure that the letters of law in the matter of Corporate Governance are followed scrupulously at all times and any delinquency is taken note of and dealt with effectively and expeditiously. Surveillance and enforcement, thus, become important functions of the regulator. In economic terms, both these functions in the regulator’s office on a company are value destroyer of the enterprise. Surveillance would command the allocation of additional resources to deal

Monitoring Pyramid  205

with the regulatory over tones which, in effect, becomes the cost centre, and the enforcement of any direction, whether penal or otherwise, impacts the image and goodwill of the enterprise and, thus, is a value destroyer. Excellence in Corporate Governance, therefore, commandeers that no occasion is provided to the statutory regulators to do either more than normal surveillance or enforcement in the matter of Corporate Governance. The private sector regulators include SROs and the market, in general. The SROs bring about peer effect and the market does the valuation of the quality of Corporate Governance and adds/ subtracts the enterprise’s value depending on how it perceives. Peer affect would mean not only the compliance of additional regulatory direction issued by the SROs, but also the ground-level understanding of what the company does and the action thereon. This becomes a value destroyer and hence has to be avoided by making sure that the company complies with all the regulations and directions issued by the SRO as well and also the peer effect—comparison and perception—comes to play favourably. The market has its own understanding of the quality of Corporate Governance. Several researches that have been quoted somewhere else in the book do provide a peep into the economic value—positive or negative—of the quality of Corporate Governance. The company, therefore, not only has to architect and work its way through in bringing about excellence in Corporate Governance, but also has to build a perception around that. A good perception will enhance the enterprise’s value, and a not-so-good one will reduce the valuation. In fact, it might be helpful for the public sector regulator as also private sector regulator to watch the behaviour of the other to assess the quality of Corporate Governance. This becomes, additionally, a communication issue. Hence, a strategy has to be drawn up by the company to effectively disseminate the good work done by the company, particularly in the matter of Corporate Governance. In substance, the regulators do the monitoring of the Corporate Governance and they either destroy or enhance the value. It would, therefore, be wise to consider them as a part of the monitoring pyramid and use their presence only as a value enhancer.

16 Evaluation of Quality of Corporate Governance

T

he regulatory frameworks compel the management of a JSC to conform to the directions laid down. However, the observance of directions is of two kinds: (a) form of compliance and (b) substance of compliance. 1. Form of compliance: It means that the enterprise follows the rules and regulations in letter. For such enterprises, each rule is like a box and the moment it is followed in letter, the box is ticked. Whenever the verification is undertaken by one of the levels of the pyramids of monitoring governance, it is shown to have been complied with. Unfortunately, in such enterprises, even the mandatory level of statutory audit does not go into the spirit of compliance but looks at whether the letters of law have been followed. Furthermore, the enthusiasm of both the managers of the enterprise and the monitoring pyramid of Corporate Governance compliance is limited to the form of it. They have neither the patience nor the inclination to go beyond. The results of such compliance are that they cannot be found wanting as far as the law is concerned.

Evaluation of Quality of Corporate Governance  207

However, the benefit of good Corporate Governance does not flow adequately to the stakeholders via optimal wealth creation, maximizing wealth management and sagacious wealth sharing. If one goes in the depth of most of the Corporate Governance failures around the world, it would be apparent that the failures took place notwithstanding the conformance with the letters of law. In such cases, Corporate Governance compliance remains a tyranny. 2. Substance of compliance: It goes beyond the letters of law and conforms to the regulatory obligations and also voluntary compliance in letter and spirit. For example, when disclosure is required, such enterprises do not give out only some information but truly disclose full information, which can eventually help those for whom this disclosure is meant to appreciate the transactions and analyse the information to make a sense out of it. Such enterprises take every item of the required compliance very seriously and understand the purpose of it and evaluate whether it really means to achieve what is expected out of it. Wherever the compliance of regulatory requirement, both compulsory and voluntary, is done in spirit, wealth creation is higher, wealth management is superior and wealth sharing is appreciated. ‘Mahindra is nothing without substance of Corporate Governance’, asserts Anand Mahindra, Chairman, Mahindra group. ‘Market always rewards good Corporate Governance’, pronounces Adi Godrej, Chairman, Godrej group. However, the evaluation of Corporate Governance can be done through several methods. In fact, some of the organizations are trying to use most of those methods. These methods could be, for example, (a) Corporate Governance rating, (b) economic value addition (EVA), (c) market value addition (MVA) and (d) market appreciation. It is important to mention here that the market is able to appreciate the quality of Corporate Governance and factor it in the pricing.

208  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

Market appreciation is assessed by the amount of Enterprise Value reflected by the price of its equity shares. For example: Particulars Total Number of Equity Shares

1,00,000

Market Price of Share

120

Face Value of Share

100

Enterprise Value

1,20,00,000

The quality of Corporate Governance does affect the market price of the shares, which has been exemplified by the researches quoted in Chapter 17. When the market price of shares goes up, the enterprise value goes up, and if the market price of share goes down, enterprise value goes down. Other factors like profitability and outlook about the industry and company by and large remain the same, the rise and fall in enterprise value as a consequence of rise and fall of share price is represented by quality of Corporate Governance. It would be worthwhile to discuss each of these methods for the evaluation of the quality of Corporate Governance a little more in detail.

16.1. Rating of Corporate Governance Some of the credit rating agencies have developed methodologies and tools for evaluating the quality of Corporate Governance and have started assigning rating. In India, the Credit Rating Information Services of India Limited (CRISIL), now wholly owned by Standard and Poor’s (S&P), and Investment Information and Credit Rating Agency of India Limited (ICRA), a subsidiary of Moody, have developed such rating. In fact, the Unit Trust of India (UTI), now UTI Asset Management Company Limited (UTI AMC) had a rating frame for a long time. The Institute of Company Secretaries of India (ICSI) has also developed a rating frame. These frameworks are broadly discussed in the next few sections.

Evaluation of Quality of Corporate Governance  209

16.1.1. CRISIL Governance and Value Creation (GVC) Rating 16.1.1.1. Introduction Corporate Governance has been defined as ‘the way in which a company manages itself in order to ensure fair and equitable returns to all stakeholders and other financial stakeholders’ and extends to include ‘the rules and incentives by which shareholders control and influence a company’s management so as to maximise profits and value of the corporation’. The process of adjudging the rating is built on the following four pillars: (a) ownership structure and influence, (b) financial stakeholders’ relations, (c) financial transparency and information disclosure and (d) board and management structure and processes. CRISIL GVC rating provides an independent assessment of an entity’s performance and future expectation on ‘balanced value creation through sound Corporate Governance practices’. This appropriately balances the quantitative value creation measures with qualitative evaluation and provides a view on the entity’s expected performance in future and addresses all stakeholders more equitably. The CRISIL GVC rating evaluates how a firm is performing on its raison d’être or the primary purpose of existence that is creating value for its owners and various shareholders. This rating is based on the criteria from which the present condition and future progress can be assessed, measured and analysed. CRISIL believes that such a measure seeks to ensure that two equally well-governed companies will not, prima facie, receive identical ratings if one is a significant value creator, while the other is destroying the value. CRISIL evaluates two broad aspects to arrive at GVC ratings for companies. These comprise the following: 1. Value creation and distribution: In this category, CRISIL looks at the company’s track record in creating and distributing value amongst the various stakeholders in the

210  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

system. The criteria are so constructed that the interests of various stakeholders are evaluated in a balanced manner by appropriately assigning weights to individual stakeholders. The stakeholders’ considered and indicative list of the parameters, used to evaluate respective value creation and distribution, are as follows: • Shareholders: The measures used include return on invested capital compared to the weighted average cost of capital (WACC), dividend payout ratio and the like. • Debt holders: CRISIL looks at relative debt protection measures. These will include credit rating and upgrades in ratings, among others. • Customers: The parameters include market share, assessment of customer satisfaction and cost savings passed on to customers. • Employees: The parameters considered include absolute salary levels, adjusted growth in average annual salaries, employee stock option, attrition rates and intangible factors. • Suppliers: The factors considered include the relative change in credit terms, passing on of increased realization and support to suppliers, among others. • Society: Here, the measures include total direct taxes paid, employment generated expense on social infrastructure, environmental and social impact cost and fair practices. 2. Corporate Governance and wealth management: Under this category, CRISIL looks at the company’s capabilities and processes to ensure good governance, the checks and balances that it has instituted to prevent abuse of power, transparency of reporting and the capabilities and robustness of the company’s management.

Evaluation of Quality of Corporate Governance  211

The broad factors which CRISIL uses to analyse the performance on this category are: • Assessment of management capabilities, including success of strategies, ability to re-strategize, track record of innovation and experience of management • Financial transparency and disclosure, including independence and standing of the auditors, disclosure standards, timing of disclosures and the like • Influence of majority or large stakeholders, including decision-making processes, evaluation of sources of receivables and destination of payables and affiliate or group company transactions • Board composition and effectiveness, including the criteria for selecting board members, board meeting processes, information availability and timeliness, role and effectiveness of independent directors, board evaluation, compensation and succession policies The evaluation process comprises analysing both information that is confidential and in the public domain, as well as having intensive interactions with the management personnel, board members, especially external directors and representative of key stakeholders. CRISIL GVC rating is assigned on a scale of eight levels and is valid for a period of one year from the date of assignment of the first rating. Thereafter, the ratings are reviewed annually, or more frequently if the circumstances so warrant.

16.1.2. ICRA ICRA’s stakeholders’ value and governance (SVG) rating indicates the relative level to which an organization creates and manages value for its stakeholders, along with an opinion on the quality of its Corporate Governance practices. The emphasis of SVG ratings is on value creation and value management for all the stakeholders of a company, including its Corporate Governance practices.

212  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

16.1.2.1. Ratings Variables The key variables that are analysed while arriving at the SVG rating for a corporate entity are as follows: 1. 2. 3. 4.

Wealth creation and management Financial discipline Transparency and disclosures standards Relationship with stakeholders, including shareholders, creditors, employees, customers and society 5. Shareholding structure 6. Board structure and processes 7. Governance structure and management processes Each of these variables are evaluated on a set of parameters, and a composite assessment using a proprietary model developed by ICRA is made for the overall rating. The thrust of ICRA’s analysis is on the following. Wealth Creation and Management ICRA believes that an accurate measure of value added by a company should not only consider the wealth created in the past, but also take into account the monetary and non-monetary investments made by it for future growth and profitability. Thus, the SVG assessment takes into account both the wealth created by the company in the past and the investments made by it that would influence future wealth creation. Some of the parameters which ICRA evaluates while making the assessment of wealth creation and management are as follows: 1. Shareholders • Return on net worth in relation to cost of equity • Return on capital employed (ROCE) in relation to WACC • Risk adjusted market returns based on stock price adjusted for dividend and equity dilutions • Dividend policy

Evaluation of Quality of Corporate Governance  213

2. Debts holders • Level of credit rating and trends thereof, if available • Financial indicators for debt service and financial risk Financial Discipline The ultimate objective of Corporate Governance is to create and maximize shareholders’ value while balancing and protecting other stakeholders’ value. 1. Business segments in which the country operates 2. Rationale for presence in multiple businesses 3. ROCE in each business in comparison with peers in similar industries 4. History of equity dilution 5. Extent of reliance on debt funding 6. Dividend policy 7. Number of subsidiaries/associates and rationale for the same 8. Nature of transactions with subsidies Transparency of Disclosures Standards The key parameters that ICRA examines to assess a company’s transparency and disclosure standards include the following: 1. Accounting quality, including compliance with accepted accounting standards 2. Changes in accounting policies 3. Notes to accounts of a materially significant nature 4. Quality and level of detail in accounts, especially with respect to items such as loans and advances, inter-corporate advances and contingent liabilities 5. Disclosures on transactions with subsidiaries and associates 6. Additional information to shareholders 7. Quality of disclosures in management’s discussion and analysis (MDA) While assessing the MDA, ICRA evaluates the extent to which meaningful insights are available on the business segments in

214  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

which a company operates, its growth prospects and the associated risk factors since such insights could help an investor take an informed decision on the company’s business prospects. The trends in share price movements around major corporate announcements are also taken note of to evaluate whether pricesensitive information is disseminated in a timely manner to all stakeholders. Shareholders Relations ICRA’s SVG ratings take into account the value added to the stakeholders of a company, namely shareholders, employees, creditors, suppliers, customers and society at large, while maintaining the primacy of shareholder value creation in the evaluation process. Shareholding Structure ICRA analyses an organization’s shareholding structure to understand its ownership pattern, identify the dominant shareholder(s), evaluate the extent of cross-holdings and identify the extent of shares held by its promoters/promoter groups. A transparent ownership structure where the key shareholders are easily identifiable and the absence of opaque cross-holdings are considered positives from the SVG rating’s perspective. Board’s Structure and Processes An organization’s BoD is expected to lend leadership and strategic guidance to it, ensuring that the legal and statutory requirements are complied with and balance the rights and concerns of the shareholders and other stakeholders. ICRA analyses the broad’s structure and processes of the company being rated with reference to various parameters, including the following: 1. 2. 3. 4. 5. 6.

Size of the board Selection criteria for directors Proportion of independent directors Professional standing of independent directors Other directorships held by the independent director(s) Retirement/compensation policy

Evaluation of Quality of Corporate Governance  215

7. 8. 9. 10. 11.

Frequency of board meetings Time gap between any two meetings ATR since the last board meeting Composition of the board committees Attendance record of directors

The emphasis, however, is on the substance over form; the ICRA essentially attempts to evaluate the effectiveness of the board by examining issues such as timeliness in the circulation of agenda papers, quality of information contained in the agenda papers and comprehensiveness of the minutes of board meetings. Some key issues that are studied include deliberations related to major investments, capital expenditure, performance (vis-à-vis), RPTs, compliance with statutory requirements and possible product liability matters. Governance Structure and Management Processes The key focus of ICRA’s analyses, here, is on the internal decisionmaking process followed in the company being rated and the quality and nature of information that is presented to the company’s BoD. ICRA also believes that the monitoring function of a company’s BoD is critically dependent on the quality of information that is supplied to it and on the procedures established to ensure that feedback is provided to the board on all items where queries, if any, have been raised. It, therefore, evaluates the quality of information submitted to the board, especially in respect of major corporate decisions such as mergers and acquisitions, diversifications, large capital expenditure, inter-corporate loans and other RPTs. Rating Approach As is evident from the discussions on various ratings, ICRA’s SVG ratings involve the assessment of both quantitative and qualitative parameters. While evaluating quantitative parameters, ICRA makes suitable adjustments for differences in accounting policies. The emphasis is on relative (in relation to the suitably defined peer group) rather than stand-alone performance, and sustainable rather than sporadic performance.

216  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

16.1.3. Unit Trust of India The UTI’s methodology used long ago was also numeric. The scores accorded are as follows: Quantitative Criteria and their Weights (Figures in parentheses are scores assigned to that item) 1. Governance Structure: 30 per cent 1A. Composition of the board (15 per cent) 1B. Committees of the board (15 per cent) 2. Disclosure in the annual report 20 per cent 2A. Statutory disclosure (10 per cent) 2B. Non-statutory disclosure (10 per cent) 3. Timelines and content of information to the investors and public 20 per cent 3A. Compliance with listing agreement (6.67 per cent) 3B. Contents on websites (6.67 per cent) 3C. Grievance resolution ratio (6.67 per cent) 4. Enhancement of shareholder value 30 per cent 4A. Share prices (7.5 per cent) 4B. Return on net worth (15 per cent) 4C. Book value (7.5 per cent) Total 100 per cent

16.1.4. Institute of Company Secretaries of India The ICSI rating covers the following areas: (a) board management and structure inclusive of board committees and procedures, (b) transparency and disclosures, which has elements such as director remuneration, directors background, shareholding patterns in addition to usual statutory and non-statutory disclosures relating to financials and so on and (c) investors relations and financial performance—shareholders’ value enhancement, which is evaluated through (i) dividend payment, (ii) dividend growth consistency and (iii) return on net worth. The method used is numerical and includes the interviews of the management and directors of assessing subjective areas.

Evaluation of Quality of Corporate Governance  217

I have stated in Chapter 4 that the fundamental purpose of the formation of a JSC, investors sharing the vision of the entrepreneur by investing their surplus resources, HR joining the organization and the society facilitating its incorporation and continuance is wealth creation, wealth management and wealth sharing.

16.1.4.1. Wealth Creation and Wealth Management and its Appraisal Simply put, wealth creation is the excess of the value of the output over the value of the input. Example of Value Creation Value of all inputs (physical, financial and human resources) Value of all outputs (products and services, rights and so on) Wealth (value) created

= 100 = 150 Ro =   50

Since the stakeholders–shareholders, debt providers, HR, suppliers of services as also society have other options to invest their resources, it is important to validate the level of wealth creation in the process of husbanding of resources by the firm—Corporate Governance. The significance of wealth creation has grown over the years since the invention of the institution of JSC, as a small active minority controls and manages the investments/resources and interests of a large majority of passive stakeholders who have multiple options to deploy resources or choose the management of enterprise. The board has the authority of the shareholders to manage the enterprise. Hence, it must state/chart out the objective of maximizing stakeholder value via wealth creation at the commencement business, and every year thereafter. Maximizing stakeholder’s value is not an elusive thought. It is a concrete preposition. It can be translated into arithmetic, and the evaluation is possible. It is a noble and pragmatic objective and, if communicated well, will encourage, enthuse and envelop the managers at all levels to efficaciously execute the strategies and

218  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

take organizational decisions in the pursuit of that objective of optimal wealth creation. Of course, optimal wealth creation, inter alia, commandeers far-sighted imagination, ardent skills and sharp focus, coupled with devotional determination. Since the potential for wealth creation, albeit value creation is enormous, it is the grit, imagination and ambition of the board and the top management that will determine the level of the objective. However, the journey has to begin from a reference point which could be enterprise value as reflected by the market forces on the date of reckoning. In the case of a listed company in a matured market, the market valuation of the enterprise is the easiest way to find a reference point. The market valuation, however, may be lower than the enterprise value that the board/ management considers appropriate. Let us call enterprise value, as assessed by the board/management, ‘eligible value’, which can be calculated by using various methods. These methods of calculating the enterprise value have been described by various authors in various ways. The most commonly used is ‘building relationship between cash flow and shareholder value’. In case the debt market is developed, ‘determination of the value of the corporate bonds’ can also be used. Yet another way is to evaluate the ‘value of the common stock’. However, while calculating the enterprise value through either of these methods, it is important to add the value of the brands that the company owns as also the value of the goodwill. Sometimes, these values are on the balance sheet, but in most cases, are off balance sheet. Actually, often, these are not even calculated. The gap between the eligible value of the enterprise and the market value (MV) of the enterprise mentioned earlier should be the first starting point for the board to set the objective. Bridging the gap between two values (eligible value and MV) should begin with the investigation of the possible factors including the perception about the Corporate Governance causing the gap. Most of the time, the gap is explained by the quality of Corporate Governance as also perception thereof in the market. Growth in the eligible value coupled with its conversion in the MV in a year can be considered as the wealth creation. The level of such wealth creation should be compared with the

Evaluation of Quality of Corporate Governance  219

comparables—firms in the market place—creating wealth. Direct and even vicarious impact of the favourable environmental factors must be considered while crediting the management and board for the level of success achieved in wealth creation. While encashing the environment to enhance wealth creation is a job well done, beating adverse environmental factors without negatively impacting wealth creation is excellence.

16.2. EVA Method The most often used determinant of the value created during the financial year is the EVA. It was hailed by Fortune magazine back in 1993 as the foremost method of assessing the wealth creation. Many firms across the world are assessing the EVA periodically. The evolution of EVA has a bit of history. It seeks its origin in the work of two professors of finance in their seminal work, ‘Dividend, Policy, Growth and Valuation of Shares’, published sometime in 1961. Their concept of free cash flow and the evaluation of business on cash basis was developed into a kind of measurement in the shape of EVA by Mr Joel Stern and Mr John Shiely, and was outlined in their book, The EVA Challenge, as follows: ‘EVA = Net Operating Profit after Tax (NOPAT) – [Capital × Cost of Capital]’ As explained in the book, EVA is the net operating profit minus an appropriate charge for the opportunity cost of all capital invested in an enterprise. As such, EVA is an estimate of true ‘economic’ profit, or the amount by which earnings exceed or fall short of the required minimum rate of return that shareholder and lenders could get by investing in other securities of comparable risk.1

http://books.mec.biz/tmp/books/ORBGSC4H3GLOK4IHHISQ.pdf (accessed on 30 May 2016). 1

220  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

EVA is now considered as the most successful performance metric, from the commercial point of view, worldwide. This metric is very well justified by financial theory. For calculating EVA, the following three components have to be unravelled first: NOPAT: Net operating profit after tax Capital: Capital employed in the business Cost of Capital: Weighted average cost of capital NOPAT, in the book referred to earlier, is calculated by adding depreciation—straight line method—and expenses such as research and development (R&D), advertising and promotion, staff training and development and deferred revenue expenses written off. Income tax provision and interest and financial charge are also added. Thereafter, sinking fund depreciation, R&D expenses recurring, advertising and promotion expenses, staff training and development expenses and income tax provision and deduct payment basis are added. Under the EVA model, depreciation is calculated using sinking fund or annuity method, as it considers that the business, besides losing the original cost of the assets, also loses interest on the amount used for buying the asset, which the enterprise could have earned in case the same was channelized in some other form of investment. Capital employed in calculated as the book value of average long-term fund employed in the business during the financial year. Cost of equity can be calculated by using either of the following three methods: (a) dividend yield method, (b) dividend growth model and (c) capital asset pricing (CAP) model. Under CAP, the cost of equity (Ke) is calculated as follows:

Ke = Rf + b (Rm – Rf ) where Rf is the risk-free rate of return, b is the market risk of the security and Rm – Rf is the risk premium of the asset over riskfree return.

Evaluation of Quality of Corporate Governance  221

Example of Calculation of EVA Particulars

2014–2015

2013–2014

Cost of Capital Cost of Equity (per cent)

20.89

23.53

Cost of Preference Capital (per cent)

10.00

10.00

Cost of Debt – Net of Tax (per cent)

6.56

6.13

13.86

13.69

9,746.25

8,131.06

NOPAT

2,462.40

1,936.98

Less: Cost of Capital

1,350.83

1,113.14

EVA

1,111.57

823.84

11.41

10.13

WACC (per cent) Average Capital Employed EVA

EVA/Capital Employed (per cent)

For the detailed process of the calculation of NOPAT, capital employed and the WACC, the book The EVA Challenge by Joel Stern and John Sheily may be referred to. MVA = V – K where V = MV of the company including the value of firms equity and debt. K = capital invested in the firm.

16.3. MVA Method MVA, a much simpler concept, is represented by the difference between the total value of the firm, also called the enterprise value, and the capital (both equity and debt) employed. This in effect would mean ROCE has to earn a rate higher than the cost of capital. For this purpose, cost of equity capital, which varies from market to market as is the case with cost of debt, has to be calculated and added to the sum of interest obligations on the debt.

222  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

MV is actually the present value that the market offers and is also called the enterprise value. The idea is to identify a reference point. Calculation of MV Particulars MV of equity 10 per cent cumulative redeemable preference shares

2014–2015

2013–2014

5,768.85

4,065.67

306.93

306.93

Loan funds

4,590.33

4,505.66

Total MV

10,666.11

8,878.26

Particulars

2014–2015

2013–2014

MV

10,666.11

8,878.26

Less: capital invested

10,529.43

8,963.05

MVA Control Sheet

MVA

136.68

(84.79)

Having identified both the relevant reference point and the objective along with the method of calculation of wealth creation and management, let us very briefly discuss how this can be achieved. The journey of wealth creation and wealth management in a company begins with the quality of management, which is reflected by three Ps: principles, people and processes. The principles are often articulated as the values and culture in an organization. Wealth maximization should be one of the most important values among those. Wih resources being limited with possible alternative uses, the optimization of value creation becomes a high ground of service for the society. Next are the people in the organization right from the BoD to the last person on the shop floor who practices the principles of the enterprise. Integrity, commitment and accountability to creating wealth must be ingrained in them. The habit of choosing and implementing the best option for the deployment of resources must be inculcated, which should extend to even organizational design. People must be educated to link strategy with financial performance. Every organization operates through an array of systems and processes. These systems and processes, inter alia, must work as a

Evaluation of Quality of Corporate Governance  223

check on the application of principles by the people in the organization. These processes will include decision-making, resources’ allocation, architecting performance targets and linking compensation, especially of the top management, with wealth creation. It is understood that all decisions cannot be right but if the process is robust and related with wealth creation, wrong decisions will turn out to be an investment in learning, eventually helping in building counter pressures and improving the quality of decisionmaking. The process must include financial forecasting, which is missing in most enterprises. And, forecasting must include the derivation of economic profit. This will involve superior financial information and controls. Having decided the basics of the enterprise, the journey must move forward into creating a framework, and our recommendation is to use a four-pillars frame as shown in Figure 16.1. In the management of wealth creation appears an accountability frame to various stakeholders, which is reflected in Figure 16.2. Figure 16.1      Management of Wealth Creation

MANAGEMENT OF WEALTH CREATION

Policy Frame Visioning • Ambition • Values • Culture • Environment Management

Strategy Frame Direction • Market Positioning • Input Mobilization • Execution Processes

Operational Frame Performance Monitoring • Financial Control • Resources Utilization • Competency Management • Capability OUT-PUT EVALUATION VIS -A-VIS STRATEGY FRAME

Value Delivery Accountability • Shareholders • Work Force • Customers • Suppliers • Society • Compliance

The real voyage of discovery consists not in seeking new landscape but in having new eyes: Marcel Proust

224  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE Figure 16.2      Accountability Frame

1. VALUE DELIVERY • Shareholders • Work Force/HR • Customers • Suppliers • Society 2. COMPLIANCE

WEALTH CREATION

WEALTH MANAGEMENT

WEALTH SHARING

STAKEHOLDER VALUE

I have mentioned in Chapter 8 that the board should focus its attention more on the policy and strategy frame. It is the board’s responsibility to outline the vision. However, designing of vision must be a collaborative exercise. The views and opinions of all the HRs, in particular, the senior management, should be sought and considered. Lest it would be bereft of collective wisdom and ground-level realities and will not assimilate enough commitment for the eventual fructification of the vision. Vision includes the long-term ambition of the enterprise: Where it wants to be from where it is today. This is also described as the dream to be realized over a frame of time. This ambition is to be supported by a mission statement and values and cultures. The environment management is an integral part of the vision because every enterprise functions under the overall canopy of both macro- and micro-environment. It is very difficult for an enterprise to change the environment, and, therefore, it has to live with it, although it is possible to introduce element(s) which can change the course over a period of time. Hence, the board has to outline the methodology of managing the environment as well. The policy frame has to be revisited periodically, at least once in a year, because the environment undergoes unremitting transformation. The rapidity and profundity of changes is often confounding.

Evaluation of Quality of Corporate Governance  225

Therefore, the validity or the relevance of components of policy frame has to be tested periodically on the platform of sagacity. Next is the strategy frame. In very brief, strategy can be described as market choices, product choices and the pricing options. Slightly broadening this definition will include market positioning, input mobilization and execution processes and, in effect, value drivers. It is the board which will have to take a call in which markets the enterprise will operate, what kind of product it will market and how will its pricing policy play. The market can be considered attractive only if it has the potential to deliver economic profit to an average competitor. Similarly, product and pricing options must be chosen with the perceptions of propensities of reaping economic profit in a predetermined frame. It is the board that will determine whether it will be playing a larger game of market share or picking up the niche with high propensities of profitability or a combination of both. It is the board which will have to direct the management whether it has to play volume or the margin game or a combination of both. Since it is not the theme of this book to dwell on the strategy, I would not like to go in greater detail. It is suffice to say that the objective of wealth creation will be determined by the vision, and its fructification will travel on the vehicle of the strategy. Policy and strategy frame, therefore, become a kind of direction that the board would provide to the management team. The job of the management will be to implement and to come back with the issues in the implementation and on the possibility of achieving the expected outcome. The third frame is the operational frame. As mentioned earlier, the management is expected to implement the vision and the strategy as specified by the board and deliver the expected outcome of the value enhancement. However, the board has the ultimate responsibility of the output and, therefore, will have to do the performance monitoring. It must be made clear here that while doing the performance monitoring, the board should not indulge in replicating what the management is expected to do. Hence, its role should be that of superintending rather than getting deeper into doing or reviewing what the top management of the company does or is expected to do. The areas where the performance has

226  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

to be monitored closely by the board can be broadly classified into four parts: (a) financial controls, (b) resources’ utilization, (c) competency management and (d) capability enhancement. The entire gamut of performance monitoring should be the evaluation of the output vis-à-vis the strategy frame. The board must be able to decipher how the internal value drivers are playing and where the value is being created and where it is destroyed. This analysis has to be done for each business unit/department/function. This, in fact, means to check whether the outcomes as expected, while designing and approving the strategies, are actually being delivered. In case this is not happening, it has to assess ‘why of it’. In case it is being exceeded also, it has to be understood what elements have delivered better so that those could be strengthened and replicated/ utilized subsequently elsewhere. Finally, the board’s attention must converge on value delivery frame. It has been mentioned elsewhere in the book that the compliance can be both, a value enhancer—when done well—and a value destroyer—when not done well. Hence, it is singularly important for the board to ensure compliance in letter and spirit. This becomes significant particularly for the manufacturing companies, such as companies manufacturing food, drugs and medicines, chemicals and so on. Any deviation can ruin the enterprise and expose even the directors to penal actions. The board has to decide, approve and communicate to the management at the beginning of every year, the objective of value creation that is expected of the management to deliver. In most companies, budgets are approved a month or two in advance of the commencement of the financial year. However, the budgets do not detail, albeit even mention, about the target of value creation during the year. It has also to be specified from where the value will emerge and how will it be measured. Our recommendation would be to detail out how the resources’ utilization will be undertaken in value maximizing rather than just deploying them as per the demands of the various layers of the management. It is possible that the management would propose and the board would accept that a certain portion of the resources will be allocated for building the sustainability of the value drivers and that the impact thereof may not be felt in one year or even two.

Evaluation of Quality of Corporate Governance  227

However, such allocations must be approved and done along with the signals/portends that would demonstrate that the value creation is taking shape, albeit in medium to long term. Once the objective of value creation is approved by the board and accepted by the management, it has to be evaluated periodically through the validation of the allocation of resources and the emerging trends. However, at the end of the financial year, it must be assessed as to how much amount of value has actually been created. Our recommendation would be to use EVA to do that assessment and cross-check by comparing MV with eligible value. Since the methodology for the assessment of value creation would have been agreed in the beginning, eventual assessment would be far easier and acceptable. It must also be compared with other comparables in the market. In this exercise of value creation, the board will play the crucial role by providing definite direction. It also must own the responsibility for lower or no value creation, if the directions were faithfully adhered to by the management. This can be obviated in case post-periodical review during the currency of the financial year, re-engineering of the strategic approaches and direction takes place. This is how accountability must be determined and appropriate action taken. Thereafter, it has to weigh whether the value is being created for all the stakeholders. It should not happen that the focus is purely on share price, which enhances shareholders value, and there is no focus on sustainability and/or enriching the life of HR. In fact, this is a tricky thought and most of the time it becomes very difficult to assess whether the value is being created equally for all the stakeholders. The best measurement would be to ascertain if the interest of any other stakeholders is being hurt. Post that, it becomes a question of sharing the wealth.

16.3.1. Wealth Sharing The wealth created by an enterprise belongs to all the four stakeholders in proportion to the contribution of inputs provided to the enterprise. There are stakeholders who have contractual ownership

228  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

and there are the remaining stakeholders who have the residual ownership. As stated earlier in the book, the contractual stakeholders belong to the category of HR and the suppliers of debt capital and other goods and services. Oftentimes, the precedence of sharing of wealth is agreed. For example, the HR and the suppliers of raw materials and the debt capital get precedence over the providers of risk capital—equity holders. Similarly, a part of the payment of wealth to the society in the shape of payment of taxes takes precedence over the payment to shareholders. Figure 16.3 depicts the ownership of the wealth to contractual and residual formats. The enterprise, therefore, must architect the disbursal philosophy and policies in a manner and method that the wealth is shared sagaciously. A set of stakeholders are disbursed wealth, which is proportionate to their contribution and is not at the cost of proportionate sharing with other stakeholders. In most Corporate Governance misdemeanours, it has been brought to light that the executive compensation is disproportionate to their contribution of wealth creation and wealth management.

Figure 16.3      Stakeholders Chain CONTRACTUAL Value Creation for Buyer

Value Creation for Supplier

CUSTOMERS

BOARD

ENTITLEMENT

Safety of Interest & Principal Enhancement of Portfolio Quality

SUPPLIERS

LENDERS

Taxes, Employment, Societal Commitments SOCIETY

EMPLOYEES

MANAGEMENT

RESIDUAL ENTITLEMENT

MAJORITY SHAREHOLDERS

MINORITY SHAREHOLDERS Value

Salaries Benefits Stability

Evaluation of Quality of Corporate Governance  229

Similarly, the examination of the RPTs reveals the benefiting of one set of stakeholders of an enterprise at the cost of other stakeholders of the same or some other related enterprise. 1. Shareholders The shareholders share company’s wealth in the following ways: • Dividend • Bonus shares • Right shares • Share price appreciation Wealth sharing with shareholders is generally measured through total shareholders’ return (TSR), which is calculated with the analysis of the following factors: • Sales growth • Earnings before interest, taxes, depreciation and amortization (EBITDA) movement • Change in capital structure, a ratio of market capitalization to the total enterprise value • Dividend yield It must be ensured that they get their due and that too periodically. 2. Debts Holders The sharing of wealth by the debt holders is reckoned in two forms: • Payment of interest and repayment of debt on due date(s) • Rating of the debt papers Obligations must be kept up and rating must not be allowed to deteriorate. The effort should be to improve to enhance their confidence and contract risk premium. 3. Human Resources The evaluation of sharing of wealth with HR is done through the assessment of: • Growth in compensation package • Rise in hierarchy • General welfare of HR • Attrition rate

230  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

HR satisfaction is primary to the sustainability of the enterprise and, therefore, has to be measured through ‘happiness index’, a new measure introduced. 4. Customer A company has to seriously engage in crafting value for its customers—the most preferred method of sharing wealth with them. The initiatives can be segregated into four parts: price, quality and satisfaction index and customer retention. • Price: Company has to price its products competitively. Industry benchmarks have to be kept in view while determining the price. The reviews of the prices of the company have to be undertaken periodically while maintaining the margins to deliver economic profit. • Quality: It brings about satisfaction and retention of customers. • Satisfaction: Customer grievances received in writing, verbal or vicariously are to be dealt with efficaciously to ensure that the customers’ confidence level is fully maintained, nay, enhanced. The company has to create a well-laid down procedure for the analysis of customer demands and preferences so as to appropriately devise the product line and service standards including post-sales. Probably, the satisfaction of customers stems out of the quality and competitive price that the company offers. • Customer Retention: 100 per cent retention of its regular customers demonstrates that the customer satisfaction is very high, a result of wealth sharing. Eventually, it enhances economic profit via reducing the cost of acquisition of customers. 5. Society: CSR Wealth sharing with the fourth set of stakeholder namely the society is undertaken by: • Paying all the taxes and such like obligations, in time. • Undertaking projects which benefit the society at large. The company has to be conscious of its obligations to society and has always to pay taxes and discharge its obligations fully and in

Evaluation of Quality of Corporate Governance  231

time. It has to be regular in depositing with appropriate authorities the undisputed statutory dues including those relating to provident fund, employee’s state insurance, income tax, sales tax, wealth tax, service tax, customs duty, excise duty, cess and other material statutory dues applicable to the company. It has never to default and hesitate to pay applicable taxes on schedule. It is time that the CSR initiatives of the company are scientifically assessed to establish that the company is rising up to be a model corporate citizen, which is eulogized and exemplified to promote CSR as a virtue in the corporate world. Several methods are used for the evaluation. The virtue matrix (see Figure 16.4), propounded by Professor Roger L. Martin of Rotman School of Management,  is one such method which can be used. To help the management to do the evaluation, an outline described by Professor Roger Martin himself as to what virtue matrix is and how it functions is very briefly described as follows. Figure 16.4      The Virtue Matrix

Note: Created by Professor Roger L. Martin of Rotman School of Management, Canada.

232  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

The virtue matrix, as per Professor Roger, depicts the forces that generate CSR. The bottom two quadrants of the matrix are the civil foundation which consists of norms, customs and laws that govern corporate practice. Companies engage in these practices either by choice (they choose to observe norms and customs) or in compliance (they are mandated by law or regulation to comply). Behaviour in the civil foundation does no more than meet society’s base line expectations. Since it explicitly serves the cause of maintaining or enhancing stakeholder value, this behaviour can be described as instrumental. Corporate innovations in socially responsible behaviour occur in the frontier—the matrix’s upper two quadrants. The motivation for these innovative practices, at least initially, tends to be intrinsic: Corporate managers engage in such conduct for its own sake, rather than to enhance stakeholder’s value. The behaviour that benefits shareholders and adds to the supply of social responsibility falls into the strategic frontier: It is intrinsically motivated behaviour that coincidentally advances the corporation’s strategies. The structural frontier houses actions that benefit society but not shareholders, creating a structural barrier to corporate action. As the matrix’s downward pointing arrows suggest, behaviour in both frontiers can migrate to the civil foundation—from the strategic frontier through the widespread imitation of the successful innovator, or from the structural frontier through collective action or government mandate. This migration ratchets up the civil foundation. But then, the foundation can be ratcheted down if a critical mass of companies abandons a socially responsible practice. Corporate Governance of the enterprise, designed on the principles of optimizing wealth creation and maximizing wealth management and equitable sharing of wealth, can effectively navigate the headwinds of environment and pressures of the expectations of the stakeholders. It can also erect safety belts for the long-term sustainability of the organization. This is called the substance of Corporate Governance. It has the potential to convert the so-called tyranny of Corporate Governance rigors into the triumph of the institution.

17 Conclusion: Corporate Governance—Triumph of the Enterprise

A

firm is shaped to create wealth. Equity and fairness are the credo. Stakeholders’ trust is the bedrock. Relationships architect trust. Corporate Governance is all about erecting and strengthening the pillars of relationships. The confidence of the market is the hallmark of Corporate Governance. Innumerable misdemeanours in the affairs of the firms have destroyed value, dealt a body blow to equity and fairness, shattered the relationships and rocked the trust and confidence. The unfolding of every major misconduct in the functioning of firms has engineered the refinement of the ground rules across geographies. The exercise remains on a boiling pot. The regulatory framework is getting wider and steelier. Navigation is becoming onerous and expensive. The formidability of converting input costs of Corporate Governance into wealth is obvious. Managerial inadequacy to address the task is apparent in most cases. Eventually, the process ends up into the perception of a tyranny. While on the Chair of SEBI, I often used to reflect on the impact of policing by the regulator. My highway of pondering would mostly narrow down in the lane of thinking that ethics win only when the armoury of value system is manifestly potent and

234  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

that policing, howsoever rigorous, cannot close all the windows of human ingenuity to short change the passive stakeholders. Human ingenuity coupled with an inherent trait of self-aggrandizement can be a deadly beast. It gives birth to misdemeanours. Hence, my meditation used to centre on the motivations. If the crux of all motivations is the ‘monetary gains’, could there be a way to harmonize and synthesize ethics with monetary gains in the limited sphere of Corporate Governance? And, I stumbled upon the process of promoting and propagating the substance of Corporate Governance. This was also the logic of travelling an extra mile to encourage rating agencies to design a tool to assess that substance, which may eventually build market and peer pressure. Transiting from the stance of the compliance of regulatory obligations to the raison d’être of the firm—wealth creation, wealth management and wealth sharing, I would like to quote the findings of a 2002 Mckinsey survey published in its quarterly under the heading, ‘A premium for good governance’. Institutional investors in companies based in emerging markets claim to be willing to pay as much as 30 percent more for shares in companies that are well-governed. Do these investors mean what they say? The survey examined 188 companies from India, Korea, Malaysia, Mexico, Taiwan, and Turkey to test the link between market valuation and corporate-governance practices. They found that companies with better corporate governance had higher price-to-book ratios, indicating that investors do indeed reward good governance, and with quite a large premium: companies can expect a 10 to 12 percent boost to their valuation by going from worst to best on any single element of governance.

In another survey conducted by the Credit Lyonnais Securities Asia (CLSA), sometime in 2005, it was revealed that when the market prices of the shares went up, the prices of the shares of companies in the top quartile of the Corporate Governance went up more by upto 25 per cent, and when the market fell, the loss in valuation of such companies was much lower. Just imagine the additionality of value to the stakeholders if the various parameters reflect a value of the enterprise to be 100 and a fund manager assigns an additional valuation of 25 per cent for Corporate Governance. Matthew Morey and Aron Gottesman at the Lubin School of Business, Pace University, Edward Baker at the Cambridge Strategy

Conclusion: Corporate Governance—Triumph of the Enterprise   235

(Asset Management) Ltd and Ben Godridge at Alliance Bernstein have, in their research, established evidence that changes in good Corporate Governance practices of emerging countries are directly related to incremental changes in company value. This, in effect, implies that Corporate Governance is an important component of company valuation. Allen Ferrell, Harvard Law School and Martijin Cremers, Yale School of Management, have found a robust, statistically significant, negative association between poor governance and firm valuation over the period 1978–2006. Another study by McKinsey (February, 2005), where 70 successful private equity deals were analysed, found that the primary source of value creation in majority of these deals was the out performance of the company—not price arbitrage, financial engineering or overall sector gain or stock market appreciation—just by better management of business. Mckinsey findings further discovered, albeit surprisingly, that out performance was primarily driven by changes to the way the boards of these enterprises worked. Mckinsey describe this as a more engaged form of Corporate Governance. Yet another research, conducted by Bernard S. Black of Stanford Law School, Hasung Jang of Korea University of Business School, Woochan Kim of KDI School of Public Policy and Management, found a strong positive correlation between the overall Corporate Governance Index (CGI) and firm value. In an important study conducted on 155 Canadian firms (517 firm-year observations) over a four-year period from 2002–05, Bozec and Bozec (2010) find strong evidence that the cost of capital decreases as the quality of Corporate Governance practices increases. Balasubramanian et al. (2011) researched the Corporate Governance practices of public firms in emerging markets—in this case, India—and, inter alia, found a positive and statistically significant association between the Indian CGI and firm market value. A large scale survey of institutional investors conducted in 2002 (Global Investor Opinion Survey Key Findings McKinsey & Co) found that a majority of investors consider governance practices to be at least as important as financial performance when they are evaluating companies for potential investment. Indeed, they would be prepared to pay a premium for shares in

236  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

a well-governed company as compared to poorly governed company exhibiting similar performance. All the aforesaid researchers indicate that there is a significant monetary value in practising good Corporate Governance.1 The focus of assessment of all the envisaged processes of Corporate Governance has to be eventual wealth creation and enhanced valuation of the enterprise; in effect, the encashability of the quality of Corporate Governance. I would, therefore, strongly advocate for minority/majority equity owner–managers of the firms that their interest, including financial, lie in practicing good Corporate Governance because the value addition as a consequence thereof will always be greater than by the lack of it— diversion of resources, short changing other stakeholders and/or downright siphoning of funds. Arguably, the design, direction, diligence and demonstration in the observance of Corporate Governance rigours can transform this exercise into value creation and eventual triumph of the firm. There are four pillars which hold the edifice of relationships that culminate in trust, of which I spoke in the beginning of this chapter. These are (a) transparency, (b) consistency, (c) equity and fairness and (d) value. If all these pillars remain strong, the relationship will turn into bonding, and trust may transit to perpetuity. However, the fragility of trust is inherent, about which I will talk a little later. On several occasions, I have been challenged by a variety of young entrepreneurs, in particular to suggest a model or plan to architect excellence in Corporate Governance. Although it might appear presumptive to lay down a model/plan, I would still attempt to outline an approach to facilitate the creation of excellence in Corporate Governance. This journey, to my mind, must begin with the belief of what Mr Anand Mahindra, Chairman of M&M Group India, called, “custodians of stakeholder’s interest” 1 (1) Stephen Yan-Leung Cheung, Department of Economics and Finance City University of Hong Kong. (2) J. Thomas Connelly, Faculty of Commerce and Accountancy, Chulalongkon University. (3) Piman Limpaphayom, Sasin Graduate Institute of Business Administration, Chulalongkon University (4) Lynda Zhou, Department of Economics & Finance, City University of Hong Kong.

Conclusion: Corporate Governance—Triumph of the Enterprise   237

or what Mr Deepak Parekh, Chairman of HDFC Group, called, “trustees of the stakeholder’s interest and wealth”. Such philosophical underpinning should fashion the psyche of managers at all levels, beginning with the very top in the enterprise. In fact, Mr Anand Mahindra shared with me a photocopy of the first advertisement that M&M had issued at its debut in 1945. Essentially, it incorporates that it will work in the interest of all the stakeholders. A firm is expected to function under the broad canon of corporate democracy. The members (shareholders) authorize the management to manage the firm and create and share wealth. At the top of managerial pyramid sits the BoD. The first and foremost essential requirement, therefore, would be of constituting the board—a board which has skills and experience, exuberance and maturity, integrity and commitment and operates as a team. Comfort, convenience and/or coalescence in the boardroom should be replaced with alacrity, concern, alternative thinking and dynamic tension. The process of organizing such a team in the boardroom is like a journey which must undergo refurbition with every milestone on the way. Deficiencies, whether in the area of required skills, experience, commitment and/or contribution, must be addressed very quickly. This will necessitate a very effective and meaningful evaluation of the performance of directors. The evaluation must also assess the quality of teamwork in the boardroom, because even great individual abilities and/or performances do not win a match. What triumphs is a teamwork. Although the substantial responsibility will devolve on the chairman, every board member has to contribute to team building and pragmatic play. Individuals must get adequate opportunity to contribute while organization gathers genuine and honest feedback to bridge the gaps. The board must lay down the broad principles that will guide the functioning of the firm. Although these principles will have to be in sync with the regulatory framework, the philosophical underpinning has necessarily to be creation of wealth, its optimal management and sagacious sharing. The principles must be value based and universally applicable. Defining the basic principles must be complimented with its propagation and practice. The

238  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

board, CEO and top executive management team will have to earn moral authority to preach by scrupulous self-adherence. I suggest that every company must enshrine six ideologies, three of which are in the nature of philosophy and the other three as precursor to decision-making principles.

17.1. Value Builders: Philosophy The ideologies of philosophies should be the following: 1. Integrity: It cannot be compromised by any firm, at any level, at any point in time. Integrity includes both financial and intellectual integrity. In many corporations, there is serious effort to maintain financial integrity, whereas intellectual integrity is compromised rather quite often. Intellectual integrity, to me, means ‘convergence of thought into action’. It is my belief that intellectual dishonesty has the potential to do greater harm to an enterprise, individual or even society than financial dishonesty. While loss on account of financial integrity can possibly be made up some time or the other, damage done by the lack of intellectual integrity may not be possible to repair at all or may take several generations to achieve. One concrete example is that of Arthur Anderson, a one-time top management consulting and accounting firm, which was destroyed more by intellectual dishonesty than by the financial impropriety. Even three generations of Arthur Anderson could not have put the organization back on the same platform, which was eventually dissolved. This is not to state that the financial integrity can be compromised. The short point is that the BoD, the top management and everybody in the organization must observe highest standards of both financial and intellectual integrity. 2. Transparency: Since there are stakeholders of the firm who are not actively involved in the management, it is essential that utmost transparency is maintained, which helps the

Conclusion: Corporate Governance—Triumph of the Enterprise   239

passive stakeholders to know how the management is being run and judge its performance. Although every regulatory jurisdiction has laid down certain minimum disclosures and standards of transparency, what I suggest is the principle: ‘Come what may, whatever helps reinforcing trust will be shared with all the stakeholders’, whether it is mandatory, voluntary or not as per the regulatory dictate. In any case, complete transparency must be maintained with the BoD, and nothing that is important and/or material in the functioning of the firm is to be withheld from them. 3. Equity and fairness: Since a firm is created for the benefit of all stakeholders who have a right to share its wealth, it is important that equity and fairness of highest order are maintained. There should be no case of short changing by the active stakeholders, either for their own benefit or for the benefit of anybody else. Equity and fairness must not only be practised but perceived to be there.

17.2. Value Enablers: Principles The three ideologies of principles stated as follows must become the basis around which the decision-making revolves. The decisionmaking wheel should have three circles. 1. Evaluating options: First circle should be of ‘evaluating options’. There are always alternatives to a proposed decision. However, many a times, alternatives are not considered, and the only preposition made by the management is accepted which often does not deliver optimal value. It is possible that, at the same time, there could be option(s) which have the potential to deliver higher value. Any pragmatic decision-maker must, therefore, evaluate various options before taking a decision. Sometimes, it does happen that the options are brought to the table but they are either rejected upfront without consideration, or not considered from all angles or undervalued. Hence,

240  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

it is important that the principle of ‘evaluating options’ is established. The quality of decision-making will be retarded in the absence of this principle. 2. Respect for dissent: The second circle would be that of respecting dissent. Many a times, even in the assembly of highly accomplished minds, dissent is not welcomed and/ or respected. The intolerance of dissent leads to the lack of in-depth consideration of an issue/subject/preposition and often lands in authoritarianism. Dissent engages the minds of the assembly and helps draw out best in them. It helps in testing the validity of the assumptions and/or the arguments advanced in favour of a preposition. I have watched in many board meetings that dissenting voices are few and far between. Even though there are disagreements, divergence of thinking and even differences of opinion, in the absence of respect for dissent, these are not voiced at all or are meekly mentioned. In the absence of respect for dissent, the quality of decision-making takes a serious beating. Hence, it is important to not only respect dissent, but also respect dissenter so that he continues as also inspires others to come forward with the criticism and/or alternative views. 3. Value preposition: The final circle should be of value preposition that is, the decision-maker, while taking a decision, must be able to understand, recognize and state the value preposition of the decision. This is to ensure that the resources of the firm do not seep out, are frittered away and/or are even underleveraged. Based on what has been stated earlier, the frame of ideologies is shown in Figure 17.1.

17.1.1. Monitoring Once the philosophy and principles have been designed, outlined and communicated, the monitoring of the observance must be rigorous. The rigors of the monitoring must be outlined,

Conclusion: Corporate Governance—Triumph of the Enterprise   241

Figure 17.1      Frame of Ideologies

DECISION MAKING PRINCIPLES OPTIMAL VALUE PREPOSITION

EQUITY & FAIRNESS TRANSPARENCY

PHILOSOPHY

INTEGRITY: FINANCIAL & INTELLECTUAL

documented and enforced with alacrity and ruthlessness. It may become well-nigh impossible for the board alone or even the CEO to accomplish efficacious monitoring. Hence, the layers and processes have got to be well defined and followed scrupulously. The sequencing of process can be organized in the manner exhibited in Figure 17.2. Constituting an accomplished and committed board, laying down the philosophy and principles may be easier than ensuring efficacious monitoring. In the absence of effective monitoring, the

Figure 17.2      Monitoring Process DEFINING PRINCIPLES

EDUCATION

TRAINING

EVALUATION

RE TRAINING

ENFORCEMENT

242  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

entire framework and exercise of building excellence in Corporate Governance may remain a distant dream. Hence, this should be a process in accomplishment; it must remind everyone that he is a trustee and has a fiduciary responsibility. Breach of trust may adversely affect their own interests and jeopardize even the existence of the firm. Hence, it must become an exercise of collective delivery. My recommendation would be to convert the nomination and remunerations committee designated under the statute, as ‘governance committee’, which will have, in addition to the defined role, the monitoring of Corporate Governance compliance as an added responsibility. Some firms have created a separate committee for Corporate Governance compliance. I would, however, recommend a combined committee which takes care of the compliance as well. The monitoring of Corporate Governance compliance should include scrupulous observance of all directions, whether mandatory or voluntary laid down by any regulatory body whose jurisdiction extends over the firm. However, to my mind, monitoring should, in addition, include the monitoring of the ideologies: philosophy and principles of governance stated earlier in this chapter. Monitoring should not be a ticking box but it should be with reference to the outcomes of the efforts made. It should be something like performance audit, which will take shape by assessing the impact of Corporate Governance, both positive and negative. The negative impact would be whether the firm would be subjected to any kind of regulatory enforcement including the issue of any direction or advice. It must be made clear to everyone in the organization that any adverse finding by any regulatory body and so on is not acceptable. Something of a kind of zero defects must be the case. Anytime, anything is observed, it has to be dealt with the imposition of: 1. Severe penalty upon the person(s) whose fault or negligence led to such a regulatory enforcement action. 2. Take corrective steps to ensure that this does not happen again. In addition, regular reports must be thoroughly scrutinized, and any potential non-observance likely also must be addressed beforehand.

Conclusion: Corporate Governance—Triumph of the Enterprise   243

The performance audit of decision-making (strategic and important decisions such as mergers and acquisitions (M&A), branching into new business line) must also be organized to find out the value creation—what was envisaged and what has been actually realised—and if it is lower than expected, action must be taken to analyse the information and thereafter, appropriate guidelines and directions must be handed out. While monitoring of compliance, as written in the book elsewhere, will not undergo change, the governance committee will take a helicopter view to make sure that the architectural design drawn out by the board and under various regulatory directions shapes up the organization well. Governance committee should not replicate what others in the organization are expected to do in the matter of the monitoring of the compliance of Corporate Governance. It should focus more on wealth creation, wealth management and wealth sharing. The board and the top management must take pride in building an image of the firm’s good governance, which is not only envied but eulogized. The responsibility for doing so should also be entrusted to the board governance committee.

17.1.2. Evaluation of Wealth Creation I am of the firm view that the entire programme of Corporate Governance must culminate in optimal value creation. Annual exercise should be undertaken to assess value created by the firm. Elsewhere in the book, I have given various methodologies to evaluate wealth creation. However, my recommendation would be as follows: It should be a three-staged process. The first stage would be the evaluation of value creation through EVA methodology (detailed earlier). This methodology will bring out what has been the value creation during the year. The second stage would be to compare the value creation arrived at by the EVA method with the MVA which should be arrived at by reducing the current market value (enterprise value) as reflected by the pricing of the common stock with the value at the beginning of the financial year. The difference

244  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

between the EVA and MVA should then be tempered with the environmental factors and/or any other factor (that helps in addressing the appropriateness of the referencing figures of MVA at the beginning and at the end of the year) that might have positively or negatively affected the market value. Although it might be difficult to exactly assess the role played by the environmental factors in influencing the market value, an intelligent guess can certainly be made. In case the MVA is less than the EVA, a thorough analysis must be done to find out the reasons. The analysis may throw out the factors (a) which were beyond the control of the management and/or (b) which could have been managed by the management. This analysis will also bring out change, if any, in the perception of the market about the quality of Corporate Governance during the intervening period. ‘CG along with perception, I think, gives you appropriate value’, suggests Kishore Biyani, CEO, Future Group. The third stage should be of comparing the value arrived at by the second stage, with reference to the value created by peers in the same industry within and outside the country and also with some leading value creators even in other industries. This exercise will call for deeper analysis of the factors that might have contributed in building of greater value by another enterprise. In case the firm has done better than the best or has even been placed in the top quartile of the value created by firms, the management and the board deserve full appreciation. However, in case it does not fall in the top quartile, a thorough analysis would help in (a) strengthening decision-making process, (b) strengthening monitoring process and/or (c) improving perception about the quality of Corporate Governance of the firm. The objective of the entire three-staged exercise stated earlier should be to assess how has the wealth creation evolved during the year and what light does the analysis show for the journey ahead. There are a few firms such as Infosys in India, which use EVA method of evaluating the value creation and disclose to the market also. However, there are not many firms which undertake such an incisive exercise. I must put a note of caution here. The board must not look at only one year’s performance in the aforesaid format. The outlook should be of a journey of value creation, where

Conclusion: Corporate Governance—Triumph of the Enterprise   245

the year under review should be a milestone. The performance of the year under review must be related with the past years and also the perspectives it pronounces of the journey forward. The annual performance review should not even vicariously allow seeping in of short-term approach. The board should always focus on building a sustainable, long-term enterprise value. However, an annual review cannot be obliterated and should provide insight into the movement of that journey with lessons learnt during the year for still better onward movement. Such an assessment will take care of both wealth creation and wealth management. Similarly, an exercise has to be undertaken to assess the efficacy of wealth sharing. How to do such an assessment is detailed at the appropriate place in the book. Excesses and/or delinquencies have to be corrected forthwith. Some pundits of Corporate Governance may question as to whether value building is the only objective that the Corporate Governance of a firm should be concerned with. Logically replying to that question, it might be useful to remind that the fundamental purpose—the raison d’être—of the creation of a firm is value building: wealth creation. Furthermore, all that has been enshrined in the Corporate Governance framework through the legislations and regulations, whether directed to be observed as an obligation or voluntarily, is aimed at creating, preventing erosion and protecting the value of the enterprise, and its sagacious sharing amongst all stakeholders. What could be a better assessment of the quality of Corporate Governance than its impact on the wealth creation, wealth management and wealth sharing? The assessment must be based on the analysis of the numbers revealed by the financials of the firm. Hence, the entire focus of my recommendations is not only on creating an overarching frame of ‘value building philosophy’, but also ‘enabling principles’. It must be remembered that value creation, value management and value sharing eventually culminate into trust building, which is a journey and not a destination. Hence, every milestone of the journey must help the firm in re-engineering, redesigning and/or refurbishing its march into building the ‘perpetuity of stakeholders trust’. The eventual frame is shown in Figure 17.3.

246  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE Figure 17.3      Corporate Governance Wheel

CYCLE OF CREATING EXCELLENCE IN CORPORATE GOVERNANCE

MONITORING OF IMPLEMENTATION OF GOVERNANCE PRICIPLES LETTER & SPIRIT

CONSTITUTION OF BOARD SKILLS, EXPERIENCE, EXURBERANCE, MATURITY, INTERGRITY, COMMITMENT, TEAMWORK

IDEOLOGIES OF GOVERNANCE: LONG-TERM VALUE CREATION & INTEGRITY IN OPERATION

WEALTH CREATION, WEALTH MANAGEMENT, WEALTH SHARING PERFORMANCE EVALUATION

STRATEGIC FRAME ORGANIZATION DESIGN VISION, MISSION, VALUES & CULTURE

Corporate Governance is the ‘universe of management’. I have tried to picturize my recommendations on that universe of management in the shape of a wheel. The wheel is oscillating and has, at its base, a three-layered strong pyramid. The rationale of creating this picture of a wheel is the need of interlinking various facets of Corporate Governance. The unremitting transformation in the environment, which calls for a dynamic frame of reengineering of all relevant processes, if and when necessary, is my

Conclusion: Corporate Governance—Triumph of the Enterprise   247

logic behind the oscillation of the wheel. The pragmatism propels that the architecting of changes should be a stitch in time. The direction of oscillation has been determined by the order of steps in the design of Corporate Governance. Since orderly oscillation commandeers a firm base, I have placed the wheel on a strong pyramid of vision, missions, values and cultures. I reiterate my strong belief that the sustainability of a firm is enabled by the trust of stakeholders and the foundation of that trust in the management of a firm is the economic gain that the stakeholders reap during the currency of relationship with the firm. The sustainability of this stakeholders’ trust stems out of optimal wealth creation and management and sagacious sharing. The ever-changing macro and micro environment have made resilience of a firm difficult, culminating into uncertainty in delivering economic gains to the stakeholders, which has added to the fragility of the trust of stakeholders. Liberalization and globalization of economies have facilitated the movement of resources across firms and geographies in quest of returns—gains. The transition of Earth into a planetary village enabled by communication revolution has facilitated and heightened that quest. This makes the delivery of economic gains further difficult. Thus, the durability of trust and, therefore, the relationship with stakeholders becomes fragile. It is my belief that the instrumentality of Corporate Governance can hold a protective umbrella over the fragility of stakeholders’ trust and ensure the durability of their relationship with the firm. There is a strong possibility that an architectural design suggested in the book may deliver excellence in Corporate Governance and eventually perpetuate the trust of the stakeholders. It even makes an economic sense to address the subject of Corporate Governance sagaciously. And, addressing the subject in the recommended frame may eventually turn out to be the triumph of the Corporate Governance that I seek to promote.

Caveat: All the case studies have been written based on the published material drawn from various sources. The author does not claim to have done the primary research. In fact, it is a kind of a secondary research of the materials published in various websites, media reports, regulatory orders and so on. Since numerous sources have been used, it is difficult to give credit to any particular source. However, wherever it is possible, credit for the sources used have been given in the relevant places.

ANNEXURE 1 Case Studies Case Study 1: USA Enron Corporation: Chimera of Imperviousness Enron was founded in 1985 by Kenneth Lay with the merger of Houston Natural Gas and Internorth as a gas pipeline company. Enron quickly diversified into a varied variety of businesses such as crude oil, natural gas, petro-chemicals, plastics, electricity, coal, shipping, steel and metals, pulp and paper and even weather and credit derivatives. In 1999, it even launched EnronOnline, the trading website which allowed the company to better manage its contracts’ trading business. Enron held a variety of assets around the world including electricity plants, gas pipelines, pulp and paper plants, water plants and broadband services. In Enron, Kenneth Lay, Chairman, along with Jeffrey Skilling, President and CEO, created a very complex business model that spanned across products, geographies and hierarchies. In some businesses, Enron was a producer, in some, it was a distributor, while in others, it acted as an intermediary and market maker. Enron’s revenue expanded exponentially from $13.3 billion in 1996 to $100.8 billion in 2000, a growth of more than 750 per cent. In 2000, Enron made a profit of almost $1 billion. Fortune magazine named Enron as America’s most innovative company for six consecutive years ending in 2000. Summing up in a sentence, the growth story of Enron would be of an organization rising like a phoenix within a short span of its life out of unbridled and unruly creativity. Even though some of the creativity was really original and is still being used across

250  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

geographies and businesses for hedging, Enron was essentially using that creativity to ‘hedge against itself’. This particular aspect was not noticed and deciphered by the oversight mechanism of the audit committee and auditors, and even by the market.

What Went Wrong? The company was making complicated bets on the future, and many of those gambles on the future energy prices, in particular, were losing money. And to hide, the management used creative accounting and off-balance-sheet financing vehicles. The method was adopted to use mark-to-market accounting practice to book entire profit from an asset such as a power plant to its balance sheet—even though the project may not have made a single dime—and then to hide losses. The loss-making projects would be transferred to special purpose entities (SPEs) from the company’s books. Many dubious ‘partnerships’ were created, which allegedly bought losing businesses from Enron to boost Enron’s balance sheet. Furthermore, the company did not hedge unrealized gains and losses of long-term contracts even though it used mark-to-market accounting for income recognition and made forecast of energy prices and interest rates. Disproportionate compensation was paid to key managerial personnel and vicarious monetary gains made by executives, directors and auditors of Enron. For example, company’s CFO, Fastow, earned $30 million in just one deal as a compensation for managing Lea, Jeffrey, Matthew (LJM) limited, one of the many ‘‘partnerships’’ floated by the company to hide debt. Many of the company’s executives allegedly raked in millions by selling their shares before company’s problems went public. Enron had its governance frame; 14 board members with only two insiders, and a full complement of board subcommittees such as executive, finance, audit and compliance, compensation and nomination and Corporate Governance. However, the oversight mechanism was hopelessly ineffective. Audit committee was not focused and failed to do its job. It held fewer yet shorter meetings that covered greater grounds.

ANNEXURE 1  251

This meant that they were unable to fully comprehend such a complex business and the true financial health of the company. There was also a significant conflict of interest with the statutory auditors. For example, Arthur Anderson, Enron’s audit firm, was accused of applying lax standard in its audit of Enron because of huge compensation and consulting fees that it received. In 2000, he received $25 million in audit fees and $27 million in consulting fees. This represented a major part of the revenue of his Houston office. The governance failures at Enron were pervasive and, at multiple levels from lack of independence of its directors to financial engineering, undertaken deliberately to overstate profits and hide losses, minimal disclosures, conflict of interest, scandalous compensations, to collapse of oversight mechanism and fiduciary failures.

Lessons One of the most important lessons from Enron is the danger of creating a culture of chasing shareholder returns at the expense of everything else. The cowboy culture of the company, especially promoted by top bosses Kenneth Lay, Jeffrey Skilling and Fastow, CFO as also by others, ultimately led to the destruction of the company. Enron had a banner in the lobby of their headquarters which read ‘the world’s leading company’, and executives at the company were determined to make this true at all cost, even if it meant cooking books and hiding loses. In fact, there was a deep internalization of a culture of winning at all cost by hook or crook, and it reflected in the systems and procedures of the company. The value system in the company was rotten with impropriety right from the very top with blatant disregard for the conflict of interest, be it in acquiring a company co-owned by a son of Chairman Kenneth Lay or urging employees to use a travel agency operated by the sister of the chairman. The Enron saga teaches us how important the probity and behaviour at the top is. Any conflict of interest, even minor ones, should be avoided at all cost. There should be true independence for directors, CEO, CFO and most importantly auditors, both internal and external.

252  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

There has to be deep internalization of (efficacious) systems, procedure, culture and values. All, put together, must build a serious depth of belief in those systems and probity. Adherence to Corporate Governance framework is important for all business. However, it should not be just about the form of compliance with regulatory obligations and mandatory disclosures or accounting standards, but these standards, disclosures and regulations should be followed in true spirit and be emphasized by the top management, in particular. There should be effective oversight of board committees and compensation monitoring. The boardroom practices were seriously deficient in Enron. The ills relating to ineffective monitoring stemmed out of inadequacy engagement of the board. The boardroom is a place where the members gather for a serious review and discussions on the performance and strategic issues. The depth of the review, quality of decision-making, choices of strategy and eventual sustainability of the enterprise has a direct and proportionate relationship with the boardroom practices. Hence, there should be a focused approach on the boardroom practices. The core of the Corporate Governance is the fiduciary responsibility of the top management and the board in holding the enterprise in trust for future, for long-term sustainable profitability rather than chasing short-term profit at any cost.

Case Study 2: Continental Europe Parmalat: Unquestionable Belief in Morality of Management Parmalat SpA represented the core milk and dairy food business of the Parmalat Group. Parmalat SpA was an unlisted company controlled by Parmalat Finanziaria, which was listed on the Milan Stock Exchange. Its main shareholder was Coloniale SpA which owned 50.02 per cent of the company’s voting share capital. The Coloniale SpA was under the control of the Tanzi family, through some Luxembourg-based companies. There were other two institutional investors which were minority shareholders in

ANNEXURE 1  253

Coloniale SpA: Lansdowne Partners Limited and Hermes Focus Asset Management Europe Limited. To sum up, Parmalat was a complex group of companies controlled by Tanzi family with presence of limited number of other shareholders. A brief sketch of the ownership structure is outlined in Figure A.1, which speaks the volumes of the complexity built around the ownership design. This, in fact, is the case with many entrepreneurs-dominated firms around the world. In the 1980s and 1990s, the Parmalat was hailed as a jewel in the Italian commerce. The credit for this goes to Calisto Tanzi who successfully converted his father’s ham retailer business into a global giant in food and dairy business. It all started with a pasteurization plant in Parma which opened in 1961 by Calisto Tanzi, then a 22-year-old college dropout. The main reason for company’s success was its technique of using the ultra-hightemperature process, which produced long-life milk. On 22 April 2002, Parmalat’s share price reached a record and the company was valued at 3.7 billion. It had over 30,000 employees in over 30 countries. The company had diversified into many different kinds of businesses including travel group—ParmaTour, a TV channel—Odeon TV, football clubs—Parma A.C. and S.E. Palmeiras, and had sponsorship of S.L. Benfica, Boca Jniors, C.A. Penarol and Brazilian formula one racing driver Pedro Diniz.

What Went Wrong? In 1997, Parmalat decided to become a ‘global player’ through acquisitions and debt financing. It lured investors through imaginative and speculative structured instruments designed by a group of global and Italian bankers and siphoned off large amount of money to a network of 260 companies. The company created an illusion of liquidity through bond sales. In fact, an ingenious product called ‘Buconera—Black Holes’ designed by CITI Bankers was used. The company justified borrowing through fictitious sales in a scheme devised and executed by Tanzi, top managers, lawyers and outside auditors. For example, in one of the most brazen case, the company created a bogus milk producer

5%

Bonlat Financing Corporation (Cayman Islands)

100%

Parmalat Capital Finance Ltd (Malta)

35.78% Food Consulting Service Ltd (Isle of Man)

100%

100%

10.82%

100%

0.86%

Cureastle Corporation NV (Dutch Antilies) 100%

Parmalat Finance Corp. (Netherlands)

100%

Zilpa Corporation NV (Dutch Antilies)

Dalmata Sri

Newport S.A. (Luxembourg)

100%

Parmalat Austria Gmhb (Austria)

Source: Blackwell Publishing Ltd 2005. Corporate Governance Failures.

99.75%

64.22%

Parmalat S.p.A.

95%

Parmalat Soparfi S.A. (Luxembourg)

Parmalat Malta Holding Ltd (Malta)

0.33%

89.18%

Parmalat Finanziaria

49.16%

Coloniale S.p.A.

Figure A.1      Parmalat’s Ownership Structure

ANNEXURE 1  255

in Singapore that supposedly supplied 300,000 tons of nonexistent milk powder to a Cuban importer via Bonlat, a Cayman Islands subsidiary of Parmalat. By 2002, Bonlat’s fictitious assets had grown to $8 billion. The company kept showing fictitious sales and kept hiding its debt by transferring them to shell companies in offshore tax heavens. It involved reputed banks such as Bank of America and Citibank to keep raising finances on the basis of its supposedly ‘healthy’ balance sheet and high ratings by rating agencies based on fake sales. It also employed auditors such as Grant Thornton and Deloitte and Touche who apparently failed to notice giant holes in the books of Parmalat. Investments were made by the company in the high-flying world of derivatives and speculative enterprises. Some of the acquisitions ushered in red figures in late 2001. A minority shareholder (Hermes Focus Asset Management Europe Ltd) raised alarm and filed a claim on the bond issues, which was brushed aside as ‘no irregulatory found’ by the auditors. In December 2002, auditors first enquired about an offshore account in the Cayman Islands and received a letter on Bank of America stationery in March 2003 confirming the existence of the account purporting to contain $4.1 billion for a subsidiary of Parmalat called Bonlat set up in Cayman Islands. This letter turned out to be a forgery as the Bank of America denied having any such account in the investigations that followed when the company defaulted on a 150 million euro bond. The management claimed that default was because a customer, a speculative fund named Epicurum, did not pay its bills. Allegedly, Parmalat had won a derivatives contract with Epicurum, betting against the dollar. However, it was soon discovered that Epicurum was owned by firms who had the same address as some of the Parmalat’s own offshore entities. In effect, Epicurum was owned by Parmalat only, and the whole transaction was a sham. This revelation by Bank of America in December 2003 started the collapse of the group. Trading in the Parmalat shares were frozen. Tanzi, several of his family members and various executives were arrested. Later, the total debt of the company was declared to be 14 billion This is eight times what the firm had admitted as its total debt. At the time, Parmalat was the largest bankruptcy in European history, aggregating 1.5 per cent of Italian Gross National Product (GNP). In terms of proportion to the

256  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

national GNP, it was bigger than the combined ratio of the Enron and WorldCom bankruptcies to the US GNP. There were many causes that led to the Corporate Governance failure at Parmalat. There was a combined position of chairman and CEO resulting in reduced oversight. There was inadequacy in the number and independence of independent directors. There was a complete failure of monitoring structures such as board, committees and auditors. There was connivance of auditors as well as bankers, which helped to hide the true health of the company. There was lack of access to information related to controlling shareholders’ activities. Like in the Enron, creative accounting and financial engineering were used to commit fraud on the investors, shareholder and debtors. There was also a conflict of interest in RPTs that was ignored. Approvals of the proposals affecting company’s financial position were given by the BoD who was linked by family ties. The transactions were not treated according to the criteria of both ‘substantial AND procedural fairness’. Further disproportionate remuneration was given to executive directors and key managerial personnel.

Lessons There are many lessons to be learned from this scam. Prime among these is the importance of effective and multilayer oversight and control mechanism. There should be strict adherence to Corporate Governance standards and code of best practices. There should be adequate number of independent directors on the board, ensuring optimum composition of independent and executive directors in internal control committees. There should be very efficacious monitoring structure accountable to good Corporate Governance for the nomination and remuneration committee in the appointment of directors on the board and the audit committee and the external auditors. The board should not only undertake very effective superintendence of the monitoring structure of its subcommittees, but also must, through potent boardroom practices, undertake a thorough review and provide direction to the management of the enterprise.

ANNEXURE 1  257

There needs to be control on unbridled creativity in accounting and financial engineering. There should be a separation of the position of chairperson and CEO. However, all these measures will amount to nothing if the rot is at the highest level, just as it was in this case and in the Enron case. Thus, there needs to be better governmental regulation on the oversight of corporations and their financing. Also, there needs to be better regulation of auditing firms and rules governing external audit of corporations. The Italian Government did take some steps in the aftermath of Parmalat scandal, for example, it introduced a new insolvency legislation based on America’s Chapter 11. There was also talk of creating a strong super regulator overseeing corporate finance.

Case Study 3: UK Equitable Life: Collective Rationalization and Illusion of Unanimity Equitable Life Assurance Society (ELAS) was started in 1762 in the UK. It was the world’s oldest mutual life insurance company. It was the first life insurance company in the world to decide premiums rates based on age and mortality. ELAS used methods invented by James Dodson, defined by scientific basis for calculating premiums using mortality tables and probability studies to design tables of fair annual premiums. This was the company which invented level premiums. However, Dodson died five years before the company was founded and, hence, Edward Rowe Mores became its first CEO with the title of actuary; first ever use of the term even though he was not a statistician. ELAS marketed life insurance, annuities, pensions and permanent health insurance to customers in UK, Germany and Ireland. Fixed premiums were charged, and the amount payable on death was guaranteed. At its peak, the Equitable had 1.5 million policyholders with £26 billion worth of funds under management. ELAS had 12 directors, five among whom were executive directors, while seven were NEDs. Executive directors, though in

258  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

minority, exercised greater influence on the board. Roy Ranson was the CEO and appointed actuary during the period of 1992 to 1997. This combination of CEO and actuary was not only uncommon, but undesirable in the light of appointed actuary’s specific obligated role. The appointed actuary, who is an essential part of the UK national insurance, is supposed to act as a guardian of policyholders’ interests, but in this case, UK regulator did not do its job properly and allowed Ranson to become the CEO without relinquishing his role as the appointed actuary. NEDs were dependent on actuarial reports produced and submitted by the CEO and the appointed actuary (combined positions) and were incapable of exercising any influence on the actuarial management of the company, since they had no knowledge of the actuarial science and practices. The board had constituted its subcommittees, and the following committees were functional: • • • • •

Audit Legal audit Remuneration Investment Nomination committee

What Went Wrong? In 1983, the executive management of the company decided that in the event of sustained period of low interest rates, the cost of annuity guarantees will be met from terminal bonuses. This decision became known as ‘differential terminal bonus policy’. However, this was not approved by the board and was not even communicated until 1993. Even policyholders were informed about this only in 1988. Terminal bonus policy propelled the management not to commence a new bonus series in 1988 and continue to market new personal pensions such as earlier annuity business, whereby unguaranteed terminal bonus received increasingly larger allocation of total surplus. The society’s solvency position was boosted up by the consistent adoption of weakest valuation basis, valuation practices of dubious actuarial merit and

ANNEXURE 1  259

other financial adjustments. The worst of all, the board accepted fragmented financial and product information. Between 1956 and 1988, ELAS sold polices with option to select either a guaranteed annuity rate (GAR) or the current annuity rate (CAR). GAR, as the name suggests, had the fixed annuity rate of returns based on the lump sum accumulated, irrespective of the interest rates prevailing or longevity. However, in CAR, the rate of return of annuity changed depending on the prevailing interest rates and longevity expectations. The company did not charge any additional premiums in respect of the guarantee. Also, there was no provision made for adverse market positions. According to an affidavit sworn by Actuary Christopher Headdon, At no time did Equitable ever hedge or reinsure adequately against the GAR risk to counteract it. The reason for this was Equitable’s belief that it could neutralize the potential effect of the GAR risk through the exercise of its discretion to allocate final bonuses under Article 65.1

In October 1993, due to falling inflation and interest rate, the Equitable first faced the problem of market annuity rate dipping below its GAR. Despite this, it did not build any reserve to cover up the growing GAR liability. Instead, the management guided by Ranson decided to use its discretion to give lower terminal bonus to policyholders who opted for GAR, effectively nullifying the guarantee. In spring 1994, inflation and interest rate rose and the GAR issue went away for the time being. However, in May 1995, Equitable’s GAR was again higher than the market rate, and, by September 1998, its guaranteed annuities were worth 30 per cent more than the market annuity rate posing significant financial risk. In January 1999, Financial Service Authority (FSA) issued guidelines on ‘insurance company solvency margins’, stipulating that it should be assumed that 80 per cent of the qualifying policyholders would choose to exercise their guaranteed annuity option. Until then, insurance companies were free to choose their own estimate of the percentage of potential policyholders that would The Equitable Life Assurance Society. From Wikipedia, the free encyclopedia. Available at: https://en.wikipedia.org/wiki/The_Equitable_Life_ Assurance_Society (accessed on 30 May 2016). 1

260  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

exercise guaranteed annuity option, and Equitable had anticipated that only 2 per cent would do so. This meant that rather than a loss of £50 to £200 million, Equitable had a hole of the size of 1.5 billion pound on its balance sheet. The company decided to use accounting techniques to boost Equitable’s solvency position, even though it was overdrawn on internal office valuation to the extent of £4.4 billion by mid-July 2001. It entered into a reinsurance agreement with an Irish company. This was claimed by the company as an asset worth £800 million. Government Actuary’s Department examined the transaction and found it insufficient to justify such a credit. However, despite this, FSA approved the reinsurance. Following an increasing number of consumer complaints regarding lower terminal bonuses, Equitable decided to go to court to test the lawfulness of bonus cuts. In September 1999, the High Court ruled in its favour, but this proved to be a temporary relief as this was challenged in the Court of Appeal which ruled against it. Equitable then sought a ruling by the House of Lords. On 20 July 2000, the House of Lords upheld the judgment of the Court of Appeal. It found Equitable in breach of contract—a guarantee was a guarantee. ELAS ceased writing new business following the House of Lords directive that it had underpaid 90,000 guaranteed annuity policyholders. Having lost the case and unable to pay £1.5 billion, Equitable put itself up for sale, but in a final blow of indignity to the oldest life insurance company in the world, it failed to find a buyer. In December 2000, the company was closed to new business.

Lessons One of the important lessons to be learned from Equitable saga is that in an insurance company, the position of an appointed actuary cannot be combined with that of a CEO, as it undermines, fundamentally, the role of appointed actuary as a whistle blower and protector of policyholders’ interests. Also, it is not ideal to have one set of professionals, that is auditors, to express views about the assets and liabilities and the other set of professionals, that is actuary, to independently certify liabilities without their coordinating and

ANNEXURE 1  261

working together. The main cause, which could help the management to perpetuate impropriety, was a single fund of impenetrable complexity for all products. This fund comprised of: • • • •

Traditional life insurance products Pension products Pure investment products Domestic and overseas business

There were widely varying types and levels of guarantees within the same types of policy. There was inadequate mechanism to foster the appropriate balance between policy values and asset shares. In fact, there has to be a separate fund for each class of business. The reason for Equitable’s collapse was its risky business model of full distribution and resultant low reserves, which delivered rapid growth for a while. However, for long-term sustainability, it is important that the insurance companies take into account all the different risks and provide for adequate reserves to cover them. When a company has a widely mixed portfolio of fund, like Equitable had then, the management policies have to be dynamic and cannot be bereft of environment and financial prospects. Calls on interest rates while calculating premiums, bonuses and liabilities have to well thought judgement choices based on the analysis of macroeconomic factors. Another important lesson from Equitable is the need for full and accurate disclosure of financial health, changes in policies conditions, scope of regulation and so on to customers. In summary, the following stand out as the lessons: • Homogeneity of any unitary with profits fund gets undermined as a life office reacts to changing market conditions and shifting product preferences. • In a widely mixed fund, management of policies has to be dynamic and cannot be bereft of environment and financial prospects. • ‘Discretion’ of the board allowing one set of professionals—auditors—to express view about the assets and the other professionals—actuary—to independently certify the liabilities is like commissioning two legs of a pair of

262  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

trousers from two different tailors. These have to be very effectively coordinated. • In life office, the position of an appointed actuary cannot be combined with that of a CEO as it undermines fundamentally ‘whistle blowing’ obligations of the appointed actuary. • Full and accurate disclosure of financial health, changes in policies, scope of regulation to customers is essential.

Case Study 4: UK Marconi: Stereotype Vision and Superfluous Reviews Marconi, the great inventor of telegraph registered this company as Wireless Telegraph and Signal Company in 1897. In December 1898, the first wireless equipment manufacturing plant in the world was set up in an old silk factory in Hall Street in Chelmsford near London. Wireless Telegraph and Signal Company changed its name several times as it evolved over the years to Marconi’s Wireless Telegraph Company in 1900. It might be worthwhile to note here that when the ‘Titanic’ stuck an iceberg and sank on 14 April 1912, 712 survivors owe their lives to the distress calls from Marconi’s wireless equipment on ship board. Fast forwarding the journey of its successful and sustainable business until the beginning of the twentyfirst century, it can be said that the organization was able to survive the vicissitudes of the fast-changing technological environment. During the period of 17 May 2001 to 4 July 2001, Marconi’s senior executive management comprised of CEO Lord Simpson, Deputy CEO John Mayo and CFO Steve Hare. Sir Roger Hurn was the chairman of the company. Marconi was listed on London Stock Exchange (LSE) under the name of General Electric Company Ltd (GEC) and was a constituent of the Financial Times Stock Exchange (FTSE) 100 Index. It may be noted here that overtime, the autocratic CEO, Arnold Weinstock attained absolute powers by 1970s. The company grew fast as from the early 1980s by exploiting cost and inflation proofed contracts, telecoms, power engineering and defence, all in public sector then. He was able to get appropriate approaches for the company caved up politically,

ANNEXURE 1  263

which may not have necessarily made the economically beneficial preposition for the buyers of products. Thus, it was more of a political management than an economic proficiency of the enterprise, which provided the growth and success. Once British economy was privatized, Lord Weinstock, who basked in the political manoeuvrings, faded as corporate financier and John Mayo took over as the CEO of the company. He transformed it into overleveraged telecoms, particularly an internet equipment specialist. However, delegating substantial responsibilities to division heads and abandonment of Weinstock’s famous ratios and trend lines led to deteriorating working capital, which remained unaddressed. The company and the board did not clearly decipher where rapid technological changes were driving the market. The board also did not comprehend the impact of changes in the structure of British economy relating to the sector transiting from public sector to privatization. The most important transformation as the consequence of structural change was the disappearance of political influence, which was the strong driving force behind the company’s success. As European and Chinese suppliers underbid, Marconi failed to win the piece of British telecom’s twenty-firstcentury network project worth about £10 billion. This brought a serious setback to the economics and long-term sustainability of Marconi. Investors lost faith in the company as a strong long-term player in the telecom sector. Overnight, it lost 50 per cent of its market cap, which led to cascading affect. Trigger was forecast and shareholders, in 2003, lost 99 per cent of their equity value. It might be worthwhile quoting the trigger below to validate the point. Forecast Period Year Ending 31 March 2002 (Managements Estimates) Forecast date

Prior Year

17 May

£m

£m

£m

Sales

6,942

NA

Costs

6,135

NA

Operating Profit/(loss)

807

807+

2 July

Variance 26 June to 2 July

£m

£m

£m

7,435

6,364

6,200

(1,235)

6,944

6,092

5,800

1,144

491

272

400

26 June 30 June

(91)

Source: FSA Final Notice 11 April 2003 (figures indicated greater variance)

264  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

What Went Wrong? The first and foremost to unleash the distress was changes in the organizational structure of the company, which left gaps in information flow and responsibilities. Vital data was not assembled and was completely overlooked during the restructuring of the company. The spiralling level of working capital requirements went undetected. The management of cash was poor to the extent of being dangerously inefficient, albeit reckless. The company was thriving on political manoeuvring and never focused enough on building the economics of competitive environment; once the strongest strength of the company—‘political manoeuvring’— faded, the business model fell flat. It did not anticipate and envisage the onset of new players in the market even after the structure of the sector got transformed. The director ‘gene pool’ was too small with wholly inadequate knowledge and/or industry-specific experience. Cronyism and rubber stamp of decisions was manifest all over. There was a complete lack of management competence in the board. The reviews of the performance were hopelessly scant. No probing or questioning of management’s figures and explanations was undertaken, no ‘why’ and ‘how’ of performance numbers and budgeting was raised. There were delays in holding board meetings under controversial disclosures circumstances and failure was often observed in compliance with the obligations of listing rules on timely basis. The board did not anticipate emerging trends. In fact, it did not provide direction and vision (primary role) to the company at all.

Lessons This was a case of boardroom failure, coupled with management incompetence and unprofessional approach. The board failed in its duty of monitoring and superintendence. In fact, it failed to govern the company. Boardroom is a place where reviews should be thorough, direction to the management clear and vision of the company manifestly delineated. It is possible only if the board is divergent, knowledgeable and probing and committed to the role.

ANNEXURE 1  265

It must question both good and bad. It must ask the obvious questions and also not so obvious question in the typical phrase, ‘too good to be true’. This has to be done when the company performs well and the outlook appears to be too good. The board should satisfy itself about the sustainability of the journey forward. In conclusion, it might be said that the Corporate Governance and the board’s monitoring and superintendence should focus not merely on the form of compliance, but also on the substance of it. It must stretch enough to live up to the responsibilities it is expected to discharge. The management of the companies, in general, and the board, in particular, must remain focused on the emerging horizons of the environment. Those horizons must extend beyond the industry and encompass to technological changes, competition, customer sensitivity, economic, political and even social environment. The impact of fusion of all these environment factors on the business and sustainability of the company must be assessed. In the absence of such an approach, the success of the day will eventually transit into failure of tomorrow. Wisdom lies in doing scenario building annually, drawing up a matrix of approaches and applying the best fit to the known, unknown and know– unknown and/or unknown–unknown that eventually emerge with the changes in the environment, which may affect the business of the company. Superfluous reviews and stereotype vision of the board builds concrete pathways for the ruin and even destruction of the company, which is what happened in this case.

Case Study 5: INDIA Satyam: Manipulation, Fraud and Governance Apathy Satyam Computers was set up by Mr Ramalinga Raju and Mr B. Rama Raju on 24 June 1987. On 26 August 1991, it was converted into a public limited company. In the year 1992, it went public. It was listed in SXs such as BSE, NSE, New York Stock Exchange and Euronext (Amsterdam). Satyam’s network of customers covered 67 countries across six continents, employing

266  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

more than 40,000 employees including in development centres spread over India and around the world (USA, the UK, the United Arab Emirates, Canada, Hungary, Singapore, Malaysia, China, Japan, Egypt and Australia). The company served more than 654 global companies, 185 of which were Fortune 500 Companies. It received many awards. It became world’s first ISO 9001:2000 company to be certified by Bureau Veritas Quality International (BVQI). In 2003, Satyam started providing IT services to the World Bank and signed up a long-term contract with it. In 2005, it was ranked 3rd in a Corporate Governance survey by Global Institutional Investors. Interestingly, it had received many awards for its excellence in Corporate Governance and CSR. Mr Raju, the founder and chairman, had also received numerous awards and honours including E&Y Entrepreneur of the year 1999 and 2007, Dataquest IT Man of the year 2000, CNBC’s Asian Business Leader—Corporate Citizen award 2002, amongst others. It is interesting to note here that the entire manipulation and fraud came to light only when Mr Raju himself disclosed in a letter to Satyam Computers’ BoD that he has been manipulating company’s accounting numbers for years and that the assets have been overstated in the balance sheet by $1.47 billion. He and the company’s global head of internal audit employed a variety of techniques to perpetrate the fraud. In his personal computer, Mr Raju created numerous bank statements, falsified bank accounts with inflated balances and income statements including claiming interest income from bank deposits and so on. He also created over 6,000 fake salary accounts and appropriated the money after the company deposited. The global head of internal audit forged board resolutions and illegally obtained loans for the company. It was brought to light that the money company raised through American depository receipts in the USA never made it to the balance sheet. In December 2008, five independent directors had approved the founder’s proposal to buy the stake of over 50 per cent in Maytas Infrastructure and all of Maytas Properties, both to be converted into fully a owned subsidiary, for $1.6 billion. Incidentally, it may be noted that Raju had 37 per cent stake in

ANNEXURE 1  267

Maytas Infrastructure and 35 per cent in Maytas Properties. The directors moved forward with the management’s decision without shareholders’ approval. However, the transaction was reversed in 12 hours after the investors sold Satyam’s stock and threatened action against the management, which was followed by lawsuits (filed in USA) contesting Maytas’ deal. In December 2008, Investment Bank DS Prabhudas (DSP) Merrill Lynch was appointed by Satyam to look for a partner or buyer for the company. He observed financial irregularities, blew the whistle and terminated its agreement. The following is a snapshot of the fabricated balance sheet: Fabricated Balance Sheet and Income Statement of Satyam as of 30 September 2008 (` in Crore (10,000,000)) Items Cash and Bank Balances Accrued Interest on Bank Fixed Deposits

Actual 321 Nil

Reported

Difference

5,361

5,040

376.5

376

Understated Liability

1,230

None

1,230

Overstated Debtors

2,161

2,651

490

Nil

Nil

2,112

2,700

588

61

649

588

Total Revenues (Q2 FY 2009) Operating Profits

7,136

What Went Wrong? What comes foremost to the mind of an objective observer about Satyam Computers is a complete apathy towards Corporate Governance. Even though the judicial verdict is still to establish, apparently, there was a criminal connivance of the auditors. The apathy of Corporate Governance can be summarized in the following points: 1. Efficacy of management information system was never assessed, verified or audited. 2. Manpower inventory was not even looked at.

268  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

3. Inserting of invoices directly in Invoicing Management System (IMS) through Excel porting was not questioned. 4. The role of the auditors was questionable. 5. The audit committee did not scrutinize and monitor the independence, role and functioning of internal audit and statutory auditors. It did not go into examining either the financial statements as to whether they provide correct, full and credible pictures, seek details about frauds, irregularities, failures of internal control system, or even financial disclosures. 6. The monitoring by the board committees and superintendence by the board was conspicuously absent. 7. The directors were hugely compensated including with stock option at `2 when the market price was `500. 8. All this, put together, provided a field day for Mr Raju and his associates in crime—in whom probably the BoD had put their full trust—to manipulate and undertake the fraud.

Lessons This is a case where Corporate Governance was at its worst. The entire edifice of monitoring and superintendence had failed. The system and processes which help the company to reflect the true picture of its financial health should be examined periodically by an independent auditor as to its efficacy and the potential possibilities of manipulation. The independence, competence, commitment and role of the auditors must be scrutinized very thoroughly by the audit committee and also the board. The monitoring mechanism of board subcommittees must be robust, and their effectiveness in rendering obligatory responsibilities of monitoring must be assessed by the board periodically. The conflict of interest including disproportionate remuneration to key managerial personnel, auditors and/or the BoD must not be allowed. In fact, their compensation must be looked from critical angles to appreciate the appropriateness. Boardroom

ANNEXURE 1  269

practices have to be improved and made very effective. This will involve timely holding meetings of the board and its subcommittees, designing and drafting of agenda papers, circulation of those papers well in advance, thoroughness of discussions in the meetings, which must involve incisive scrutiny of financial numbers and reports placed before them and writing of minutes. The meetings of the board committees and the board should not be a gathering over a cup of tea and snacks for a kind of social chat, but should be a platform where hardcore business discussions take place about the functioning of the company its strategies, direction on vision and so on. The board must provide a clear verdict on its performance, deliver unambiguous decisions and amply delineate directions provided. This entails that the board and committee members have skills, knowledge, time and commitment, and seriously engage in undertaking their role. Their performance must also be assessed annually. This will mean that the board and committee meetings cannot be convened at a short notice and without the circulation of agenda in advance. The attendance of the BoD and committee members in the meetings is insisted upon. The recordings of minutes envisage, fairly in detail, the discussions that took place, including possibly who said what, decision taken and direction provided. In effect, the entire process of Corporate Governance of the company has to be made very robust and effective.

ANNEXURE 2 Board Allocation of Role Between Board and the Management

Board

Management

1. Design of vision, mission, values and cultures 2. Strategic approaches 3. Direction, which will include • Value creation goals • Monitoring and control systems 4. Approval of annual budget and value creation goals 5. Broad allocation of various kinds of resources—physical, financial and human 6. Mergers and acquisition 7. Disinvestment and consolidation and hiring office • Discontinuance and/or addition of a new line of business 8. Policies and programmes, which include governance of the company and so on 9. Major investment 10. Review of operations vis-à-vis value creation goals

1. Manage the operations of the company 2. Execute policies and programmes decided by the board 3. Realization of budget and the value creation goals—day-to-day management of the company 4. Within the overall framework provided by the board, allocation of resources 5. Anything which is necessary to manage the performance of the company but is not part of the board’s role 6. Assist board by providing inputs— data, information, aspirations of stakeholders in designing vision, mission, strategy and direction 7. Assist board in evaluating the performance of individuals and also strategies, direction and so on 8. Provide to the board any other assistance, information data that may be

ANNEXURE 2  271

Board 11. Succession planning and appointment and removal of top management positions such as CEO, CFO, company secretary, internal audit chief and so on 12. Compensation policy and approval of compensation of CEO, CFO and other boardlevel appointees. 13. Delegations of authority In effect, the management of the enterprise

Management necessary for the discharge of its role successfully In effect, the management of the business of the company

ANNEXURE 3 Board and Its Subcommittees Meeting Protocols

1. Venue   i. The place of the meeting must be exclusive and specified in the notice itself. It should be secured with no obstruction of any kind including noise, and should be equipped with gadgets necessary for video, audio participation and recordings, presentations, mike and so on. Adequacy of recording facility must be ensured, which can be done depending upon the ruling of the chairman.   ii. The room must be kept fully ready before the members arrive for the meeting, so that no time is lost in starting the meeting. 2. Attendance   i. The persons participating should be only the members of the board/committees.   ii. Names of special invitees, whether from the board or from the HODs’ team or any other person, must be discussed with the chairman, and, unless approved, participants should not be allowed to come in the meeting. iii. During the meeting, nobody should enter the room unless expressly permitted by the chairman. This is necessary to ensure that all the discussions in the committee/ board, which are privileged, are not heard by any person other than the ones authorized to attend the meeting.

ANNEXURE 3  273

iv. During the meeting, no tea, coffee should be served. It can be arranged before the start of the meeting and kept outside for any of the attendees in case he or she desires to have during the course of the meeting. This will facilitate undisturbed and uninterrupted discussions. 3. Participation   i. The chairman should open the meeting with his welcome and commence the agenda. He should allow free discussions on all the items of the agenda.   ii. No person should start making observation unless he has sought the nod of the chairman to make his observations. iii. If any member/invitee is speaking, except for raising queries on that person’s observations, no other member should butt in to make his comments. He should indicate to the chairman who will offer opportunity at the appropriate time. iv. The chairman must offer opportunity to all the members to make their observations in full on all the items of the agenda.   v. Person speaking should not be cut short. However, in case the observations become longer than required or repeated, the chairman can make a suggestion to be brief. The chairman has to exercise his authority to control extraneous factor, unrelated with the agenda, to be discussed in the meeting. vi. These meetings are formal forums where decency, dignity and decorum of the highest order must be maintained while the agenda items are debated. It is the chairman’s duty to control the environment and ensure that. vii. The chairman must facilitate quality discussions. viii. At the end of the each item, the chairman must summarize clearly the decision taken and provide definite direction to the management as to the action to be taken on the decision. ix. Before the commencement of the meeting, the chairman must ask the members if any one would like to add any item to the agenda, and, depending upon the time and the context, he can decide to allow. At the close of the

274  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

meeting, he must ask members once again whether they have any point or observation to make or any other item to discuss. He should close the meeting only after that. 4. Minutes The company secretary must take copious notes so that he can draft the minutes currently, which truly reflects the discussions, observations, comments, suggestions, direction and so on provided by the members and the chairman and even incorporate tone and tenor of the board members, whether appreciative and/or critical.

Caveat: Annexure 4 (models of Policies) is a compilation of information and text from the following sources: 1. Applicable legislative and regulatory provisions of the relevant laws and regulations mostly, from India but in some cases a few other jurisdictions. 2. Policies approved by various Boards where author has been/sits as a Director. However, author had contributed significantly both orally and writing in the design of those policies. 3. Materials developed in Intuit Consulting, in particular by the author during consultancy projects and supplied to clients. 4. Some information sourced from the websites/publications of Public Ltd companies. Even though, the author has used his skills and experience and done rationalisation, rewriting, reorientation in most cases, he does not claim exclusive authorship either full or part of the text and/or material incorporated in the Annexures. These compilations have been made with a view to help the readers who are practicing managers to design their policies as also students and academicians to have a fair idea of what should be included in the policies.

ANNEXURE 4 Policies* Related Party Transaction Policy Preamble The BoD (the ‘board’) of the company has adopted this policy and procedures with regard to RPTs. The board reserves the right to review and amend this policy from time to time, based on the recommendation received from the audit committee and/or legislative or regulatory direction. This policy is intended to regulate transactions between them, based on the applicable laws and regulations.

Purpose This policy is framed as per the requirement of Listing Regulations of India executed by the company with the SXs and intended to ensure that proper approvals are obtained and proper reporting is made of transactions between the company and its related parties. This may have to be modified in consonance with the applicable laws and regulations of geographies operated by the company. The company is required to disclose the RPTs in the financial statements every year.

* All these policies have been designed with reference to Indian laws, rules and regulations as issued by various regulatory authorities. These will have to be suitably modified with reference to the applicable laws of the jurisdiction(s) where the company operate.

ANNEXURE 4  277

The policy of the company concerning transactions with the related parties are also required to be disclosed in the annual report.

Definitions ‘Audit committee or committee’ means the committee of the Board of Directors of the company, constituted under the provisions of Listing Regulations of India, 2016 and Section 177 of the Companies Act, 2013. ‘Board’ means the Board of Directors of the company. ‘Key managerial personnel’ means the key managerial personnel as defined under Section 2(51) read with of the Companies Act, 2013. ‘Material RPT’ means a transaction with a related party where the transaction(s) to be entered into individually or taken together with previous transactions during a financial year is in excess of the lower of the limits mentioned as follows: i. Five per cent of the annual turnover or 20 per cent of the net worth of the company as per the last audited financial statements of the company, whichever is higher or ii. the six threshold limits mentioned as follows as per the Companies Act, 2013, read with the rules framed thereunder and notified from time to time, which presently are: (a) When a transaction involves sale, purchase or supply of any goods and material exceeding 10 per cent of annual turnover as per last year’s audited financial statement or `1 billion, whichever is lower. (b) When a transaction involves selling or buying of any property exceeding 10 per cent of net worth of the company as per last year’s audited financial statement or `1 billion, whichever is lower. (c) When a transaction involves leasing of property of any kind exceeding 10 per cent of net worth or 10 per cent of turnover or `1 billion, whichever is lower.

278  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

(d) When a transaction involves availing or rendering any services exceeding 10 per cent of the turnover of the company or `0.5 billion, whichever is lower. (e) When a transaction involves appointment to any office or place of profit in the company, its subsidiary company or associate company at a monthly remuneration exceeding `0.25 million. (f) When a transaction involves remuneration for underwriting the subscription of any securities or derivatives thereof of the company exceeding 1 per cent of the net worth. ‘Policy’ means RPT policy. ‘Related party’ means related party as defined in Clause 49 of the Listing Agreement which is as follows: A ‘related party’ is a person or entity that is related to the company. Parties are considered to be related if one party has the ability to control the other party or exercise significant influence over the other party, directly or indirectly, in making financial and/or operating decisions. It includes the following: 1. A person or a close member of that person’s family is related to a company if that person i is a related party under Section 2(76) of the Companies Act, 2013, that is, (a) a director or his relative (b) a key managerial personnel or his relative (c) a firm in which a director, manager or his relative is a partner (d) a private company in which a director or manager or his relative is a member or director (e) a public company in which a director or manager is a director and holds along with his relatives, more than 2 per cent of its paid-up share capital (f) anybody corporate whose BoD, MD or manager is accustomed to act in accordance with the advice, directions or instructions of a director or manager

ANNEXURE 4  279



(g) any person under whose advice, directions or instructions a director or manager is accustomed to act, provided that nothing in sub-clauses (vi) and (vii) shall apply to the advice, directions or instructions given in a professional capacity (h) any company which is a. a holding, subsidiary or an associate company of such company; or b. a subsidiary of a holding company to which it is also a subsidiary; (i) director, other than independent director, or key managerial personnel of the holding company or his relative with reference to a company ii has control or joint control or significant influence over the company; or iii is a key management personnel of the company or of a parent of the company; or 2. An entity is related to a company if any of the following conditions applies: i. The entity is a related party under Section 2(76) of the Companies Act, 2013. ii. The entity and the company are the members of the same group (which means that each parent, subsidiary and fellow subsidiary is related to the others). iii. One entity is an associate or joint venture of the other entity (or an associate or joint venture of a member of a group of which the other entity is a member). iv. Both entities are joint ventures of the same third party. v. One entity is a joint venture of a third entity and the other entity is an associate of the third entity. vi. The entity is a post-employment benefit plan for the benefit of employees of either the company or an entity related to the company. If the company is itself such a plan, the sponsoring employers are also related to the company.

280  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

vii. The entity is controlled or jointly controlled by a person identified in 1. viii. A person identified in 1. (ii) has significant influence over the entity (or of a parent of the entity. For the purposes of this clause, the term ‘control’ shall have the same meaning as defined in SEBI (substantial acquisition of shares and takeovers) Regulations, 2011, and the term ‘relative’ shall have the same definitions as that in Section 2(77) of the Companies Act, 2013. Related Party Transaction means any transaction directly or indirectly involving any Related Party which is a transfer of resources, services or obligations between a company and a related party, regardless of whether a price is charged.

Policy All RPTs must be reported to the audit committee for its prior approval in accordance with this policy and as per the notifications amending the Companies (meetings of board) Rules, 2014 made by the Central Government from time to time or as per the applicable laws and regulations of the geographies operated by the company.

Identification of Potential Related Party Transactions Each director and key managerial personnel is responsible for intimating the board and the audit committee of the names of the companies in which they have concern or interest as a director or member and the related party(ies) at the beginning of every financial year and the changes therein on the event occurring during the course of the financial year. The board/audit committee may reasonably request for additional information, if required, to

ANNEXURE 4  281

determine whether the transaction does, in fact, constitute an RPT requiring compliance with this policy.

Restrictions for Related Party Transactions All RPTs shall require prior approval of audit committee/board. Furthermore, all material RPTs shall require the approval of the shareholders through a special resolution, and the related parties shall abstain from voting on such resolutions.

Review and Approval of Related Party Transactions The following shall be the process of approving RPTs: 1. RPTs will be normally referred to the next regularly scheduled meeting of audit committee/board for their review and approval. 2. For seeking the approval of the audit committee/board, at the beginning of each financial year, the commercial department and accounts department shall identify the transactions likely to occur during the financial year with the related parties and the value of such transactions which are likely to take place during the year. On the basis of the information gathered, the following information is required to be sent by the concerned unit to the audit committee/board at least 15 days in advance of the first audit committee/board meeting to be held in the financial year in order to enable it to be circulated in advance: i. Name of the related party and nature of relationship ii. Nature and duration of contract iii. Particulars of contract or arrangement iv. Material terms of contract or arrangement v. Value of contract or arrangement (total value of contracts for the year to be given) vi. Advance paid for contract or arrangement

282  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

3.

4. 5. 6.

vii. Manner of determining pricing and other commercial terms both included as part of contract and not considered as part of contract viii. Whether all factors relevant to the contract have been considered; if not, the details of factors not considered and the reasons thereof ix. Any other relevant information to enable the audit committee/board to take a decision on the matter. In case of contracts which arise during the course of the year, information as in point 2 is to be sent to the head office/Company Secretary at least 15 days in advance of the audit committee/board meeting. Any member of the committee/board who has a potential interest in any RPT will recuse himself/herself and abstain from discussion and voting on the approval of the RPT. The committee will be provided with all relevant material information of the RPT, including the benefits to the company and any other relevant matters. In determining whether to approve an RPT, the audit committee/board will consider the following factors, amongst others, to the extent relevant: • Whether the terms of the RPT are fair and on arm’s length basis to the company and would apply on the same basis if the transaction did not involve a related party. • Whether there are any compelling business reasons for the company to enter into the RPT and the nature of alternative transactions, if any. • Whether the RPT would affect the independence of an independent director. • Whether the proposed transaction includes any potential reputational risk issues that may arise as a result of or in connection with the proposed transaction. • Whether the company was notified about the RPT before the execution of the transaction, and if not, why pre-approval was not sought and whether subsequent ratification is allowed and would be detrimental to the company.

ANNEXURE 4  283

• Whether the RPT would give rise to a conflict of interest for any director or key managerial personnel of the company, considering the size of the transaction, the overall financial position of the related party and the ongoing nature of any proposed relationship and any other factors the board/committee deems relevant. 7. If the audit committee/board is of the view that the RPT is material or is not at arm’s length basis (though it does not exceed the limits specified above) and hence requires the approval of the shareholders, then such transaction shall be placed before the shareholders at a general meeting to be convened for such purposes or by way of postal ballot and approval sought. The transaction shall not be put into action before the receipt of the shareholders’ approval. 8. The approval shall not be required in case of the following transactions: • Transaction that involves the providing of compensation to a director or key managerial personnel in connection with his or her duties to the company or any of its subsidiaries or associates, including the reimbursement of reasonable business and travel expenses incurred in the ordinary course of business. • Transaction for allotment or transfer of securities issued by the company.

RPTs not Approved Under this Policy In the event, the company enters into an RPT without the prior approval of the audit committee/board, and such matter is discovered later, then the same shall be put up before the audit committee/board at the next following meeting. The reasons for not getting the same approved by the audit committee/board shall be made explicit. The audit committee/board may, at its sole discretion, permit such deviation and approve the same. In the event the transaction is not approved and has not yet been concluded, the transaction shall be cancelled forthwith and all advances made, if any, shall be recovered from the concerned

284  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

party, failing which necessary disciplinary action will be taken against the concerned head of commercial/accounts/unit.

Whistle Blower Policy To enhance the efficacy of Corporate Governance, companies are required to focus on two areas: (a) creating a strong ethical compass to guide the organization, (b) establishing a comprehensive framework of internal controls to foster a culture of accountability. Ernst Young’s annual survey of global fraud has rated whistle blowing mechanism above external audits as the second most effective means of detecting corruption. People are now prepared to acknowledge that whistle blowing is about good corporate citizenship. It is now mandatory requirement in quite a few regulatory jurisdictions to have a whistle blower policy within a company. The whistle blower policy of the company could be designed on the following lines.

Preface The company believes in the conduct of the affairs of its constituents in a fair and transparent manner by adopting highest standards of professionalism, honesty, integrity and ethical behaviour. A code of conduct (the code) has been adopted, which lays down the principles and standards that should govern the actions of the company and its employees. Any actual or potential violation of the code, howsoever insignificant or perceived as such, would be a matter of serious concern for the company. The role of the employees in pointing out such violations of the code cannot be undermined, albeit welcomed. Every employee of the company shall promptly report to the management any actual or possible violation of the code or an event he becomes aware of anything that could affect the business or reputation of company.

ANNEXURE 4  285

Definitions The definitions of some of the key terms used in this policy are given as follows. The terms, not defined herein, shall have the meaning assigned to them under the code. ‘Audit committee’ means the audit committee constituted by the BoD of the company in accordance with relevant sections of the statute and/or regulations applicable to the company in the jurisdiction where it is set up and/or operated. ‘Employee’ means every employee of the company (whether working any where in the world), including the directors in the employment of the company. ‘Code’ means the company’s code of conduct. ‘Investigators’ mean those persons authorized, appointed, consulted or approached by the chairman of the audit committee and include the auditors of the company and the police and other investigative agencies. ‘Protected disclosure’ means any communication made in good faith that discloses or demonstrates information that may evidence unethical or improper activity. ‘Subject’ means a person against or in relation to whom a protected disclosure has been made or evidence gathered during the course of an investigation. ‘Whistle blower’ means an employee making a protected disclosure under this policy.

Scope The whistle blower’s role is that of a reporting party with reliable information. They are not required or expected to act as investigators or finders of facts, nor would they determine the appropriate corrective or remedial action that may be warranted in a given case.

286  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

Whistle blowers should not act on their own in conducting any investigative activities, nor do they have a right to participate in any investigative activities other than as requested by the chairman of the audit committee. The chairman of the audit committee will appropriately deal with protected disclosure, as the case may be.

Eligibility All employees of the company are eligible to make protected disclosures under the policy. The protected disclosures may be in relation to matters concerning the company or any of the subsidiaries of the company.

Disqualifications While it will be ensured that genuine whistle blowers are accorded complete protection from any kind of unfair treatment as herein set out, any abuse of this protection will warrant disciplinary action. Protection under this policy would not mean protection from disciplinary action arising out of false or bogus allegations made by a whistle blower knowing it to be false or bogus or with a mala fide intention. Whistle blowers who made three protected disclosures which have all been subsequently found to be mala fide, frivolous, baseless, malicious or reported otherwise than in good faith will be disqualified from reporting further protected disclosures under this policy. In respect of such whistle blowers, the company/audit committee would reserve its right to take/recommend appropriate disciplinary action.

Procedure All protected disclosures concerning financial/accounting matters and other protected disclosures should be addressed to the chairman of the audit committee of the company for investigation.

ANNEXURE 4  287

The contact details of the chairman of the audit committee are: 1. 2. 3. 4.

Name Phone No. Mobile No. Email ID

If any executive of the company other than the chairman of audit committee receives a protected disclosure, the same should be forwarded to the chairman of the audit committee for further appropriate action. Appropriate care must be taken to keep the identity of the whistle blower confidential. Protected disclosures should be reported in writing so as to ensure a clear understanding of the issues raised and should either be typed or written in a legible handwriting in English, Hindi or any other language of the place of employment of the whistle blower. The protected disclosure should be forwarded under a covering letter which shall bear the identity of the whistle blower. The chairman of the audit committee shall detach the covering letter and forward only the protected disclosure to the investigators for investigation. Protected disclosures should be factual, and not speculative or in the nature of a conclusion, and should contain as much specific information as possible to allow for the proper assessment of the nature and extent of the concern and the urgency of a preliminary investigative procedure. The whistle blower must disclose his/her identity in the covering letter forwarding such protected disclosure. Anonymous disclosures will not be entertained, as it would not be possible for it to interview the whistle blowers.

Investigation All protected disclosures reported under this policy will be thoroughly investigated by the chairman of the audit committee of the company who will investigate/oversee the investigations under the authorization of the audit committee.

288  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

The chairman of the audit committee may, at its discretion, consider involving any investigator or agency for the purpose of investigation. The decision to conduct an investigation taken by the chairman of the audit committee is by itself not an accusation and is to be treated as a neutral fact-finding process. The outcome of the investigation may not support the conclusion of the whistle blower that an improper or unethical act was committed. The identity of a subject will be kept confidential to the extent possible, given the legitimate needs of law and the investigation. Subjects will normally be informed of the allegations at the outset of a formal investigation and have opportunities for providing their inputs during the investigation. Subjects shall have a duty to cooperate with the chairman of the audit committee or any of the investigators during investigation to the extent that such cooperation will not compromise selfincrimination/protections available under the applicable laws. Subjects have a right to consult with a person or persons of their choice, other than the investigators and/or members of the audit committee and/or the whistle blower. Subjects shall be free at any time to engage counsel at their own cost to represent them in the investigation proceedings. Subjects have a responsibility not to interfere with the investigation. Evidence shall not be withheld, destroyed or tampered with, and witnesses shall not be influenced, coached, threatened or intimidated by the subjects. Unless there are compelling reasons not to do so, subjects will be given the opportunity to respond to material findings contained in an investigation report. No allegation of wrongdoing against a subject shall be considered as maintainable unless there is good evidence in support of the allegation. Subjects have a right to be informed of the outcome of the investigation. If allegations are not sustained, the subject should be consulted as to whether public disclosure of the investigation results would be in the best interest of the subject and the company. The investigation shall be completed normally within 45 days of the receipt of the protected disclosure.

ANNEXURE 4  289

Protection No unfair treatment will be meted out to a whistle blower by the virtue of his/her having reported a protected disclosure under this policy. The company, as a policy, will condemn any kind of discrimination, harassment, victimization or any other unfair employment practice being adopted against whistle blowers. Complete protection will, therefore, be given to whistle blowers against any unfair practice such as retaliation, threat or intimidation of termination/suspension of service, disciplinary action, transfer, demotion, refusal of promotion or the like, including any direct or indirect use of authority to obstruct the whistle blower’s right to continue to perform his duties/functions including making further protected disclosure. The company will take steps to minimize difficulties, which the whistle blower may experience as a result of making the protected disclosure. Thus, if the whistle blower is required to give evidence in criminal or disciplinary proceedings, the company will arrange for the whistle blower to receive advice about the procedure and so on. A whistle blower may report any violation of the aforementioned clause to the chairman of the audit committee, who shall investigate into the same and recommend suitable action to the management. The identity of the whistle blower shall be kept confidential to the extent possible and permitted under law. Whistle blowers are cautioned that their identity may become known for reasons outside the control of the chairman of the audit committee (e.g., during investigations carried out by investigators). Any other employee assisting in the said investigation shall also be protected to the same extent as the whistle blower.

Investigators Investigators are required to conduct a process towards fact finding and analysis. They shall derive their authority and access

290  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

rights from the audit committee when acting within the course and scope of their investigation. Technical and other resources may be drawn upon as necessary to augment the investigation. All investigators shall be independent and unbiased, both in fact and as perceived. Investigators have a duty of fairness, objectivity, thoroughness, ethical behaviour and observance of legal and professional standards. Investigations will be launched only after a preliminary review, which establishes that the alleged act constitutes an improper or unethical activity or conduct, and either the allegation is supported by information specific enough to be investigated or matters that do not meet this standard may be worthy of management review, but investigation itself should not be undertaken as an investigation of an improper or unethical activity.

Decision If an investigation leads the chairman of the audit committee to conclude that an improper or unethical act has been committed, the chairman with the concurrence of the audit committee members shall recommend to the management of the company to take such disciplinary or corrective action as deemed fit. It is clarified that any disciplinary or corrective action initiated against the subject as a result of the findings of an investigation pursuant to this policy shall adhere to the applicable personnel or staff conduct and disciplinary procedures as also law of land, equity, fairness and justice along with the interest of stakeholders must be the guiding of the company principles.

Reporting The chairman of the audit committee shall submit a report to the audit committee on a regular basis about all protected disclosures

ANNEXURE 4  291

referred to him/her since the last report, together with the results of investigations, if any.

Retention of Documents The company shall retain all protected disclosures in writing or documented along with the results of investigation relating thereto for a minimum period of seven years.

Amendment The company reserves its right to amend or modify this policy in whole or in part, at any time, without assigning any reason whatsoever. However, no such amendment or modification will be binding on the employees unless the same is notified to the employees in writing.

Code of Business Conduct and Ethics The code of ethics for the directors—executives and nonexecutives—senior management and the employees will help maintain the standards while dealing with the business of the company, complying with legal requirement and upholding high ethical standards in its affairs.

Purpose • Emphasize company’s commitment to ethics and scrupulous compliance with the law • Establish basic standards of ethical and legal behaviour • Help prevent and detect wrongdoing • Develop reporting mechanism for known or suspected ethical or legal violations

292  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

Scope The code will be applicable to all company directors, senior management and employees serving, in particular, in the roles of finance, tax, accounting, purchase, treasury, internal audit, financial analysis and investor relations. It will, of course include, all committee members and employees at all levels, and members of the BoD of the company’s subsidiaries.

Accountability to the Company and Stakeholders General Standards of Conduct 1. Employees’ accountability to the company and its stakeholders Standards of conduct: Company expects all the employees to exercise good judgment and to ensure safety and welfare of all. The standard will apply while working in the company’s premises, offsite locations where the business is being conducted, at company sponsored business(s), social events or at any other place where the employee represents the company. Employees engaged in misconduct may be subjected to disciplinary action, up to and including termination and dismissal. 2. Work environment The company would provide a work environment free of harassment. It would prohibit sexual harassment and harassment based on pregnancy, child birth or related medical condition, race, religion, caste, creed, colour, national origin or ancestry, physical or mental disability, medical condition, marital status, age, sexual orientation or any other basis prohibited by local, state or country law or ordinance or regulation, and would include the sentiments of all concerned and good order.   The company would establish anti-harassment policy, which will be applicable to all persons involved in the

ANNEXURE 4  293

3.

4.

5.

6.

7.

operations of the company and prohibit unlawful harassment by any employee of the company towards the other company employees. Drug and alcohol abuse The company would maintain a healthy and productive work environment. Misuse of controlled substance or selling, manufacturing, distributing, possessing, using or being under the influence of illegal drugs and/or alcohol, unless expressly permitted in the ordinary course of business, would absolutely be prohibited. Safety in workplace The employees would comply with all the applicable health and safety policies/standards as safety of the people in the workplace would be the primary concern of the company. It would maintain scrupulous compliance with all local laws to help create and maintain secure and healthy work environment. Dress code and other personal standard The employees would report to work properly groomed and wearing appropriate clothing as they are the representatives of the company. Employees would dress neatly in a manner consistent with the nature of the work performed. Expense claims All business-related expense claims would be authorized by the designated supervisor of the employee before incurring. The reimbursement of expense incurred would have to be claimed within the prescribed period as set by the company. Expense claims post the expiry of the date would deem to be unauthorized, unless expressly permitted. Wrong/excess claims would invite disciplinary action. Solicitation and distribution of literature In order to ensure efficient operations of the company’s business and prevent disruption to employees, the company would establish control of solicitation and distribution of literature on the company property. No employee would solicit or promote support for any cause

294  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

or organization during his/her working time or during the working time of the employee or employee of whom such activity is directed. Under no circumstances would a non-employee be permitted to solicit or distribute written material for any purpose on company property.

Applicable Laws All the company employees would comply with all applicable laws, regulations, rules and regulatory orders and directors. Each employee would acquire appropriate knowledge of the requirements relating to his/her duties, sufficient to enable his/her to recognize potential dangers and to know when to seek advice from the legal department on specific company policies and procedure as established by the company.

Corporate Opportunities Employees would not exploit opportunities for their own personal gain, which may be discovered through the use of corporate property, information or position unless the opportunity is disclosed fully in writing to company’s BoD and its permission is obtained.

Conflicts of Interest A conflict of interest exists where the interest or benefits of one person or entity conflict with the interests or benefits of the company. 1. Conflicts of interest can be categorized as the following: • Actual conflict: A business decision based on personal relationship or benefits rather than the best interest of the company. • Potential conflict: A situation where a change in circumstance would result in an actual conflict of interest. • Apparent conflict: It appears or reasonably be perceived by others that an employee is not acting in

ANNEXURE 4  295

2.

3.

4.

5.

the best interest of the company, whether or not it is really the case. Outside employment In consideration of employment with the company, the employee would accord full attention to the business interests of the company. The employee is prohibited from engaging in any activity which would interfere with the performance and/or responsibility to the company or is otherwise in conflict with or prejudicial to the interests of the company. The company would prohibit the employee from accepting simultaneously employment with a company supplier, customer, developer or competitor or from taking part in any activity that enhances or supports a competitor’s position. Additionally, the employee would disclose to the company any interest of the conflicts that occurred with the business of the company. If there are any doubts on this issue, the employee would contact the supervisor or HR department. Outside directorship It is a conflict of interest to serve as a director of any company that competes with the company. The company policy would require obtaining approval from the company’s corporate counsel before accepting a directorship to ensure there is no conflict of interest. Other business interests If there is any plan of investing in a company, customer, supplier, developer or competitor, the employee would take care to ensure not to compromise his responsibilities to the company. Many factors would be considered in determining whether a conflict exists including the size and nature of the investment, ability to influence the company’s decision, access to confidential information of the company and/or of the other company and the nature of the relationship between the company and the other company. Related parties As a general rule, everybody would avoid conducting business with a relative or with a business in which a

296  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

relative is associated in any significant role. Relatives include spouse, siblings, children, parents, grandparents, grand children, aunts, uncles, nieces, nephews, cousins, step relationship, in-laws and so on. In case of unavoidable RPTs, he/she would fully disclose the nature of the RPTs to the company’s CFO. If determined to be material to the company by the CFO, the company’s audit committee would review and approve in writing in advance such RPTs. The RPTs, particularly those involving the company’s directors or executive officers, would be reviewed and approved in advance by the company’s BoD as per the procedure laid down for the purpose. The company would report all such material RPTs under applicable accounting rules, regulations and legislation.   The company would discourage the employment of relatives in positions or assignments within the same department and prohibit the employment of such individuals in positions that have a financial or other dependence or influence (e.g., an auditing or control relationship, or a supervisor–subordinate relationship). The purpose of this policy is to prevent the organizational impairment and conflicts, which are likely the outcome of the employment of relatives, especially in a supervisor– subordinate relationship. In case of questions/queries regarding the relationship covered in the policy, the concerned person would consult HR department. 6. Other situations As conflicts of interest may arise any time, it would be impractical to attempt to list all possible situations. If a proposed transaction or situation raises any question or doubts in the mind, he/she should consult legal department or HR department. All employees would avoid situations involving actual or potential conflict of interest. Personal or romantic involvement with a competitor, supplier or subordinate or any other employee of the company, which impairs an employee’s ability

ANNEXURE 4  297

to exercise good judgment on behalf of the company, creates an actual or potential conflict of interest. Supervisor–subordinate’s romantic or personal relationships also can lead to supervisory problems, possible claims of sexual harassment and morale issues. The company would take appropriate corrective action according to the circumstances in such cases. Failure to disclose facts would constitute grounds for disciplinary action as constituted by the company.

Protecting Company’s Confidential Information The company’s confidential information is a valuable asset. The confidential information would include product architecture, source codes, product plans and road maps, name and list of customers, dealers and employees, financial information and so on. This information, being the property of the company, would be protected by patent, trademark, copyright and trade secret laws. All confidential information would be used for company’s business purpose only. This responsibility would include nondisclosure of the company’s confidential information such as information regarding company’s services or business over the internet. He/she would also be responsible for properly labelling any and all documentation shared with or correspondence sent to the company’s legal department or outside counsel as attorneyclient privileged. This responsibility includes safeguarding, securing and proper disposal of confidential information in accordance with the company’s policy on maintaining and managing records. This obligation extends to the confidential information of third parties, which company rightfully received under non-disclosure agreements. 1. Proprietary information and Invention agreement All employees would sign an agreement to protect and hold confidential the company’s proprietary information and would not disclose without the prior written consent of an authorized company officer.

298  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

2. Disclosure of company confidential information To enhance the company’s business from time to time, the company’s information may be disclosed to potential business partners; however, such disclosures would never be done without carefully considering its potential benefits and risks.   Requests by regulatory authorities: The company and its employees would cooperate appropriately with the government and/or regulators enquiries and investigations. However, it is important to protect the legal rights of company with respect to its confidential information. All such requests for information, documents or investigative interviews would be referred to the company’s legal department. No financial information to be disclosed without the prior approval of the CFO. 3. Company spokespersons The corporate communication and analyst policy would be established in the company who will be responsible for communicating information to the press and financial analyst community. All enquiries or calls from the press and financial analyst would be referred to the CFO or investor relations department. The company would designate its CEO, executive directors, CFO, investor relations department personnel as official company spokespersons for financial matters. All press releases, interviews, media enquiries would be pre-cleared by legal department.

Insider Trading Obligations under the applicable securities law apply to everyone, if listed or as when the company gets listed on any of the SXs. In the normal course of business, the directors, employees, consultants of the company come into possession of significant, sensitive information. They would not profit from it by buying or selling securities of the company by themselves. Furthermore, they would not tip others to enable them to profit or to profit on their behalf. The purpose of this policy is both to inform the

ANNEXURE 4  299

employees of their legal responsibilities and to make clear that the misuse of sensitive information is contrary to company’s policy and applicable securities law and so on. Insider trading is a crime, penalized with fines and imprisonment for individuals. In addition, the regulator may seek the imposition of a civil penalty of up to five times the profit made or losses avoided from the trading. Insider traders would also be disgorged any profits made, and are often subjected to an injunction or criminal proceeding against future violations and may be subjected to civil liability in private lawsuits.

Prohibition against Short Selling of the Company Stock The company directors, employees would not sell any equity security, including derivatives of the company directly or indirectly if he/she • Does not own the security sold. • Owns the security and does not deliver it against such sale (a ‘short sale’) within applicable settlement cycle. • The company directors, employees would not engage in short sales. • NEDs are not prohibited by law from engaging in short sales of company’s securities. However, it would be advisable for them not to do so.

Use of Company’s Assets 1. General: Protecting company’s assets would be the key responsibility of every employee. Care should be taken that assets are not misappropriated, loaned to others or sold or donated without appropriate authorization. All company employees would be responsible for the proper use of company assets and would safeguard such assets against loss, damage, misuse or thefts. Employees violating the law would be subject to disciplinary action, even

300  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

2.

3.

4.

5.

6.

up to, and including, the termination of employment or business relationship of company’ sole discretion. Company brand and logo: The company and tagline, if any, are registered trademarks of the company. They would be conspicuously marked with the ®designation or with a notation that they are registered trademarks of the company whenever it is used in any medium, presentation or other promotional context. Physical access control: The company would develop procedures covering physical access controls to ensure the privacy of communications, maintenance of the security of the company’s communication equipment and safeguard of company’s assets from theft, misuse and destruction. Company funds: Every employee of the company would be personally responsible for all company funds over which he/she is in control. It would be used only for company’s business purposes. The employees of the company would take reasonable steps to ensure that the company receives good value for company funds spent and would maintain accurate and timely records of all the expenditure. Expense reports would be accurate and submitted in a timely manner. Company funds would not be used by the employees for any personal use. Equipment: The company would try to furnish the employees with equipment necessary to do the job efficiently and effectively, and they would care for that equipment and use it responsibly only for company’s business purposes. If the company equipments are used at home or offsite, they would take precautions to protect it from theft or damage. Employees would not maintain any expectation of privacy with respect to information transmitted over, received by or shared in any electronic communication device owned, leased or operated in whole or in part by on behalf of the company. Electronic usage: The purpose of this policy is to make certain that the employees would utilize electronic and/ or other communication devices in a legal, ethical and appropriate manner. This policy would address the

ANNEXURE 4  301

company’s responsibilities and concern regarding the fair and proper use of all electronic communication devices within the organization including computers, e-mails, connection to the internet, intranet and extranet and any other public or private networks, voice mail, video conferencing, facsimiles and telephones. 7. Software/application mobile/designing, manufacturing requirements of products: This is to be used by employees to conduct the company’s business, which would be appropriately licensed. Never make or use illegal or unauthorized copies of any Intellectual Property Rights (IPR) technology, apps, software, whether in office, at home or on the road, since doing so would constitute copyright infringement and would expose the employee and the company to potential civil and criminal liability.

Maintaining and Managing Records The purpose of this policy is to set forth and convey the company’s business and legal requirement in managing records, including all recorded information regardless of medium or characteristics. Records would include paper documents, CDs, computer hard disks, email, innovative patent designs or all other media and so on that the company is required, by local, state, national, foreign and other applicable laws, rules and regulations, to retain records and to follow specific guidelines in managing its records.

Records on Legal Hold A legal hold would suspend all document destruction procedures in order to preserve appropriate records under special circumstances, such as litigation or governmental investigations and identify the type of company records or documents required to be placed under a legal hold. Every company employee would comply with the policy, failure of which would subject to disciplinary action.

302  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

Payment Practices 1. Accounting practices The company’s responsibilities to its stakeholders and the investing public would require that all transactions are recorded fully and accurately in company’s books and records in compliance with all applicable laws. All the required information would be accessible to the company’s auditors and other authorized persons and government and regulatory agencies. False or misleading entries, unrecorded funds or assets or payments without appropriate supporting documents and approvals are to be strictly prohibited as they violate company’s policy and law. There would be no wilful omissions of any company transaction from the books and records, no advance income recognition and no hidden bank accounts or funds. Any wilful material misrepresentation of and/or misinformation of financial accounts and reports would be regarded as a violation of the code, apart from inviting appropriate civil or criminal action under the relevant laws. All documentation supporting a transaction should fully and accurately describe the nature of the transaction and be processed in a timely fashion. 2. Political contribution The company would reserve the right to communicate its position on important issues to elected representatives and other government officials. It is the company’s policy to comply fully with all local, state, national and other applicable laws, rule and regulations regarding political contributions. The company’s fund or assets would not be used for or be contributed to political campaigns or political purposes under any circumstances without the prior written approval of the company’s corporate counsel and the BoD. 3. Prohibition of inducements Under no circumstances would employees offer to pay, make payment, promise to pay or issue authorization to pay any money, gift or anything of value to customers,

ANNEXURE 4  303

vendors, consultants and so on that is perceived as intended directly or indirectly to improperly influence any business decisions, any act or failure to act, any commitment of fraud or opportunity for the commission of any fraud. Inexpensive gifts, infrequent business meals, celebrating events and entertainment, provided that they are not excessive or create an appearance of impropriety, do not violate their policy.

Responsibility and Accountability to Customers and Suppliers Customer Relationship If the company puts any employee in contact with its customer, it is critical for the employee to remember that he/she represents the company to the people with whom they would be dealing. Act in a manner which would create value for the customers and help to build relationship based upon trust.

Payments or Gifts from Other Under no circumstances would employees accept any offer, payment, promise to pay or authorization to pay any money, gift or anything of value from customers, vendors, consultants and so on which is perceived as intended directly or indirectly to influence any business decisions, any act or failure to act, any commitment of fraud, or opportunity from the commission of any fraud. Inexpensive gifts, infrequent business meals, celebrating events and entertainment, provided which would not be excessive or create an appearance of impropriety, do not violate the policy. Before accepting or giving anything of value from or to an employee of a government or government entity or any other entity/person connected with company. The employee would contact the legal, HR or the finance department. Questions/queries regarding whether a

304  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

particular payment or gift violates the policy would be directed to legal department. The nature and cost would always be accurately recorded in the company’s book and records.

Publication of Other’s Copyright Material The company would subscribe to publication which includes newsletter, reference works, online reference services, magazines, books and other digital and printed work to help employees do their jobs better. Copyright law generally protects these works, and their unauthorized copying and distribution constitute copyright infringement. The company would have to first obtain the consent of the publisher of a publication before copying publications or significant part of them. It would consult the legal department on the doubt of copying a publication.

Handling the Confidential Information of Others The company would have many kinds of business relationships with many companies and individuals. Sometimes, they would volunteer confidential information about their product or business plans to induce the company to enter into a business relationship. At other times, the company would request a third party to provide confidential information to permit the company to evaluate on potential business relationship with that party. Whatever the situation, the company would take special care to handle the confidential information of others responsibly. It would handle such confidential information in accordance with the agreements with such third parties. Refer to maintaining and managing records. 1. Non-disclosure agreements Confidential information would take many forms. An oral presentation about company’s product development plans would contain protected trade secrets. A customers list or employee list would be a protected trade secret. Employee would never accept information offered by a third party,

ANNEXURE 4  305

which is represented as confidential or which appears from the context or circumstances to be confidential, unless an appropriate non-disclosure agreement, which would be signed with the party, offers the information. The legal department would provide non-disclosure agreement to fit any such situation and would coordinate appropriate execution of similar agreements on behalf of the company. 2. Need to know Once the third party’s confidential information is disclosed to the company, it would be obliged to abide by the laws of the relevant non-disclosure agreement and limit its use to the specific purpose for which it is disclosed and to disseminate it only to other company employees with a need to know the information. In case of any doubt, consult the legal department. 3. Notes and reports When reviewing the confidential information of a third party under a non-disclosure agreement, it will be natural to take notes or prepare reports summarizing the results of the review, and, based partly on those notes or reports, to draw conclusions about the sustainability of a business relationship. Notes on reports include confidential information disclosed by the other party and so would be retained long enough to complete the evaluation of the potential business relationship. These would be treated just as any other disclosure of confidential information is treated, marked as confidential and distributed only to those the company employees with a need to know. 4. Competitive information The company would never attempt to obtain competitors’ confidential information by improper means and would especially never contact a competitor regarding their confidential information. While the company might and would employ former employees of competitors, the company would recognize and respect the obligations of those employees not to use or disclose the confidential information of former employers.

306  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

Selecting Suppliers The company’s suppliers make significant contributions to the success. To create an environment where the supplier would have an incentive to work with the company, they must be confident that they would be treated lawfully and in an ethical manner. The company’s policy would be to purchase supplies based on need, equality, service, price and terms and conditions. The company’s policy would be to select significant suppliers or enter into significant supplier agreements through a competitive bid process, wherever possible. Under no circumstances would any employee attempt to coerce suppliers in any way. In some cases where the products/services are designed, fabricated or developed to the company’s specifications, the agreement between the parties would contain restrictions on sales, which must be followed scrupulously. While selecting suppliers, their record of ethics and good conduct would be ascertained.

Government Relations It is the company’s policy to comply fully with all applicable laws and regulations governing contact and dealings with government employees and public officials, and to adhere to high ethical, moral and legal standards of business conduct. The policy would include strict compliance with all local, state, national, foreign and other applicable laws, rules and regulations. In case of any question, the employee would contact company’s legal department.

Lobbying Employees whose work requires lobbying, communication with any member or legislative body or with any government official or employee of a legislative body or with any government official or employee in the formulation of legislation, would have prior written approval of such activity from the corporate counsel.

ANNEXURE 4  307

Activity covered by the policy would include meeting with legislature or members of their staffs or with government officials. Preparation, research and other background activities, which in case would be done in support of lobbying communication also, would be covered by this policy even if the communication ultimately is not made.

Government Contracts It is the company’s policy to comply fully with all applicable laws and regulations that apply to government contracting. It is also necessary to strictly adhere to all terms and conditions of any contract with local, state, national, foreign or other applicable governments. The company’s legal department would review and approve all contracts with any government entity.

Waivers Any waiver of the code of business conduct and ethics for a member of company’s BoD or executives would be approved in writing by the company’s BoD and would be promptly disclosed. Any waivers of any provision of the code of business conduct and ethics, with respect to any other employee, would be approved in writing by the company’s corporate counsel.

Disciplinary Actions The matters covered in the code of business conduct and ethics would be of utmost importance to the company, its stakeholders and its business partners, and are essential to company’s ability to conduct its business in accordance with its stated values. The company would expect all employees and consultants to adhere to the rules in carrying out their duties for the company. The company would take appropriate action against the

308  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

employee, consultants whose actions would be found to violate the policies of the company.

Industrial Espionage It is the company’s policy to lawfully compete in the marketplace. Its commitment to fairness would include respecting the rights of competitors and abiding by all applicable laws in the course of competing. The purpose of the policy is to maintain the company’s reputation as lawful competitor and to help ensure the integrity of the competitive market place. The company would also expect its competitors to respect the right to compete lawfully in the market place and vice versa. Company’s employees would not steal or unlawfully use the information material, products, intellectual property or proprietary or confidential information of anyone including supplier, customer, business partners or competitors.

Free and Fair Competition Most countries have developed bodies of law designed to encourage and protect free and fair competition. The company would be committed to obey the laws both in letter and spirit. The consequences of not doing so can be severe. These laws often regulate the company’s relationship with its distributors, resellers, dealers and customers. Competition laws generally address the following areas: pricing practices (including pricing discrimination), discounting, terms of sale, credit terms, promotional allowances, secret rebates, exclusive dealerships or distribution ship, product bundling, restrictions on carrying competing products, termination and many other practices. Competition laws also govern, usually quite strictly, the relationship between the company and its competitors. As a general rule, contacts with competitors would always avoid subjects such as prices or other laws and conditions of sale, customers and suppliers. Employees of the company would not knowingly make

ANNEXURE 4  309

false or misleading statements regarding its competitions or the products of its competitors, customers or suppliers. Participating with competitors in a trade association or in a standards creation body would be acceptable when the associations is properly established, has a legitimate purpose and has limited its activities to those purpose. The employees would not, any time or under any circumstances, enter into an agreement or understanding—written or oral, expressed or implied—with any competition concerning prices, discounts, other terms or conditions of sale, profits or profit margins, costs, allocation of product or geographic markets, allocation of customers, limitations on production, boycotts of customers or suppliers, or bids or the intent to bid or even discuss or exchange information on the same subjects. In some cases, legitimate joint ventures with the competitors may permit exceptions to the rules as may be bona fide purchases from or sales to competitors on non-competitive products, but the company’s legal department would review all such proposed ventures in advance. This prohibition would be absolute and strict observance would be kept. Collusion among competitors is illegal, and the consequences of a violation would be severe. Although the spirit of this law, known as antitrust, competition, or consumer protection or unfair competition laws, is straightforward, their application to particular situations would be quite complex. To ensure that the company complies fully with these laws, each of the employees would have a basic knowledge of them and would involve legal department early on when questionable situation arises.

Interpretation of Code Any question or interpretation under this code of ethics and business conduct will be handled by the board or any person/committee authorized by the board of the company. The BoD or any designated person/committee has the authority to waive compliance with this code of business conduct for any director, member

310  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

of core management team, officer or employee of the company. The person seeking waiver of this code shall make full disclosure of the particular circumstances to the board or the designated person/committee.

Compliance with the Code of Conduct Compliance with this code of conduct is an obligation. The company directors, senior management and all employees serving, in particular, in the roles of finance, tax, accounting, purchase, treasury, internal audit, financial analyst and investor relations, must ensure that this code is communicated to, understood and observed by all employees. It will, of course, include all committee members and employees at all levels and members of the board of the company and its subsidiaries. The directors and the senior management shall affirm compliance with the code on an annual basis. The board expects employees to bring to their attention, or to that of senior management, any breach or suspected breach of this code. Compliance with this code is subject to the review by the board and complemented by the audit committee of the board. Any modification(s), amendment(s) or review of this code shall be done by the board.

Caveat: Annexure 5 (models of Charters) is a compilation of the information and text from the following sources: 1. Applicable legislative and regulatory provisions of the relevant laws and regulations mostly, from India but in some cases a few other jurisdictions. 2. Charters approved by various Boards where author has been/sits as a Director. However, author had contributed significantly both orally and writing in the design of those Charters. 3. Materials developed in Intuit Consulting, in particular by the author during consultancy projects and supplied to clients. 4. Some information sourced from the websites/publications of Public Ltd companies. Even though, the author has used his skills and experience and done rationalisation, rewriting, reorientation in most cases, he does not claim exclusive authorship either full or part of the text and/or material included in the Annexures. These compilations have been made with a view to help the readers who are practicing managers to design their charters as also students and academicians to have a fair idea of what should be included in the charters.

ANNEXURE 5 Charters* Audit Committee The need of a powerful subcommittee of the board christened as the audit committee, which functions to help the board to assess the quality of financial reporting cannot be overemphasized.

Purpose 1. To help ensure the preservation of good financial practices throughout the company. 2. To help ensure the adoption of sound accounting policies which are consistent with the nature and size of the business. 3. To help ensure 100 per cent regulatory compliance with respect to all domestic and international tax laws and other legal acts, laws and statutes. 4. To help ensure that the company is hedged against the potential risks which could impact the business (This will not be there if there is a separate RMC). 5. To monitor that internal controls are in place and effective. 6. To help ensure the integrity of the financial information reported to the board and shareholders. * All these charters have been designed with reference to Indian laws, rules and regulations as issued by various regulatory authorities. These will have to be suitably modified with reference to the applicable laws of the jurisdiction(s) where the company operate.

ANNEXURE 5   313

7. To provide by way of regular meetings, a link communicator between the board and the external and internal auditors.

Powers of the Committee 1. 2. 3. 4.

To investigate any activity within its terms of reference To seek information from any employee To obtain outside legal or other professional advice To secure attendance of outsiders with relevant expertise, if it considers necessary.

Terms of Reference 1. Oversight of company’s financial reporting process and disclosure of its financial information to help ensure that the financial statements are correct, sufficient and credible. 2. Review the quarterly and annual financial statements with the management and auditors before submission to the board for consideration and approval, particularly on the following: i. Matters required to be included in the director’s responsibility statement as a part of the board’s report in terms of applicable laws regulations of the jurisdiction where all it is regulated ii. Any changes in accounting policies and practices and their consistency iii. Major judgmental areas iv. Significant adjustments resulting from the audit v. Regulatory Compliances including listing, tax and other legal obligations relating to financial statements vi. Disclosure of RPTs, if any vii. Qualifications in the draft audit report viii. Compliance with accounting standards ix. Management discussion and analysis and result of operations and so on

314  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

3. Review with the management and statutory and internal auditors the adequacy of the internal control systems. 4. Consider the appointment, reappointment and, if required, the replacement or removal of the statutory auditor, tax auditor and the head of internal audit (who has direct access to the chairman of the committee)/the outsourced internal audit firm, and questions relating to their resignation or dismissal, and to consider and recommend to the board the remuneration of the external auditors. 5. Review the relationship with the external auditors, including consideration of audit fees as well as any other services non-audit activities, to ensure that is balanced objectivity with the value for money. 6. Discuss with the statutory auditor, tax auditor and internal auditors, before the audit commences, about the nature and scope of audit as well as post-audit discussion to ascertain any area of concern. 7. Discuss with the external auditors the problems and reservations arising from their audits or/and any other matter the external auditors may wish to discuss. 8. Review the external auditor’s management letter and management’s response. 9. Review the annual audit programme, ensure coordination between the internal and external auditors, and also ensure that no area is left to be covered and that the internal audit function has sufficient freedom and resource to carry out its role. 10. Review any reports submitted by the internal auditors and consider the major findings of internal investigations into any material failures of internal controls, irregularities and/or frauds and to obtain management’s responses and convey the results thereof to the board. 11. Review the company’s statement on internal accounting and financial control systems prior to endorsement by the board and, in particular, to review: i. The procedures for identifying business risks (including financial risks) and controlling their financial impact on the company

ANNEXURE 5   315

12. 13. 14.

15.

ii. The company’s policies for preventing or detecting fraud iii. The company’s policies for ensuring that it complies with relevant regulatory and legal requirements iv. The operational effectiveness of the policies and procedures v. The company’s internal financial and non-financial reporting and internal control framework (including treasury) Look into reasons for substantial defaults in the payment to the depositors, debenture holders, shareholders (in case of non-payment of declared dividends) and creditors. Review and administer the functioning of the WBM. When money is raised through a public/rights/preferential issue and so on, review and ensure that the management discloses the uses/applications of funds by category (capital expenditure, sales and marketing, working capital and so on) as per the prospectus on a quarterly basis. The chairman of the audit committee to be present at the AGM to answer shareholders’ queries on matters within the committee’s area of responsibility.

Explanation: The term ‘RPTs’ shall have the same meaning as contained in the Accounting Standard 18 ‘RPTs’, issued by the institute of accountants and the regulators.

CEO/CFO Certification The audit committee shall review the disclosures, if any, made by CEO/CFO on: 1. Significant changes in internal controls, financial reporting and so on during the year. 2. Significant changes in accounting policies during the year and the disclosure thereof in the notes to the financial statements; and instances of fraud of which they have

316  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

become aware and the involvement therein, if any, of the management and/or an employee having a significant role in the company’s internal control system.

Subsidiary Company The audit committee of the holding company shall also review the financial statements, in particular, the investments made by the unlisted subsidiary company.

Authority The committee is authorized by the board to oversee any investigation of activities within its terms of reference and acts as a court of last resort. It is authorized to seek any information it requires from any employee, and all employees are directed to cooperate with any request made by the committee. It may obtain outside legal or other independent professional advice and secure the attendance of outsiders with relevant experience and expertise if it considers necessary.

Meetings 1. The committee should meet at least four times in a year, and not more than four months shall lapse between two meetings, including before the announcement of the company’s preliminary and interim results and to consider whether or not to recommend the reappointment of the external auditors at the next AGM. 2. The committee will meet the board at least once a year to discuss matters such as the annual report and the relationship with the external auditors. Additional meetings may be called by the chairman of the committee or may be requested to be called by the chairman, the MD or the company’s external auditors.

ANNEXURE 5   317

3. The quorum for any meeting of the audit committee shall be either two members or one-third of the members of the audit committee, whichever is greater, but there should be a minimum of two independent members present, with the majority of independent directors present. 4. In the absence of the committee chairman, the remaining members present shall elect one of the members to chair the meeting, bearing in mind legal and regulatory requirements. 5. The committee shall periodically meet in private with the external and internal auditors without the presence of the executive directors and management representatives. Independent directors of the committee alone can meet the statutory or internal auditors.

Composition 1. The committee members and the chairman are appointed by the board from amongst the NEDs, in compliance with legal and regulatory requirements. Chairman To be an independent director Members NEDs & Independent directors 2. However, the majority will be that of independent directors, not only by the constitution, but in every meeting. 3. All members shall be financially literate, and at least one member, preferably the chairman, shall have expertise in accounting or financial management. In attendance Internal auditor Statutory auditor/external auditors CFO Secretary Company secretary 4. The MD and/or CEO, the CFO, the internal auditor and external auditor may, at the invitation of the chairman of the committee, attend and speak at meetings of the

318  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

committee; other may be called upon or shall be able to speak, answer queries by prior arrangements with the chairman of the committee.

Reporting Procedures 1. The secretary shall circulate the minutes of the meetings of the committee to all members of the committee, following their approval by the chairman of the committee. Any director may obtain copies of the committee’s agenda and minutes with the agreement of the chairman of the committee. 2. The chairman of the committee will present to the board a brief of the discussions in the meetings of the committee.

Nomination and Remuneration Committee Analysis of several Corporate Governance failures has brought to light the payment of excessive compensation to the top management team and the BoD as one of the basic malaise. Although it is important to compensate adequately the performance and contribution, any excessive remuneration can lead to: 1. Erosion of the stakeholders’ value. 2. Disproportionate sharing of the company’s profitability by one set of stakeholders. 3. Incentive to manage and manipulate performance to promote their enlightened self-interest. 4. Prevent boards for packing up board with friends from ‘cozying up club’ rather than variety of skills, wisdom and commitment customized to the demands of the enterprise. Hence, increasingly, need is being felt of a powerful subcommittee of the board christened as nomination and remuneration

ANNEXURE 5   319

committee, which functions efficaciously to balance the adequacy and excessive compensation and obviates conflict of interest and brings talent, objectivity and wisdom to the boardroom. In some of the jurisdictions, constitution of such a committee has already been made compulsory by legislation/regulation.

Purpose The NRC will assist the BoD of the company to: 1. Determine, review and propose compensation principles for the company. 2. Setting the compensation policy of the company’s executive directors. 3. Undertake the performance appraisal of the CEO and the board-level executives. 4. Approve payments to the managerial personnel as per the policy laid down by the committee. 5. Assess and review compensation policy and plans recommended by the management. 6. Recommend suitable candidates for appointment of executive, non-executive and independent directors.

Responsibilities and Duties The responsibilities and duties of the NRC can be categorized into the following: 1. Nomination Policy i. Lay down the principles and policy for the selection and retirement of independent directors and NEDs. ii. Identify persons who are qualified to become directors— independent, non-executive and executive, and also persons who may be appointed in senior management in accordance with the criteria laid down, recommend

320  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

to the BoD their appointment and removal and shall carry out evaluation of every director’s performance. iii. Formulate the criteria for determining qualifications, positive attributes and independence of a director and recommend to the BoD a policy relating to the remuneration for the directors, key managerial personnel and other employees. 2. Remuneration Policy i. Submission of the remuneration policy to the BoD for approval. ii. The committee will provide compensation plans and practices on the basis of remuneration principles. iii. Describe main roles, responsibilities and competencies involved in the remuneration process. iv. Provide specific guidelines for the setting of BoD and executive board members’ remuneration. v. The committee would also review the company’s remuneration principles. vi. The committee would periodically review the implementation of the remuneration policy. vii. The committee may look into the company’s internal audit function limited to performing periodic reviews on the remuneration to ensure the applicable rules and standards are complied with. viii. The committee would set working standards for determining the remuneration of the members of the senior management of the company and recommend to the BoD for approval. ix. The committee shall ensure, while formulating the above policy, that: (a) The level and composition of remuneration is reasonable and sufficient to attract, retain and motivate directors of the quality required to run the company successfully; (b) Relationship of remuneration to performance is clear and meets appropriate performance benchmarks; and

ANNEXURE 5   321

(c) Remuneration to directors, key managerial personnel and senior management involves a balance between fixed and incentive pay reflecting short- and long-term performance objectives appropriate to the working of the company and its goals, provided that such policy shall be disclosed in the board’s report. The chairman of the committee or, in his absence, any other member of the committee authorized by him in this behalf shall attend the general meetings of the company. 3. Performance Review i. The committee would review competitor’s market data, trend analysis, performance and the methodology for determining annual remuneration pools with the management. ii. The committee would assess individual performance evaluations of the executive board members including their performance inclusive of managing risk, compliance to the code of conduct and so on. iii. The committee would get the inputs from the company’s internal control function, code of conduct for reviewing the performance. 4. Setting Remuneration i. The NRC would propose compensation for NEDs of the board and individual executive board director for the approval from the BoD. ii. The NRC would review and recommend the bonus pools to the executive directors of the board for approval. iii. Discuss and determine the CEO’s remuneration to achieve company’s goals and objectives upon the performance. iv. Review and recommend to the BoD for approval of any mandatory disclosures of the management compensation.

322  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

5. Reporting to the BoD i. The committee would provide a periodical report to the BoD on its activities, implementation of the remuneration policy and adhering to the applicable standards and rules and remuneration paid to the executive board members. ii. The committee would review the compensationsetting process on an annual basis. 6. Annual Remuneration Report According to the requirement of annual reporting, the committee would review and approve the annual remuneration report prior to the BoD’s approval, which satisfies the remuneration principles, policy, plans for the year. 7. Other Responsibilities The NRC would review and reassess the adequacy of the charter and perform annual self-evaluation of the performance of the NRC.

Composition 1. Minimum three members 2. Majority should be independent directors 3. Chairman should be an independent director but not the chairman of the board 4. Secretary: company secretary

Meetings Meetings can be held as and when necessary. However, at least two meetings in a year with a gap of not more than six months must be held.

Reporting The secretary shall circulate the minutes of the meetings of the committee to all the members of the committee, following their

ANNEXURE 5   323

approval by the chairman of the committee. Any director may obtain copies of the committee’s agenda and minutes with the agreement of the chairman of the committee.

Stakeholders Relations Committee Stakeholder’s confidence is primary to the survival and sustainability of success of the companies. Hence, their interests have to be well looked after, which necessitates the constitution of an effective committee which balances the interest of all stakeholders.

Purpose 1. To ensure that efficient systems are in place for expeditious transfer of shares and redressal of all the stakeholders grievances. 2. To ensure all statutory compliances relating to shares/ fixed deposits, debentures or any other security holders are compiled within the prescribed time, and there are no defaults. 3. To ensure there is balance in the interest of all stakeholders proportional to contribution and eligibility.

Terms of Reference The role of the stakeholders relations committee shall be the following: 1. Review the redressal of shareholders, debenture holders and depositors or any other security holder’s grievances/ complaints such as transfer of shares, non-receipt of balance sheet, declared dividends and interest warrants and so on, and ensure cordial relation with the stakeholders.

324  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

2. Review the adherence to service standards relating to the various services rendered by the company and company’s registrars and transfer agents. 3. Review the status of the litigations(s), complaints/suits filed by or against the company relating to the shares/ fixed deposits, debentures or any other security holders of the company before any courts/other appropriate authorities, and in particular where directors are implicated or could be made liable. 4. Review the impact of enactments/amendments made by the various regulatory authorities on matters concerning the stakeholders in general. 5. Review matters relating to the transfer of unclaimed and unpaid dividend, matured deposits, interest accrued on the matured deposits, debentures and so on to the investor education and protection fund as may be specified under any legislation, rules, regulations, directions and so on. 6. Review the status of claims received for unclaimed shares and dividend on unclaimed shares. 7. Review the initiatives taken to reduce quantum of unclaimed dividends/unclaimed deposits. 8. The chairman of the committee or, in his absence, any other member of the committee authorized by the chairman in his behalf shall attend the general meetings of the company. 9. The shareholders/investors grievance committee shall act on such further terms of reference as may be considered necessary and specified by the board in writing from time to time. 10. Review service standards and investor service initiatives undertaken by the company. 11. Review in balances conflict perceived, if any, amongst the interest of various stakeholders. The stakeholders relations committee shall have such powers/ functions/features/role and activities and shall also comply with such other stipulation to meet the requirements as may be necessary both under any legislation, as well as under the listing agreements of SXs in which the company’s shares are listed.

ANNEXURE 5   325

Meetings 1. The committee should meet at least two times in a year and, not more than six months shall lapse between two meetings. 2. The quorum for any of the meetings shall be either two members or one-third of the members of stakeholders’ relations committee, whichever is greater, but there should be a majority of independent directors. 3. In the absence of the committee chairman, the remaining members present shall elect one of the members to chair the meeting.

Composition The committee members and the chairman will be appointed by the board from amongst the NEDs, in compliance with legal and regulatory requirements, and shall not be less than three with a majority of independent directors. Chairman:

Independent director

Members:

NEDs & Independent directors

Secretary:

Company secretary

Reporting Procedures The committee shall report to the board. The secretary shall circulate the minutes of the meetings of the committee to all the members of the committee, following their approval by the chairman of the committee. Any director may obtain the copies of the committee’s agenda and minutes with the agreement of the chairman of the committee.

326  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

Risk Management Committee Every enterprise functions in a given environment. The environment is undergoing unremitting transformation. Changes in environment throw up challenges which engulf not only the operations of the company, but even its existence. The threat of the irrelevance/obsolescence of the product/service, revenue/ business model and organizational design as a consequence of changes in the environment is real. This warrants a very powerful RMC to ensure the success and the sustainability of the enterprise.

Purpose The purpose of the RMC will be to assist the BoD in the following: 1. Visualizing both macro and micro risks that may impact the business of the company. 2. Building scenarios of the environment, risks that unfold and assess the consequences thereof on the profits and the sustainability of the company. 3. Designing a framework for efficacious management of the risk. 4. Creating processes for the effective implementation of the risk management framework. 5. Reviewing the risk management. 6. Generating ideas for converting risk into opportunity.

Risk Management Committee Role 1. Define corporate risks (vision, strategy based risks), opportunity loss risks, regulatory risks project-specific risks and support and systems risks. Also, the impact of those risks at macroeconomic levels for the company. 2. Draft roles and responsibilities for locational risk committees.

ANNEXURE 5   327

3. Review locational, corporate and internal auditor’s report sent in advance (15 days prior to its meeting). 4. Review sustainability report. 5. Review and discuss market intelligence report (business competition and threats). 6. Review risk registers quarterly on sampling basis. 7. Discuss and think through solutions for top 10 identified risks along with business risk owners, and also, if required, discuss the limitations of business processes and controls. 8. Discuss HR management activities for assessing and managing succession risk. 9. Report solutions obtained on the risks to the board (solution sizing).

Agenda of RMC Some ideas on what the RMC should be doing in the meeting could be as follows: 1. Design strategic risk management plan, define corporate including organizational design risks, regulatory risks, opportunity loss risks, project-specific risks, support systems risk and the impact of risks. 2. Evaluation, review and validation of actions of risk mitigations steps from previous meeting/(s). 3. Review of solutions to acquired risks (top 10 identified). 4. Locational Risk Management Committee (LRMC) report. Revisit roles and responsibilities of LRMC, appointment of LRMC chairman and so on. 5. Sustainability report. 6. Discuss any other matter taken brought to the committee.

Other Responsibilities The RMC would review and reassess the adequacy of the charter and perform annual self-evaluation of the performance of the committee.

328  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE

Composition 1. Minimum three members. 2. Chairman should be an independent director. 3. If need be, the experts in the line of business that the company undertakes from outside may be co-opted to the committee. 4. Secretary: company secretary.

Reporting to the BoD The committee would provide a periodical report to the BoD on its activities, implementation of the risk management policy and programme and adhering to the applicable standards and rules. Review the relationship with the external auditors, including consideration of audit fees as well as any other services non-audit activities, to ensure that is balanced objectivity with the value for money.

Annual Risk Management Report According to the requirement of annual reporting, the committee would review and approve the annual risk management report prior to the BoD’s approval, which satisfies the risk management principles, policy, plans for the year to be included in the annual report of the company.

Meetings Meetings can be held as and when necessary. However, at least two meetings in a year with a gap of not more than six months must be held.

Bibliography Anand, Anita. (2013). ‘The Value of Governance’. University of Toronto. Available at http://www.ccgg.ca/site/ccgg/assets/pdf/the_value_of_governance__anand,_ anita_.pdf (accessed on 30 May 2016). Bajpai, G.N. (2003, March). S.G. Gupta lecture delivered by Shri G.N. Bajpai, Chairman, SEBI at Mumbai. Available at http://webcache.googleusercontent. com/search?q=cache:U0AhtlS65hcJ:shodhganga.inflibnet.ac.in/ bitstream/10603/34945/7/07_chapter_01.pdf+&cd=2&hl=en&ct=clnk&gl=in Balasubramanian, B. N., B. S. Black, and V. S., Khanna. (2011). ‘The Relation Between Firm-Level Corporate Governance and Market Value. A Study of India’. Law Working Paper No. 177/2011 [Online]. Available at: http://ssrn.com/abstract= 1586460st Black, Bernard S., Hasung Jang, and Woochan Kim. (2003 February). ‘Does Corporate Governance Affect Firm Value? Evidence from Korea.’ Available at http://www.haas.berkeley.edu/groups/finance/black.pdf (accessed on 30 May 2016). Bozec, Yves & Richard Bozec. (2010). ‘Overall Governance and Cost of Capital: Evidence from Canada Using Panel Data’. Journal of Global Business Management 6(1):1. Cheung, Stephen Yan-Leung, J. Thomas Connelly, Piman Limpaphayom, and Lynda Zhou. (2007). ‘Do Investors Really Care About Corporate Governance? Evidence from the Hong Kong Market’. Available at http://www.hkimr. org/uploads/seminars/290/sem_paper_0_159_cheung-paper290805.pdf (accessed on 30 May 2016). Conger, Jay A., David Finegold, and Edward E. Lawler III. (1998, January– February). ‘Appraising Boardroom Performance’. Available at https://hbr. org/1998/01/appraising-boardroom-performance (accessed on 30 May 2016). ‘Corporate Transparency: The Openness Revolution’. (2014, 13 December). The Economist. Available at http://www.economist.com/news/business/ 21636070-multinationals-are-forced-reveal-more-about-themselveswhere-should-limits (accessed on 30 May 2016). Cremers, Martijn, and Allen Ferrell. (2011). ‘Yale Thirty Years of Corporate Governance: Firms Valuations & Stock Returns’. ICF Working Paper No. 09-09. Yale International Center for Finance. Available at http://depot.som. yale.edu/icf/papers/fileuploads/2485/original/09-09.pdf (accessed on 30 May 2016).

330  THE ESSENTIAL BOOK OF CORPORATE GOVERNANCE Felton, Robert and Pamela K. Fritz. (2005). ‘The View from the Board Room’. (Special Edition: Value and Performance). The McKinsey Quarterly 49. Available at http://www.ceoexpress.com/asp/mckinseyalls4.asp?id=m0336 Fernando, A.C. (2009). ‘Corporate Governance: Principles, Policies and Practices’. Pearson Education, India. Available at https://books.google. co.in/books?id=al6zP7foCSEC&pg=PT187&dq=companies+with +good+governance+share+prices+increased&hl=en&sa=X&redir_ esc=y#v=onepage&q=companies%20with%20good%20governance%20 share%20prices%20increased&f=false Freeman, V., A. Woodwark, and E. Stephenson. (2007). ‘Acting on Global Trends: A McKinsey Global Survey’. The Mckinsey Quarterly. Available at http://www.mckinsey.com/featured-insights Hayashi, Shigeko. (2005). ‘Japan and East Asian Monetary Regionalism: Towards a Proactive Leadership Role?’ Available at https://books.google. co.in/books?id=nVJ_AgAAQBAJ&pg=PA77&lpg=PA77&dq=although+priv ate+sector+expenditure+and+financing+decisions+led+to+the+crises,+it+w as+made+worse+by+governance+issues&source=bl&ots=abf4-VD0ip&sig= AcfOXqEDpGNUTOB0tO8XuSpmhR4&hl=en&sa=X&ei=NC1sVcOjMoqj NqyKgdAJ&ved=0CB0Q6AEwAA#v=onepage&q=although%20private%20 sector%20expenditure%20and%20financing%20decisions%20led%20 to%20the%20crises%2C%20it%20was%20made%20worse%20by%20 governance%20issues&f=false ‘History of the New York Stock Exchange’. Available at http://www.loc.gov/rr/ business/hottopic/stock_market.html Ihrig, Martin, and Ian MacMillan. (2015, January–February). ‘Managing your Mission-Critical Knowledge’. Available at https://hbr.org/product/ managing-your-mission-critical-knowledge/R1501F-PDF-ENG (accessed on 30 May 2016). Jastrow, Robert, September 7, 1925–February 8, 2008. American Physicist. Available at http://biographies-memoirs.wikidot.com/jastrow-robert (accessed on 30 May 2016). Lipton, Phillip. (2009, May). ‘The Evolution of the Joint Stock Company to 1800: A Study of Institutional Change’. Working Paper No. 15. Workplace and Corporate Law Research Group, Monash University. Available at http:// www.buseco.monash.edu.au/blt/wclrg/workpaper-15.pdf (accessed on 30 May 2016). London Stock Exchange. ‘Our History’. Available at http://www. londonstockexchange.com/about-the-exchange/company-overview/ourhistory/our-history.htm Martin, Roger, Alison Kemper, and Jennifer Riel. (2009). ‘The Virtue Matrix Reloaded: What Can It Tell Us About Corporate Social Responsibility Now?’ Available at https://rogerlmartin.com/docs/default-source/Reviews/SOCIALINNOVATION/rotman_fall_09_virtue_matrix_reloaded (accessed on 30 May 2016).

Bibliography  331

McKinsey & Company (2002). ‘Global Investor Opinion Survey: Key Findings.’ Available at http://www.eiod.org/uploads/Publications/Pdf/II-Rp-4-1.pdf (accessed on 30 May 2016). Morey, Matthew, Aron Gottesman, Edward Baker, and Ben Godridge. (2009). Journal of Banking & Finance 33 (2, February): 254–262. Available at http://www.cfapubs.org/doi/pdf/10.2469/dig.v39.n3.9 (accessed on 30 May 2016). Newell, Roberto, and Gregory Wilson. (2002). ‘A Premium for Good Governance’. The McKinsey Quarterly (3). Available at http://www.globalclearinghouse. org/wefhongkong/Docs/Premium%20for%20good%20governance.pdf (accessed on 30 May 2016). O’Brien, Damien (February, 2005). ‘The Private Equity Board: A Good Governance Model’. Available at http://www.egonzehnder.com/us/leadership-insights/ the-private-equity-board-a-good-governance-model.html (accessed on 30 May 2016). Piketty, Thomas. (2014, March). ‘Capital in the 21st Century.’ Paris School of Economics. Available at http://piketty.pse.ens.fr/files/Piketty2014Capital21c. pdf (accessed on 30 May 2016). Scott, William R. ‘The Constitution and Finance of English Scottish and Irish Joint Stock Company to 1720’. Available at http://socserv2.socsci.mcmaster. ca/econ/ugcm/3ll3/scott/JointStockv1.pdf (accessed on 30 May 2016). Stern, J.M., John S. Shiely with Irwin Ross. (2001). ‘The EVA Challenge: Implementing Value-Added Change in an Organization’. New York: John Wiley & Sons. Available at http://books.mec.biz/tmp/books/ ORBGSC4H3GLOK4IHHISQ.pdf Walker, Steven. (2013). ‘Corporate Governance: Its Effect on Share Price’. Available at http://webcache.googleusercontent.com/search?q=cache:yXEiz e2b1DsJ:https://www.researchgate.net/file.PostFileLoader.html%3Fid%3D5 507efb3f15bc7c1108b45eb%26assetKey%3DAS%253A273735871860736 %25401442275125719+&cd=1&hl=en&ct=clnk&gl=in

Index agricultural economy’s, 6 audit committee authority, 316 meetings, 316 bioeconomy’, 7 board board committees, 72 committees meetings, 113 benefits, 114 minutes of, 116 management, role between, 270 performance evaluation of, 137 sub-committees meeting protocols attendance, 272, 273 participations, 273 venue, 272 boardroom, 62 barrier to broader debate in, 121 practices, 62 collective rationalization, trends, 66 illusion of unanimity, trends, 68 Body of individuals (BOI), 33 Bubble Act, 13 budgeting exercise, 127 action plan fabrication, 129 scenario building, 128 strategy formulation, 129 case studies UK equitable life, 258

code of business conduct and ethics accountability to company and stakeholders, 292 code of conduct, 189 Corporate Governance barriers executive powers, abuse of, 50 non-alignment of interests of directors with long-term value creation, 50 edifice of, 61 cosmic economy, 8 CRISIL Corporate Governance and Value Creation Rating (CRISIL GVC Rating), 209 value creation and distribution, 210 disclosures, 70 means, methods and manner, 172 East India Company (EIC) advent of, 15 economic value addition (EVA), 207, 219, 221 evolution of economies cosmic economy, 8 industrial economy, 7 information economy, 7 ICRA board structure and processes, 215 financial discipline, 213 ICRA’s Stakeholders Value and Governance (SVG), 211

Index  333

industrial economy, 7 information economy, 7 Investment Advisors Act of 1940, 24 Investment Company Act of 1940, 23 joint stock companies evolution of, 9 in India economic success, 16 EIC, advent of, 16 managing agency system, 16 listed company, 35 Maloney Act 1938, 23 management, 71 market value addition (MVA) method, 221 control sheet, 222, 224 market value, calculation, 222 monitoring pyramid auditors, 201

raison d’être of Joint Stock Companies physical resources, 40 wealth creation, 42 related party transaction (RPT), 70, 71 auditors and audit committee fundamental principles, 162 policy, 163 Securities Act of 1933, 23 Securities and Exchange Act of 1934, 23 securities markets evolution of, 19 life insurance companies, nationalization of, 21 New York Stock Exchange, 20 society, 2 stakeholders relations committee reporting procedures, 325 strategy, focus on, 122 audit, 127

New York Stock Exchange, 20 organization structure and corporate governance cooperative society, 33 AOP, 33 proprietary ownership, 31 principles, value enables monitoring evaluation of wealth creation, 247 private company, 35 Public Utility Holding Act of 1935, 23 pyramid accounting and financial reporting, 156

Trust Indenture Act of 1939, 23 tyranny of corporate governance society, 2 Unit Trust of India (UTI), 208 vision and direction, 117 visionaries, 1 wealth creation, 217 wealth management, 217 wealth sharing, 217, 228 human resource (HR), 229 shareholders chain, 228 website, 192

About the Author Ghyanendra Nath Bajpai, a distinguished leader in Indian business was the chairman of the Securities and Exchange Board of India (SEBI). Earlier, he was the chairman of the Life Insurance Corporation of India (LIC). Mr Bajpai is known for his visionary leadership. He has served/serves as a non-executive chairman and a director on corporate boards in India and other countries, received awards for contribution to business and authored several books. He has been the chairman of the Corporate Governance Task Force of International Organization of Securities Commissions and the chairperson of the Insurance Institute of India (III). As the chairman of SEBI, Mr Bajpai oversaw the orderly functioning of India’s securities markets. With a vision to make India a global benchmark, he initiated numerous reforms and innovations in India’s securities markets. The Indian securities market now ranks as one of the most advanced in emerging markets and may well surpass developed markets in certain respects. As chairman, Mr Bajpai transformed LIC to meet the challenges of deregulation and competition from global insurance companies. Under his leadership, LIC became a financial powerhouse with the largest asset base in the Indian subcontinent. Mr Bajpai has been a member of the board of directors at General Insurance Corporation of India, ICICI Bank, Unit Trust of India, UTI Bank now Axis Bank, Tata Chemicals, Jindal Steel, Thane Electric Supply Co., National Housing Bank, Discount and Finance House, Indian Railway Finance Corporation, India International Insurance Ltd, Singapore and Ken-India Ltd, Nairobi (Africa). He was also the non-executive chairman of National Stock Exchange, Stock Holding Corporation of India, LIC Housing Finance Ltd and LIC International EC Bahrain and LIC Nepal Ltd.

About the Author  335

Currently, Mr Bajpai is a consultant on Corporate Governance and also a non-executive chairman and non-executive director of several corporates in India. He heads Intuit Consulting Pvt Ltd, a boutique consulting outfit engaged in providing highquality value-added advice and service in building excellence in Corporate Governance. Several large corporates have benefited out of his sagacious advice. Improving the effectiveness of the board is a greatly admired advice of Mr Bajpai. Mr Bajpai is on the board of advisors of Indian Army Group Insurance Fund and a member of Governing Board of National Insurance Academy. He was the chairman of Indian’s National Pension Trust Board. Earlier, he has served on the Governing Board of Indian Institute of Management, Lucknow. He has been a visiting faculty at leading institutes of management and training. He was the visiting Professor of Middlesex University, London. He is being regularly invited to speak at seminars in India and abroad. He has delivered lectures at London School of Economics (LSE), Harvard University and so on and also addressed OECD and IMF seminars. He has written three popular books: The Securities Market, Marketing of Insurances and How to Become a Super Successful Salesman. He received a number of awards, notable among them being the ‘Outstanding Contribution to the Development of Finance’ award from the prime minister of India and ‘W. G. Chirmule Puraskar, 2014’ for commendable contribution in the fields of insurance and regulation of stock market. Mr Bajpai holds a master’s degree in commerce from the University of Agra and a degree in law (LLB) from the University of Indore. He is an avid golfer.