1. Corporate governance: Legalising the spirit, but will it really work?

Corporate governance: Legalising the spirit, but will it really work?

In OECD’s definition, corporate governance is a system by which business corporations are directed and controlled based on the fundamental principles of accountability, responsibility and transparency.

By: | Published: November 2, 2017 5:11 AM
In OECD’s definition, corporate governance is a system by which business corporations are directed and controlled based on the fundamental principles of accountability, responsibility and transparency.

A committee under Uday Kotak, tasked with formulating measures to enhance corporate governance by the Securities and Exchange Board of India (Sebi), has proposed changes which, if implemented, would have far-reaching consequences for the way business entities are regulated and boards and independent directors function. In OECD’s definition, corporate governance is a system by which business corporations are directed and controlled based on the fundamental principles of accountability, responsibility and transparency. This determination is significantly more grounded in rules and regulations than what the committee suggests—which is a combination of both de facto and de jure measures—a clear departure from governance emanating from processes and systems and leans towards codifying principles in many of its recommendations. Sebi governs markets through laws and rules, breaches of which have sanctions, including criminal prosecutions. Therefore, recommendations for changes should have been within a framework of rules, moving away from expectations arising out of ethical standards and values, which are essentially best practices or codes. In attempting to codify constructs of corporate and boardroom behaviour, which is often qualitative, we often evaluate corporate governance from a lens of ethics and virtue and, hence, the results get a moral undertone.

The existing relationship of directors and management with a company and its shareholders is embedded in law, and their roles, responsibilities and consequent liabilities—either personal or collective, civil or criminal—are well-codified by law. Affirmative corporate action or failure to safeguard needs to be judged based on facts and evidence, and measured against the construct of laws, which drives a contractual relationship between shareholders, regulators, creditors, lenders, etc, and the company, its board and management. This determination from a lawmaker’s and the company’s perspective has to be legal and evidence-based, rather than measured with a moral compass. The report has some far-reaching recommendations on material related party transactions, including payment for brand or royalties, where it says that such transactions should be voted by the majority of minority shareholders, which is in line with the earlier drafts of the Companies Bill.

The mechanisms of oversight of unlisted companies include review of utilisations of material loans or setting boundaries for remuneration to promoters and executive directors, enhanced disclosures of financial ratios, credit rating, etc. These measures are definitive and will create more transparency and accountability. However, when it comes to qualitative aspects like its recommendation on enhancing independence of directors ‘in spirit’ by having at least half the board of all listed companies consist of independent directors, a process of self-certification of independence of mind by the director and one done by the rest of the board on their view of the individual’s independence gets tenuous. Absence of what constitutes or is a benchmark for such a qualitative judgement, leaves interpretation of independence of mind very subjective and will probably result in a round of ticking boxes.

The view that a minimum size of the board has to be mandated or a non-executive director could be the chairman of the board for those companies having a public shareholding exceeding 40% leaves most family or government-owned companies out of the purview. Moreover, there is very little empirical evidence that such measures create better governance. The proposal regarding board matters which are critical to business and omnipresent like strategy, risk, succession planning, etc, mandated to be discussed in one board meeting clearly questions the judgement of boards in India. Many of the committee’s recommendations are based on rectitude, but it doesn’t debate on alternative points of view or refer to the empirical evidence on which their far-reaching conclusions are based, making it difficult to understand the reasoning.

Inclusion of a statement like “A confirmation that the board of directors has been responsible for the business and overall affairs of the listed entity in the relevant financial year and that the reporting structures of the listed entity, formal and informal, are consistent with the above” in the certification process has consequences. A majority of the board would be independent or non-executive, and by definition non-working. Now, should such a board be held responsible for business results of the company, and in case there is a loss or lower profits, be responsible to all the stakeholders for such losses? Does this transfer the risks of business to the board and its independent directors? Besides, how does such a board certify that informal reporting structures are in line with the business and overall affairs?

The committee could have made a strong impact on some areas like stakeholder committee, which could have been made more inclusive, rather than taking care of just the shareholders or stockholders, and aligned with Section 166 of the Act of 2013 which makes directors responsible to all the stakeholders but does not define how. The debate between principles and rules in respect of corporate governance is as old as the subject itself. Principles get manifested in codes or guidance, but regulatory intent is to create oversight through a legal process and undertone. The overlap of guidance into laws when it comes to corporate governance becomes a hazard for those who are responsible to implement it, including the regulators.

We need to define the path India would follow—whether we align to principles of comply or explain school or lean on those founded by rules? An amalgamation of both imperils free business enterprise through a shift to excessive caution and heightened accent on compliance. This weans us from the benefits from operating in a fair market regime, where markets determine rewards or penalties for failure to meet their expectations, which are normally brutal, quick and long-term. The risks and responsibilities of capital and oversight be shouldered fairly by all the stakeholders, from boards, management, regulators, markets and investors. Else, the office of the independent director will soon become the office of the scapegoat, as the responsibility of oversight and accountability continue to be foisted on them, and corporate India will probably see an exodus from this institution, creating a void in governance landscape.

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