The Satyam scandal of 2009 gave Indian corporate stakeholders a cataclysmic jolt. Ramalinga Raju, who was recently sentenced to seven years in jail, was the chairman of Satyam Computer Services who committed financial fraud to the tune of Rs. 7000 crore. Shockingly, the company’s auditors, PricewaterhouseCoopers, did not notice it. The scale of the scandal and the auditing firm’s neglect brought to light glaring loopholes in the regulatory and legal framework dealing with the directors and the auditors of companies. Eventually, it led to changes in the law.
Before the scandal, the erstwhile Companies Act, 1956, the primary legislation dealing with the conduct of corporations in India, did not contain any provision for independent directors or impose any stringent obligations on auditors. The report of the Kumar Manglam Birla Committee in 1999 recommended improvements to the function and structure of the board of directors of a company and emphasised disclosures to shareholders. Clause 49 of SEBI’s Listing Agreement (applicable to listed companies only) became a reflection of these recommendations. In 2002, the Naresh Chandra Committee on corporate audit and governance, drawing from the Sarbanes-Oxley Act in the United States, suggested various reforms relating to the appointment of auditors, audit fee, and the certification of accounts. In 2003, the Narayana Murthy committee analysed the role of independent directors, related parties, and financial disclosures. Clause 49 was amended to incorporate its recommendations with respect to the requirement of independent directors on corporate boards and audit committees and the compulsory disclosures that listed companies had to make to its shareholders.
After the scandal, the Confederation of Indian Industries set up a task force to suggest reforms and the National Association of Software and Services Companies established a corporate governance and ethics committee headed by Narayana Murthy. The report of the latter addressed reforms relating to audit committees, shareholder rights, and whistleblower policy. SEBI’s committee on disclosure and accounting standards issued a discussion paper in 2009 to deliberate on (i) the voluntary adoption of international financial reporting standards; (ii) the appointment of chief financial officers by audit committees based on qualifications, experience, and background; and (iii) the rotation of auditors every five years so that familiarity does not lead to corporate malpractice and mismanagement. In 2010, SEBI amended the Listing Agreement to include the provision dealing with the appointment of a chief financial officer but it did not insist on the compulsory rotation of auditors.
In 2009, the Ministry of Corporate Affairs also released a set of voluntary guidelines for corporate governance, dealing with the independence of directors, the roles and responsibilities of audit committees and the boards of companies, whistleblower policies, the separation of the offices of the chairman and the CEO to ensure independence and a system of checks and balances, and various other provisions relating to directors such as their tenures, remuneration, evaluation, the issuance of a formal letter of appointment, and placing limits on the number of companies in which an individual can be a director.
A new company law – independent directors, accountable auditors, additional disclosures
India’s 2013 company law incorporated many provisions and reforms suggested by the various committees and organisations during the past decade. It clearly established the responsibility and accountability of independent directors and auditors. It provided for the compulsory rotation of auditors and audit firms. In fact, it even prescribed a statutory cooling off period of five years following one term as an auditor.
Under the Companies Act, 2013 (“the Act”), an auditor cannot perform non-audit services for the company and its holding and subsidiary companies. This provision seeks to ensure that there is no conflict of interest, which is likely to arise if an auditor performs several diverse functions for the same company such as accounting and investment consultancy services. Auditors also have the duty to report fraudulent acts noticed by them during the performance of their duties.
The new law also insisted on companies having independent directors, that is, directors who do not have a material or pecuniary relationship with a company. The requirement under Clause 49 of the Listing Agreement, which applied only to listed companies, would thus apply to many more companies. Independent directors have been prohibited from receiving stock options and are not entitled to receive remuneration for their services, except for reimbursement. At least one-third of the board of a company has to consist of independent directors. Even the audit committee has to feature a majority of independent directors. One independent director is required to be a member of the remuneration committee as well.
Additional disclosure norms such as the formal evaluation of the performance of the board of directors, filing returns with the Registrar of Companies with respect to any change in the shareholding positions of promoters and the top ten shareholders, were also mandated. After Satyam, aggrieved Satyam stakeholders in the United States were able to initiate class action suits against the company and its auditors for damages. The same remedy is now available to Indian stakeholders.
(Vera Shrivastav is an Associate at LegaLogic law firm and is a part time researcher and writer.)
In my last post, I had looked at the bare minimum requirements for the board of directors from different types of companies under the Companies Act, 2013 (“Act”).
In this post, let us take a look at specific requirements that apply to unlisted public companies. There are various thresholds specified in different sections of the Act, which aim at making larger companies subject to more stringent corporate governance requirements.
Here we can see a graphic representation of the different thresholds applicable to the composition of the board of directors of unlisted public companies.
These thresholds also apply to the committees of the board of directors. Here is a simple checklist depicting the companies, which must mandatorily set up certain committees.
Remember that the Audit Committee must have a minimum of three directors, the majority of whom should be independent directors. The Nomination and Remuneration Committee must be composed of three or more non-executive directors, the majority of whom should be independent directors. The chairperson of the Stakeholders Relationship Committee must be a non-executive director.
At the outset, it is important to note that corporate governance primarily concerns itself with public companies. The balancing of profit making with public or shareholder interests assumes legislative importance where the public are substantially interested in a corporation or where the shareholders are greatly dispersed. Such companies are invariably listed companies, that is, their securities are available on specified markets for purchase by all members of the public.
The board as interlocutor
In our previous article here, we outlined the evolution and purpose of the board of directors (“BoD”). We understood how the BoD, placed between shareholders and the executive management, is primarily a tool to resolve agency problems that arise to shareholders because of the diversification of ownership and control. Briefly summarised, the agency problems of a corporation are threefold: (a) conflicts between shareholders and management, (b) conflicts between majority and minority shareholders, and (c) conflicts between the controllers (majority shareholders or the management) and other stakeholders (such as creditors, clients, and regulators).
The role of corporate governance and law is therefore to effectively manage these conflicts. The BoD makes high-level decisions and monitors the performance of the management. It acts as a key interlocutor in the process of effective monitoring and resolution of these agency problems. The structure and organisation of the BoD assumes importance in addressing these problems. Historically, the BoD has been composed of the representatives of controlling shareholders, executive management, and at times, non-executive persons (who were representatives of other stakeholders such as creditors), people of prominence, or people otherwise affiliated to the company. This mix, although representative of the corporation, does not by itself eliminate the possibility of the functioning of the BoD being captured by the controlling constituents, that is, the controlling shareholders or the executive management, whichever has greater control of the corporation either through ownership or decision-making. This may lead to the decisions of the BoD being challenged by stakeholders on account of conflict of interest. In these situations it is likely that such decisions will be invalidated by courts or under law as it is difficult for a BoD composed in such a manner to demonstrate independence of judgment in cases where conflict is alleged by the affected stakeholders.
The prescription of non-executive and independent decision-making
Globally, the modern composition mandate of the BoD prescribes a mix of constituents including shareholder representatives, executive directors, and non-executive and independent directors (“IDs”). This mix has its origins in the corporate jurisprudence of the United States and the United Kingdom, self-regulation by stock exchanges, and legislation. The prescription for non-executive and independent directors in the U.S. was formed as a response to judicial decisions that gave weight to the non-executive and independent character of decisions in evaluating the proper discharge of the fiduciary duties of the BoD in situations of conflict such as self-dealing transactions and takeovers and business reorganisations. Corporate and accounting scandals such as those related to Enron and Worldcom further brought the failure of proper BoD oversight and action under public scrutiny and led to the mandatory prescription under the Sarbanes-Oaxley Act, 2002 (“SoX”). In the U.K., the concept of board independence dates back to the establishment of committees studying corporate governance beginning with the Cadbury Committee Report, 1992 and culminating with the consolidated Combined Code on Corporate Governance, 2008. Thus, the need for board independence that we have discussed in the previous paragraph, rose sharply after various multinational corporate failures resulting mainly from poor executive decision making, non-compliance with good company practices, and the internal corruption that ultimately reflected inefficient and conflicted board oversight.
Board independence in India
In India, the Securities Exchange Board of India (“SEBI”) has spearheaded the adoption of board independence starting with the Kumar Mangalam Birla Report, 2000 which was followed by the Narayan Murthy Report, 2004. The mandatory prescription of board independence in the form of requiring a certain number of non-executive and independent directors was achieved via self-regulation in the form of Clause 49 of the listing agreement between the stock exchange and the companies. The Companies Act, 1956 was silent on the aspects of board independence and general directorial responsibilities.
In the wake of corporate governance failures such as those involving Satyam, further reform has been brought in place by the Companies Act, 2013 (“Act”), which now provides a legislative mandate for board independence, prescribes duties and responsibilities for the BoD, and fixes accountability on the actions of the BoD.
Importantly, the Act is the first Indian legislation to require corporate governance in the form of board independence not only from listed companies but also on public companies that (a) have a paid-up share capital of at least ten crore rupees, (b) have a turnover of at least one hundred crore rupees, or (c) have in aggregate outstanding loans, debentures, and deposits exceeding fifty crore rupees. Under the Act, listed public companies have to have at least one-third of its BoD consisting of IDs and the public companies (meeting the aforementioned criteria) are required to have at least two IDs.
The comprehensive and exhaustive criteria of independence for an ‘independent director’ (Section 2(47) read with Section 149(6) of the Act), which were missing from the Companies Act, 1956 are objective as well as subjective. One objective qualification to be an independent director is that a person cannot have any interests, pecuniary or real, in the company or its affiliates or with the promoters, directly or indirectly. The criteria that one must be a ‘person of integrity’ and ‘possess relevant expertise and experience’ are, on the other hand, subjective. The criteria also takes care to prohibit service providers such as accountants and legal professionals who meet specified thresholds in the form of pecuniary or transactional relationships with the company. It may be noted here that the Act for the first time lays down limits on the number of directorships an individual may hold simultaneously, namely, twenty for private companies and ten for public companies.
The roles and responsibilities of the IDs are expressly incorporated in Schedule IV of the Act. The Act mandates that the IDs have to exercise their judgments to take fair decisions in the interest of the company and the stakeholders and evaluate whether the BoD and the other directors are taking decisions safeguarding the interests of all the stakeholders. There are also broad guidelines prescribed for the IDs like upholding ethical standards of integrity, acting objectively, devoting sufficient time to ensure balanced decision-making in order to fulfil their duties and obligations such as assisting the company in implementing the best corporate governance practices and even to moderating and arbitrating in the interest of the company in situations of conflict between the interests of the company and shareholders. The Act gives enhanced significance to the role of the IDs to ensure that the companies are encouraged to follow the best corporate governance practices. In this regard, Section 173(3) of the Act requires that if the IDs are absent from any board meeting, any decision that is taken in the meeting shall be final only after it is ratified by at least one independent director. This provision also ensures that the board doesn’t arbitrarily take decisions in the absence of the IDs.
Board independence will be merely symbolic without adequate access to data and information, in the absence of which, even an independent director cannot be expected to discharge his function of oversight and control effectively. In order to ensure that the IDs are provided with enough data and information related to the affairs of the company, the Act mandatorily requires the companies to form various committees like the nomination committee, the remuneration committee, and the audit committee. Provisions have been made to involve the IDs in the decision-making of these committees by providing for conditions such as a minimum number of IDs or an ID as chairman of a committee.
Code VII of the Schedule IV of the Act requires the IDs to convene at least one meeting in a year without the presence of non-IDs and members of management which is called a ‘separate meeting’. The objective of conducting a separate meeting is to allow the IDs to discuss and evaluate the performance of the company, its chairperson, and other directors. It also allows the IDs to assess the quality, quantity, and timeliness of the flow of information between the management of the company and the board of the company which is necessary for effective and reasonable performance of the duties by the BoD. However, the powers of evaluation are reciprocal. The entire board also has the power to evaluate the performance of the IDs and the decision of whether to extend or continue the terms of appointment of the IDs is taken on this basis.
The SEBI has also brought in amendments to board independence requirements under the Model Listing Agreement to align it with the Act and adopt “best practices on corporate governance”. The provisions of Section 149(3) of the Act have been replicated by the SEBI in Clause 49(II)(B) of the Listing Agreement. The listing agreement also provides a limit on the number of directorships that a person can undertake while serving as an independent director. A person cannot serve as an independent director in more than seven companies at a time and if a person serves as a whole time director in any listed company, then the limit on his directorship as an independent director in other companies comes down to three.
Balancing the wide arena of responsibilities and obligations imposed on the IDs under the Act and to ensure that the IDs are not fastened with the liability in the affairs of the company where there is no involvement on their part, the Act provides that IDs may not be held liable for an offence by the company unless it is established that they had knowledge of the act and consented or connived in its occurrence. The Act provides that the “knowledge” of the ID can be attributed through board processes, therefore the records of a board meeting such as the minutes are enough to establish that the ID had “knowledge” of the act leading to an offence by the company. Further, the Act also provides that the ID may not be held liable if it can be proved that he acted diligently. There have been various judgments from the Supreme Court and several high courts where the IDs have not been held liable in the affairs of day to day management of the company. The liability instead, has been fastened on the people who had been in-charge of the affairs of the company and were responsible for the actions taken on behalf of the company. (See, Central Bank of India v. Asian Global Ltd., (2010) 11 SCC 203, National Small Industries Corpn. Ltd. v. Harmeet Singh Paintal, (2010) 3 SCC 330)
The reader may also note that the Act ushers in significant provisions regarding the constitution of the BoD and functioning of directors of the company. In our next article we will study the duties of directors (including IDs) from a legislative and judicial perspective and its impact on board independence and liability. We will also examine certain provisions of the Act which fix specifically liability on executive management or the BoD.
(Jitender Tanikella is a corporate and tax lawyer with an advanced law degree from Columbia University. Anirudh Rastogi is a general corporate lawyer with an advanced law degree from Harvard University. They are part of Tanikella Rastogi Associates.)
– llan, Kraakman, Subramanian, Commentaries and Cases on the Law of Business Organization, (Wolters Kluwer, 2009) 3rd ed., at 98.
– Umakanth Varottil, “Evolution and effectiveness of independent directors in Indian corporate governance”, Hastings Business Law Journal, Summer 2010, Volume 6, Number 2, Page 281.
– Jay Dahya & John J. McConnell, “Board Composition, Corporate Performance, and the Cadbury Committee Recommendation” (2005), available at http://ssrn.com/abstract=687429
– Erik Berglof and Ernst Ludwig von Thadden, “The Changing Corporate Governance Paradigm: Implications for Transition and Developing Countries” (1999), available at http://ssrn.com/abstract=183708
– Cadbury Committee: FINANCIAL REPORTING COUNCIL, REPORT OF THE COMMITTEE ON THE FINANCIAL ASPECTS OF CORPORATE GOVERNANCE (1992) available at http://www.ecgi.org/codes/documents/cadbury.pdf.
– Financial Reporting Council, The Combined Code on Corporate Governance, Jun. 2008, available at http://www.frc.org.uk/CORPORATE/COMBINEDCODE.CFM
– Report of the Kumar Mangalam Birla Committee on Corporate Governance (Feb. 2000), available at http://www.sebi.gov.in/commreport/corpgov.html.
– Report of the SEBI Committee on Corporate Governance (Feb.2003), available at http://www.sebi.gov.in/commreport/corpgov.pdf.
Seeking greater transparency and corporate responsibility, the Companies Act, 2013 (“New Companies Act”) has changed the role of auditors in companies.
Discussions about the role of auditors took center stage in the United States after a number of corporate scandals — the best documented of them being the Enron scandal, which sounded the death knell for its auditor, Arthur Andersen. Reacting to this scandal, the United States passed the Sarbanes Oxley Act, 2002 (“Sarbanes Act”).
This law established a separate body for the independent oversight of public company audits. This ended more than hundred years of self-regulation of the public company audit profession. The Sarbanes Act also prescribed that all audit committees (in listed companies) be independent of the management. This independent audit committee, rather than the management, would be directly responsible for the oversight of the external auditor. Additionally, audit firms were prohibited from providing certain non-audit services to the companies they audit.
All these provisions — ensuring that auditors are independent, free from all external influences, and solely responsible for doing their job efficiently — stem from the basic motive of increasing their accountability. Since its notification, the Sarbanes Act has been both critiqued and applauded.
In India, the Satyam scandal brought to the fore the inadequacies in the regulatory scrutiny of accounting. It is shocking that B. Ramalinga Raju could stand before the company’s board and admit that he had falsified accounts for “several years” to stave off a takeover, when a reputed accounting firm such as Price Waterhouse India (“PWC”) had been auditing their accounts for several years. While PWC claimed that they had received adequate evidence from Satyam and had carried out audits in accordance with applicable Indian auditing standards, the scandal begged the question whether it could have been averted if there had been stricter regulatory scrutiny of auditors. The following questions were also asked: Should a company be forced to rotate its auditors? Should there be a greater liability on auditors to deter such scandals? Let us now see whether the New Companies Act provides any answers.
Under the Companies Act, 1956 (“1956 Act”), an auditor was appointed at the annual general meeting, for a term of one year. Under Section 139 of the New Companies Act, an auditor will be appointed at the first annual general meeting and will hold office till the end of the sixth annual general meeting, though its appointment will be ratified at every AGM.
The New Companies Act (Section 139(2)) read with the draft rules provide for the mandatory rotation of auditors. Individual auditors will be compulsorily rotated every five years and the audit firm will be rotated every ten years in all companies except one-person companies and small companies. This step was inserted to ensure that auditors do not increase their familiarity and reduce their independence by continuing to audit a company for an unlimited period of time. One questions however, whether such stringent requirements are needed in private companies.
A more basic question is whether the rotation of auditors really results in independence? The Standing Committee on Finance reviewing the Companies Bill was sure that rotation does in fact lead to independence. On the other hand, some feel that companies do not have much choice in relation to auditors, and that such rotation may lead to cartelisation among large audit firms. Another argument is that the rotation policy discourages small and medium-size audit firms from investing in technology and training because of the uncertainty of securing another client of the same size operating in the same industry, given that there are only a few large players operating in a particular industry. Arguments from both the sides appear to have some strength.
A cooling period of five years is also prescribed (Proviso to Section 139(2)) before the reappointment of auditors who complete one term. The same company cannot reappoint such auditors or audit firms for the next five years after completion of one term.
Similar to the Sarbanes Act, the New Companies Act in Section 144 lists a few services that a company’s auditor cannot provide, directly or indirectly, to the company and its holding and subsidiary companies. The intent is to ensure that the auditor avoids any conflict of interest arising from the provision of other services such as accounting and book keeping, internal audit, management, and actuarial and, investment advisory services.
Tribunal’s power to remove auditors
While no separate regulatory body has been set up to regulate auditors, the National Company Law Tribunal (“Tribunal”) has (in addition to the company itself) the power to order the removal of auditors. The Tribunal under Section 140(5) can order a company to remove its auditor, if it believes the auditor has acted in a fraudulent manner, or abetted or colluded in any fraud.
The New Companies Act also enhances the accountability of auditors. It does so by placing on auditors, the onus of reporting fraud noticed by them, during the performance of their duties (Please see the draft rules).
(Deepa Mookerjee is part of the faculty on myLaw.net.)