corporate governance challenges

In this article, Aastha Jain discusses the need for effective corporate governance and biggest challenges to corporate governance in India.

Corporate Governance and its Challenges

You must be aware of the infamous Satyam case which is considered to be India’s largest corporate frauds where Satyam Computer founder R. Ramalinga Raju resigned after admitting to the fact that they had been overstating their profits and cooking their books since a long period of time. This is an example of bad corporate governance due to which frauds like this happen and in many cases, the culprits walk out scot-free. With the help of effective corporate governance, a company can excel in all aspects as it provides an assurance that management is acting in the best interest of corporation, thereby contributing to business prosperity with the help of openness and accountability.

What is the meaning of Corporate Governance?

Corporate governance is the mechanisms, processes, and relations by which corporations are controlled and directed. It stipulates the structures and principles which identify the distribution of rights and responsibilities among different participants in the corporation (such as the board of directors, managers, shareholders, creditors, auditors, regulators, and other stakeholders) and includes the rules and procedures for making decisions in corporate affairs. Simply put it is the code of conduct in business for the good management of the companies.

What are the basic principles of corporate governance?

Initially, the concept of corporate governance was introduced to stop the entrepreneurs and owners from doing unjust acts against the company. The core concept on why corporate governance was introduced still stays the same but some modifications have been made to include all the ways a company should represent itself in order to foster the trust of investors and other stakeholders. The key principles of corporate governance differ according to the country, regulator and stock exchange. However, most of the codes of governance include several same features.

  • Independent leadership: having an independent leadership is vital for the compliance of the principles of corporate governance such as an independent chairperson or an independent director. The director who invites friends and family for a seat at the board runs the risk of nepotism and prejudice. For this reason SEBI had introduced guidelines to the corporates emphasizing the need for independent leadership.
  • Transparency: one of the most vital objectives of corporate governance is considered transparency for the organizations to develop a business procedure so that all of the company’s transactions remain traceable. The other aspect includes having a clear and easy to understand company policies.
  • Accountability: the principle of accountability states that the company must be accountable to everyone who is being affected by the decisions made by the company.
  • Fairness: The Company undertakes to protect shareholders’ rights and ensure equal treatment of shareholders. There should be an effective redressal mechanism established by the Board of Directors to protect the rights of the shareholders.
  • Rule of law: the company must abide by the legal frameworks established by the regulatory bodies such as Securities and Exchange Board of India (SEBI) in case of India. There are penal provisions imposed by these regulatory bodies for the violation of rules and guidelines set by them.

Corporate governance framework in India

There are many acts with provisions relating to corporate governance in India. These provisions are set in accordance with the international standards. They are:

  1. The Companies Act, 2013 – it has provisions regarding the constituency of the board, general meetings, audit committees, board processes etc.
  2. SEBI (Securities Exchange Board of India) – there are many guidelines regarding the corporate governance which are mandatory for the companies to follow and violation of any guidelines attracts penalties.
  3. ICAI (Institute of Chartered Accountants of India) – there are various accounting standards related to corporate governance such as disclosure of financial statements set by ICAI.
  4. ICSI ( Institute of Company Secretaries of India) – there are various secretarial standards on meeting of the board of directors, general meetings etc. set by ICSI which have to be followed by the companies.
  5. Standard listing agreement of stock – this is regarded as the most important framework for corporate governance which is applicable to the listed companies.

Clause 49 of the listing agreement

The clause 49 of the listing agreement to the Indian stock exchange that came into effect from 31st December 2005 has been formulated to widen the scope of corporate governance by setting provisions for in all listed companies. Generally, the term ‘Clause 49’ is used which refers to clause number 49 of the Listing Agreement between a company and the stock exchanges on which it is listed (the Listing Agreement is identical for all Indian stock exchanges, including the NSE and BSE). This clause is a recent addition to the Listing Agreement and was inserted as late as 2000 as a result of the recommendations made by the Kumarmangalam Birla Committee on Corporate Governance constituted by the Securities Exchange Board of India (SEBI) in 1999. The provisions under clause 49 are :

  • At least 50% of non-executive members
  • For a company with an executive chairman, at least half of the board should be independent directors, else at least one-third. It would be necessary for chief executives and chief financial officers to establish and maintain internal controls and implement remediation and risk mitigation towards deficiencies in internal controls, among others.
  • Clause VI (ii) of Clause 49 requires all companies to submit a quarterly compliance report to the stock exchange in the prescribed form. The clause also requires that there be a separate section on corporate governance in the annual report with a detailed compliance report.
  • A company is also required to obtain a certificate either from auditors or practicing company secretaries regarding compliance of conditions as stipulated and annex the same to the director’s report.
  • The clause mandates the composition of an audit committee; one of the directors is required to be “financially literate”.
  • It is mandatory for all listed companies to comply with the clause by 31 December 2005

The real intention of clause 49 when it was first added was to introduce some basic corporate governance practices in Indian companies which brought a number of key changes in the protocols followed by the companies. It specified the minimum number of independent directors required on the board of a company, the setting up of an Audit Committee, and a Shareholders’ Grievance committee, among others, were made compulsory and so was the Management’s Discussion and Analysis (MD&A) section. It was mandatory to include a report on corporate governance in the annual report and also disclose the fees paid to the non-executive directors. There was also a restriction set on the number of committees a director could serve on.

Voluntary regulations, 2009

At the end of the first India Corporate Week in December 2009, the Ministry of Corporate Affairs issued new Corporate Governance Voluntary Guidelines and new Corporate Social Responsibility Voluntary Guidelines which covered the topics of:

  • Board of directors
  • Responsibilities of the board
  • The audit committee of the board
  • Auditors
  • Secretarial audit
  • The institution of the mechanism of the whistleblower policy

Major challenges

Although, there exists many guidelines about corporate governance but still many issues are arising about the compliance. The major challenges to effective corporate governance are:

  • Non-coverage of unlisted corporates

This is one of the major hindrance caused to effective corporate governance as the applicability of rules and regulations are restricted to the listed entities only as per the clause 49 of the listing agreement which leads to small and mid-sized firms to perform activities which are legal in nature but are not ethical.

  • Disclosure of off-balance sheet transactions

There are many transactions which cannot be disclosed in the balance sheet and even if they can be they cannot be displayed in monetary terms. What transactions are to be disclosed and how to be disclosed is entirely on the discretion of management. Corporate governance has a basic principle of transparency but it fails to provide a provision for its compliance.

  • Family owned business

In India, the majority of the businesses are family owned which means there is no provision regarding the dilution of powers. Ranging from directors to employees all key positions are held by family members. Also, the company’s and family’s relationship is very ambiguous in reference to that the assets of the company and the family are not separated legally.

  • Multiplicity of regulations

In India there are many regulatory bodies such as Companies act 2013, Securities and Exchange Board of India (SEBI), Reserve Bank of India, Insurance Regulatory Development Authority, etc. and they have no coordination with each other which leads to multiple provisions for a single type of event/transaction. This creates confusion and leads to chaos. This duplicity provides companies a loophole to escape from responsibility. These regulatory bodies are reactive but not proactive which means they only take action when there is a scam.

  • Corporate social responsibility

It is mandatory for companies to allocate a minimum of 2% of the profits in the last 3 years for CSR. The small and the mid-sized firms do not have the resources to allocate separate funds to CSR from its profit.

  • Challenge of existing practices

Some of the existing corporate governance practices are faulty in themselves and have many loopholes in them such as:

  • The incompetence of the board of directors to understand the type of risk they are taking.
  • Lack of independent directors
  • Presence of corporate culture which does not promote asking questions
  • Problems in whistleblowing- whistleblowing was introduced to put the guilty into limelight but are often wrong in their accusations and can cause serious harm to the person wrongly accused.
  • Problems in transparency

Management often argues that everything cannot be disclosed in a business as this information can be used by the competitors. However how much enough or what it should be disclosed and what shouldn’t be is with the discretion of the management who often abuse this power.

Overcoming these challenges

  • Investment in Compliance cost

In the initial stages, the compliance cost might seem huge but it will prove to be a huge investment in the long run. Simplifying the unambiguous regulations might promote the smooth functioning of the company and also encourage corporate governance as the compliance cost will reduce.

  • Changing regulations with time

In this time of rapid growth where the technology changes day by day it is important to upgrade the regulations of corporate governance in accordance with the changing industrial and economic climate of the country. Adhering to the old provisions might cause repercussions in the company.

  • Regulations for unlisted companies

The unlisted companies should also be brought under the purview of corporate governance for healthy competition and better competition goals. Standard and incentives are required for the mid-sized new entrants of the capital market. Right now there are only few provisions for the unlisted companies which lets them walk out scot free on the subject of corporate governance.

  • Competence of independent directors

Directors should have integrity and independence of thought; the courage to express their independent thoughts. They should possess a grasp of the realities of business operations and an understanding of business and financial language. The skill set of the independent directors has to match to the company in order for effective corporate governance.

  • Strictness in regulators vigilance

The role of regulatory bodies should not just be reactive but proactive too. They shouldn’t just react after the scam but also supervise and regulate the functions of the company to deviate risks which could be avoided. Precautionary measures have to be taken in order to avoid violation of any guidelines established by the regulatory bodies.

  • Stringent rules for transparency

Transparency is a huge part of corporate governance but there isn’t any clear regulation as to what should be disclosed and what shouldn’t be. Providing clear rules on transparency will make compliance of corporate governance easier and effective. Strengthening the disclosure strategy can prove to be the stepping stone to effective corporate governance in India.

The current scenario in India

On paper, India has the most stringent rules and regulations in the world related to corporate governance but in reality, the situation is quite different. It has been observed that promoters have considerable leeway to siphon corporate resources from the minority shareholders with the help of skewed contracts. This way promoters have a way of having pecuniary benefits for their personal use.
There are independent directors to protect the interests of the minority shareholders but as was seen in the Tata case, promoters have an influence over the directors such that a powerful and connected man like Nusli Wadia was dismissed from the board.

Another case would be of ICICI, where a conflict of interest was observed where one was with the partnership of promoter of Videocon group and Deepak Kochhar, husband of the chief executive officer of ICICI Bank. Regardless, of whether the loan, its terms or the extension were preferential, it was a huge conflict of interest due to the presence of Chanda Kochhar on the board, now the facts here are not clear as it was said that she was not the chairman of the committee. Still, speculations were raised on what did they do in order to protect the interest of the shareholders and investors but this situation did raise a question on the compliance of corporate governance on their part. The guidelines laid under corporate governance should be such that these situations can be avoided.

Recent developments

Capital market regulator Securities and Exchange Board of India (Sebi) has approved recommendations to the corporate governance framework for listed companies. The new measures are based on recommendations made by a 25-member committee headed by Uday Kotak, executive vice chairman and managing director of Kotak Mahindra Bank. The panel had suggested 81 key changes and new measures to improve the governance standards at India Inc. out of which 40 recommendations have been adopted without any modifications. Some of them are:

  • Reduction in the maximum number of listed entity directorships from 10 to 8 by April 01, 2019 and to 7 by April 1, 2020
  • Expanding the eligibility criteria for independent directors
  • Enhanced role of the audit committee, nomination and remuneration committee and risk management committee
  • Disclosures of auditor credentials, audit fee, reasons for the resignation of auditors
  • Disclosure of utilization of funds from QIP/preferential issue
  • Enhanced obligations on the listed entities with respect to subsidiaries
  • Secretarial Audit to be mandatory for listed entities and their material unlisted subsidiaries
  • Mandatory disclosure of consolidated quarterly results with effect from FY20

Conclusion

Corporate governance in developing countries is still in its infancy stage but many laws and amendments are being made in order to improve the effectiveness of corporate governance. There is no doubt that corporate governance if implemented properly, has ample benefits for stakeholders, shareholders, management employees, customers and community at large.

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