corporate governance and finance(notes for exam)

8/8/2019 Corporate Governance and Finance(Notes for Exam)

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Dear Reader,

This reading material consists of a total of 52 pages and is to the best of my knowledgesufficient. Also the reference for the material is Taxman, the handouts, slides and other

typed material, Khan and Jain and my class notes. Please ask Ankita, Janhavi and Geetan

incase any doubt arises as regards Corporate Governance or Geetan incase you want toknow something in Financial Management. You may still want to refer to any other

material (Im still a little unsure as to which one must be used). Happy Reading & Best of

Luck!

Regards,

Ankita, Janhavi and Geetan

CORPORATE GOVERNANCE AND FINANCE

Unit II- Corporate Governance- agency theory notebook

CORPORATE GOVERNANCE: AN INTRODUCTION

CONCEPT:

1. Refers to an economic, legal and institutional environment that allows companies

to diversify, grow, restructure and exit and do everything necessary to maximise

shareholder value2. Governance deals with laws, procedures, practices and implicit rules that

determine a companys ability to take informed managerial decisions.

3. Milton Friedman defines corporate governance as the conduct of business inaccordance with shareholders desires, which generally is to make as much money

as possible while conforming to the basic rules of society embodied in law andlocal customs. This is CG in the narrowest sense.4. Simplest and most common definition of CG is given by the Cadbury report is

CG is the system by which businesses are directed and controlled

5. OECD principles: CG... Involves a set of relationships between a companysmgmt, its board, its shareholders and other stakeholders. CG 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.

6. CG represents the moral, ethical and value frameworks within which a companytakes decisions.

FEATURES:1. There is no unique structure of CG in the developed world nor is one particular

type better than others.

2. Indian companies, banks and financial institutions can no longer afford to ignorebetter corporate practices.

3. CG goes far beyond corporate law, many other aspects are also considered like

quality and frequency of financial and managerial disclosure, commitment to run

company with transparency etc


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4. CG deals with laws, procedures, practices and implicit rules that determine a

companys ability to take managerial decisions.

5. CG code to have real meaning must first focus on listed companies. However,unlisted and private companies also need to be brought under the realm of CG

6. There is a diversity of opinion regarding beneficiaries of CG. The Anglo-

American system tends to focus on shareholders and various classes of creditors7. Irrespective of differences between various forms of CG, all recognise that good

CG practices must at the very least satisfy atleast two sets of claimants: creditors

and shareholders.8. The key to good CG is a well functioning, informed Board of directors.

NEED:

1. A corporate is a congregation of various stakeholders, namely, customers,

employees, investors, vendor partners, govt and society. A corporate should befair and transparent to all its stakeholders.

2. CG is about ethical conduct of a business. Ethical leadership is good for business

as the organisation is seen to conduct their business in line with expectations of all

stakeholders.3. CG is beyond the realm of law. It deals with conducting business affairs with all

fairness to all stakeholders and actions that benefit greatest number ofshareholders.

4. Corporate need to recognise that their growth requires that cooperation of all the

stakeholders and such cooperation is enhanced by the corporate adhering to the

best CG practices.5. CG is a key element in improving the economic efficiency of a corporate. Good

CG also helps ensure that corporate take into account the interests of a wide range

of constituencies. Also ensures that their Board is accountable to the shareholders,help operate for benefit of society

6. Failure to implement good CG can have a heavy cost beyond regulatory

problems.7. Credibility offered by good CG also helps maintain the confidence of investors

and reduce cost of capital and induce more stable source of financing

8. Often increased attention on CG is due to huge financial crisis. For instance theAsian financial crisis brought into subject the concept of CG in Asia.

9. CG is a concept, rather than an individual instrument. It includes debate on

appropriate management and control structures of the company.

10.The most common school of thought would have us believe that if mgmt is aboutrunning businesses, governance is about ensuring that it is run properly. All

companies need governance as well as mgmt.

OBJECTIVES OF GOOD CG:

1. To promote a healthy environment for long term investment.

2. To create trust in the corporate and its abilities.

3. To promote business development.

4. To improve efficiency of the capital markets.

5. To enhance the effectiveness in the service of the real economy.

PRINCIPLES:

1. People are more important than processes


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2. Shareholder accountability

3. External audit must be independent and penetrating

4. Disclosure and transparency are crucial to market integrity5. There must be an appropriate regulatory regime to back these obligations

OECD (organisation for economic co-operation and development):

1. Issued OECD principles of CG in 19992. Has become an international benchmark for policy makers, investors and other

stakeholders worldwide.

3. Advanced the CG agenda and provided specific guidance for legislative andregulatory initiatives of both OECD and Non- OECD countries

4. Financial stability forum has designated the principles as one of the 12 key

standards for sound financial system.

5. Principles offer non-binding standards and good practices as well as guidance onimplementation

6. OECD PRINCIPLES:

i. Ensuring the basis for an effective CG framework

ii. The rights of shareholders and key ownership functionsiii. The equitable treatment of shareholders

iv. The role of stakeholders in CGv. Disclosure and transparency

vi. The responsibilities of the board

IMPACT:

CG on performance, there are basically 2 models to be looked at:

Stakeholders model

Shareholders modelCOMPONENTS:1. It must include the framework of a strong performance orientation

2. It needs to be incorporate leadership and management imperatives that can lead to

strong financial and strategic performance3. Financial disclosure is a critical component of effective CG

4. Human resource management is another key component

5. Board of directors is the pillar on which The CG system stands.

ADVANTAGES/ BENEFITS:Good CG provides

1. A competitive edge in the global market

2. Enables companies to raise capital widely3. Easily and economically

4. Improves employee morale

5. Generates higher productivity6. Well governed companies last longer, stand the test of time and changing

environment

EFFECT OF NON-IMPLEMENTATION OF CG:


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1. A school of thought prevails on the cost-benefit analysis, whether the cost of good

governance reforms is too high

2. Failure to implement good governance procedure has a cost beyond mereregulatory problems

3. Companies suffer a significant risk premium when competing for scarce capital in

todays public markets

2.1 Introduction

1. Advantages of a company/incorporation are as follows-

(a) It can sue and can be sued in its own name.

(b) Limited liability(c) Perpetual succession

(d) Common seal

(e) Corporate personality

(f) Large funds may be raised easily(g) Sharing of risk

(h) Objectives of the Company have to be stated in the MoA and one cant go beyond thesame. In order to do an act outside the purview of the MoA, the MoA needs to be

amended.

(i) Free transferability of shares.

2. A Company is different from a sole proprietorship and a partnership. Some major

differences are-

(a) A sole proprietorship is a kind of business in which there is a single owner of thebusiness. In a partnership, there is more than just one owner.

(b)In both these cases, there is no perpetual succession. The death of the sole proprietor

or of the partner leads to the end of the organisation.(c)Also, these organisations dont require compulsory registration.

(d) Further, incase of a partnership, the liability of a partner may not be the same as what

he has actually invested, except in case of a limited liability partnership.

3. A very important concept in corporate law is the piercing of the corporate veil. This

doctrine was established in the case of Solomon v. Solomon. Solomon had a boot

manufacturing business under a sole proprietorship. He later felt that it would beadvantageous to him to form a company and hence distributed a share each amongst his

family members keeping the bulk to himself, so as to satisfy the requirements of English

law which makes it mandatory to have a minimum number of shares to incorporate acompany. His sons and he became the directors of the company. The company had

several creditors, Solomon being one of them. Later the company started doing badly, so

he filed for bankruptcy. Being a secured creditor, Solomon asked for satisfaction of hisclaims first. The other creditors instituted a suit for fraud against him. The House of

Lords on the contrary held that the shareholders (including Solomon) have a distinct

personality as compared to the company and thus Solomon was entitled to get his money

back. This case was highly criticized. Hence, incorporation leads to creation of a


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corporate veil between the company and the shareholder. Courts need to pierce this veil

and hold persons in default accountable.

4. The different types of companies are as follows-

(a) Public Limited Company(b) Private Limited Company

(c) S.25 Companies

(d) Joint Stock Companies(e) Foreign Companies

(f) Companies Limited by shares

(g) Public and Private Companies

(h) Family based Companies(i) Listed and Unlisted Companies

(j) PSU s

5. Differences between a public and private company-(a) In a private company, there can be a minimum of 2 members and a maximum of 50

members. In a public company, there can be a minimum of 7 members and there is no

maximum limit as such.

(b) In a private company, there are restrictions on transferability of shares. In a publiccompany, there are no such restrictions.

(c) In a private company, there is no concept of public issue although investments may be

made by directors, their relatives, etc. In a public company instead, deposits can beinvited from the public.

(d) In a public company, an existing shareholder of the company doesnt have the pre-

emptive right of purchasing shares of the company unless specified in the AoA. Theexisting shareholders of a private company have a pre-emptive right to purchase shares of

the company. This is primarily so that the limit of 50 is not crossed.

6. As per S.111 of the Companies Act, the Directors of a Company have a right to refuse

registration of a person as shareholder/member. This is only in case of a private company

(Amendment of 2000 stated that this provision cannot apply to a public company) as in a

public company there are no restrictions on transferability of shares. This is generallydone as private companies are essentially closed concerns. Also, an increase in the

number of shareholders would lead to crossing the statutory limit of 50.

7. A company is very vaguely defined under the Companies Act. As per the Act, acompany is one which is registered under the Companies Act.

8. There is a difference between winding up and dissociation of a company. Winding up

leads to dissociation and is a long process by itself. Liquidators need to be appointed todecide about the distribution of assets. Dissociation is when the company actually comes

to an end. Hence, it may take a very long time and this might lead to depreciation in value

of assets, development of new technology, etc.

9. A person can become the director of a maximum of 15 companies.


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10. As per the Companies Act, 11% profits must go to the Company.

11. A company is formed in the following manner-

(a) Promoters come up with the idea of forming the company and float the same amongstothers and get consensus.

(b) Permission is sought from the Registrar of Companies.

(c) Once the registrar is satisfied that all requirements have been met, he gives permissionby way of a letter/certificate of incorporation. For public companies, even a letter of

commencement is required from the registrar.

(d) Now shares may be floated, funds may be raised and the company can be started. Acompany needs to be compulsorily registered with a stock exchange before it floats its

shares.

12. The basic documents required by the registrar to give permission are the MoA and theAoA. This is mainly to know about what projects the company would indulge in, sector

in which it is working, financial status, etc.

13. The MoA states the objects of the company and the framework within which it should

work. It must always comply with the Companies Act. An AoA on the other handprescribes the internal rules and regulations which govern the company and the conduct

of its members. The AoA must never contain what is not allowed under the MoA. Non-adherence to the MoA and AoA will attract penalties. It may also lead to repudiation of

contract with the company. If the company doesnt continuously follow its objective, it

may be wound up (loss of substratum).

14. The MoA must necessarily contain the following 5 clauses-(a) Name clause- This must state the name of the Company. Such name must not be the

name of another registered company as it leads to ambiguity and may even lead to fraud.

A company cannot also register with a name which has bharat, national, hindustan,etc. in it. The name of a partnership generally has the name of its partners.

(b) Liability clause- This clause shows the liability of the company which may be limited,

unlimited, guarantee liability (company where directors guarantee to pay more than whatthey have put in-check), etc.

(c) Registered office clause- This specifies the name of the companys registered office

where all the official communications would be sent. Further, the Companies Actprovides that AGM s must be held in a city where the registered office of the company is.

(d) Capital clause- The current financial status of the company need not be depicted as

the promoters and others wouldnt have collected as many funds. What needs to be

shown is the authorized capital or the amount the company wishes to raise by way ofpublic issue in the future. For a private company, minimum authorized capital is 1 lakh

while for a public company it is 5 lakhs. The authorized capital is the maximum a

company can collect. It cannot go beyond this no matter how many times shares areissued. But only a part of the authorized capital is issued to the public at a certain point of

time. This is the issued capital. The entire amount of authorized capital need not be

issued. Out of this, the public may either oversubscribe or undersubscribe shares. This isthe subscribed capital. A company cannot go for allotment of shares unless 90% of its

shares have been subscribed to. Generally, underwriters take up shares to fulfill this

requirement under an underwriters agreement. Next is the paid up capital or the amount

actually received by the company from shareholders. Generally the company goes for


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calling on shares rather than floating shares when it is in need of funds. The shareholders

owe a debt to the company which needs to be paid back when asked for. If not paid back,

the company may forfeit shares of the shareholder and give it to someone else.(e) Object clause- This final clause mentions the objects of the company and the

boundaries within which it must work.

14. The MoA is a public document. Once a company is registered, any person from thegeneral public may approach the registrar of companies to show the MoA on payment of

a certain fees.

15. The MoA is generally drafted flexibly so that it doesnt require frequent amendmentslater on.

2.1.1 Shareholder model and Stakeholders model

1. A share is the smallest indivisible unit of a company. A share may not be further

divided but there may be joint ownership of a share.

2. Generally, shareholders interest is given primacy in a company as they are regarded as

the owners and major stakeholders of the Company. The shareholder theory focuses juston this.

3. On the other hand, there is a stakeholder theory which states that there are otherstakeholders as well to whom the company is responsible and these stakeholders are

equally important as shareholders. The stakeholders in a company include shareholders,

employees (including directors), creditors, suppliers, customers, investors, government,

society, etc.4. The reasons why these stakeholders associate with the company may be illustrated

with the help of the following table-

Sl.

No.

Stakeholder Economic Return Duration Ownership Risk Hedg

risk1. Shareholder Dividend (only

when profitgenerated and

dividend declared),

Price on sale of

shares

Depends on

shareholder.

Intangible

property.Ownership

but no

regulation.

Shareholders give shares

to directors

in trust.

Value of

shares mightdiminish due

to economic

recession, lack

of buyers,political state,

etc.

Monit

sharemarke

invest

comp

whosehealth

good,

2. Creditors Priority in payment

when company iswound up,

especially in case of

secured creditors.

Also, when time ofassociation with

company ends,

creditors must be

Generally time

specified.

Problem of

lesser amountsbeing paid

back

(especially in

limitedliability

companies)

when more is

Becom

securecredit

ascert

wheth

not thcomp

gener

profit


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repaid. invested,

incase thecompany goes

bankrupt.

charg

higheof inte

and as

for

periodpaym

3. Directors Paid remuneration.

Also paid sitting

fees for every board

of directorsmeeting.

Depends on

whether the

person is a

permanent(maximum1/3 of

board) or a

rotationaldirector

(minimum 2/3of

board).Rotationaldirectors change

every AGM

unless

reappointed.They can have a

maximum term

of 3 years. Incaseof independent

directors, one

term lasts for 3

years and theyhave a maximum

of 3 terms.

They have the

risk of

managing the

affairs of thecompany and

are the first

ones to beheld liable in

case of any

default.

They

act in

intere

thecomp

and it

varioustakeh

and n

their operson

intere

4. Employees Salary/remuneration

paid.

No fixed tenure

as such. Depends

on ones skills.Company may

terminate

employment bygiving a 3

months notice.

Risk of being

removed.

Depen

the so

relatiomaint

with

compemplo

skills

5. Community Employment,consumer goods,

infrastructure, etc.

Depends on howlong a company

exists.

Environmentalhazards

(Bhopal Gas

Tragedy),exploitation of

labour (Nike),

etc.

Exerceffect

check

compway o

basic

awarelitigat


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etc. M

stoppurch

produ

5. As per the stakeholder theory, incase there is a conflict of interests, interests of certainstakeholders including shareholders must be sacrificed or moderated to fulfill the basicdemands of other stakeholders.

6. However, the stakeholder theorists greatly underestimate the extent to which

shareholder interests may help in furthering interests of other stakeholders.

7. Milton Friedman once said that social responsibility of business is to maximizeprofits. This is opposed to the stakeholder theory which states that a company owes

responsibility to all its stakeholders on whom it depends. There are several types of

stakeholder theories given, which are as follows-(a) Ontological Stakeholder theory- This theory is about the fundamental nature and

purpose of a corporation. It says that the very purpose of a firm is to coordinate

stakeholder interests.(b) Explanatory Stakeholder theory- This theory explains as to how corporations and their

managers actually work taking into consideration stakeholder interests.

(c) Strategic Stakeholder theory- This theory states as to how devoting resources and

attention towards stakeholder interests will lead to positive outcomes.(d) Stakeholder theory of Branding and Corporate Culture- This theory states that how

paying extra attention to stakeholders improves a companys branding and adds to its

corporate culture.(e) Deontic Stakeholder theory- This theory states the legitimate interests and rights and

stakeholders vis--vis the duties of corporate management.

(f) Managerial Stakeholder theory- This involves incorporating theories such as human

resource management, leadership, operations research, etc. which helps leaders andmanagers realize the benefits of deontic stakeholder theory.

(g) Stakeholder theory of Governance- This theory deals with how stakeholder groupscould control the management.

(h) Regulatory Stakeholder theory- This theory is about how the government must

regulate businesses to protect certain stakeholder rights and interests.

(i) Stakeholder theory of Corporate Law- It deals with how corporate law should berestructured to reflect principles and practices under the Ontological and Deontic

theories.

8. The deontic theory is particularly related to Corporate Social Responsibility (CSR).

9. The stakeholder theorists firmly believe that all these theories need to be put in place

for a company to work efficiently to serve the interests of stakeholders. For example, if amoral argument exists that it is the obligation of a company to serve interests of

stakeholders, there exists a responsibility on the government to regulate businesses in a

manner that they cater to such interests. Further, every company must act in a manner as

if there was actually a regulation.10. Further, corporate law must be brought into the picture to regulate the entire process.

Corporate law is that which defines relationships between owners, the board and


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managers. The most basic right of a shareholder in particular is to get information from

managers as regards buying and selling of shares, voting rights with respect to board

membership and basic corporate policies. The primary reason why stakeholder theoristsshow an interest in corporate law is because of CSR.

11. However, there are certain implications of the same. Managers who pursue CSR as a

goal may be fired by current shareholders or even by future corporate raiders for notfurthering shareholder interests, the basic goal of every corporation. This is also because

CSR and other stakeholder friendly policies may actually end up depressing share prices

and may fail to maximize profits. Stakeholder friendly approaches may also lead toseveral agency problems.

12. This brings us to the principal-agent theory. Here the shareholders are the principal

while the managers are their agents. The principal may use either moral persuasion or

incentives to make its agents work efficiently to further its interests. However, theinterests of the corporation may be profit of the enterprise as a whole but this may be

contrary to the individual interests of persons within the corporation. A clash of interests

between shareholders and managers often leads us to characterize them as being in a

principal-agent relationship.13. A major problem arises when the agent/manager holds information which is material

to satisfaction of his interests. This leads to a moral hazard when an agents action basedon the information he has is only imperfectly visible to the principal. For e.g. managers

may waste resources to further their interests, etc. Another problem relates to a situation

when an agent has some private information prior to entering into relations with the

principal.14. Such problems may be reduced by way of compensation schemes, removal or threat

of removal, hostile takeover, etc. However, this becomes very difficult to control owing

to the wide disparities in information available to shareholders and managers. Also,shareholders do not have the time or resources to oversee the management.

15. The problem mainly lies with multitasking. Managers are expected not only to

maximize profits but also to cut costs, project a good corporate image, etc. Sometimestasks may be complimentary in the sense that investing efforts in one task would reduce

costs as regards the other tasks. But, this is only an ideal situation. The difficulty arises

incase of substitutes where doing one task would mean neglecting the other or increasingthe costs of the others. A system of dull incentives has been suggested to combat the

same so that managers would want to divert atleast some of their energy performing

every task possible.

16. However, providing an incentive becomes difficult when the principal lacksinformation necessary to determine how various tasks must be balanced against each

other. If the agent is given discretion with respect to the same, there will be no

accountability.17. Further, the principals include not only the shareholders but other stakeholders as

well. All such persons would balance tasks in their own way and automatically it would

revert back to the system of dull incentives yet again.18. There is also the triple bottom line principle which requires the management to

impose social and environmental bottomlines in addition to net income which will in turn

worsen the multitask incentive problem and the existence of multiple principals would

make the situation worse.


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19. This is one of the major problems associated with CSR and implementation of the

same by managers. This can be seen from the example of State owned enterprises which

ended up being in heavy losses and debts due to special focus on interests of stakeholdersand CSR. These enterprises where handed over the broad responsibilities of

macroeconomic projects, pursuance of national interest, redistribution, acting as a model

employer and reduction of negative externalities.20. Managers of such enterprises were not efficient primarily because of lack of proper

incentives. Also, there was no threat of a hostile takeover incase of continuous losses,

mismanagement, etc. There were also several agency problems.21. Agency problems arise mainly when managers are given multiple tasks and then

asked to do the best they can. This brings in a sort of vagueness into the system. This

provides managers an opportunity to pursue their own interests. Incase of any losses, the

management can easily say that it is due to losses with respect to a particular task theywere handling and not due to inefficiency. They could easily say that costs increased with

respect to certain activities in order to meet certain other objects.

22. Such problems may be resolved not only by incentive and internal controls but also

by good faith and efforts on the part of the management. Further, the principal may alsospecify to the management, the average balance he would like to see as regards the

various objectives. For that the principal must be aware of the profits generated and costsincurred with respect to various activities.

23. Another problem which may arise is the multiprincipal problem which may lead to

provision of incentives from various principals. When there is a clash between these

incentives, it will lead to confusion in management as to which interest they must caterto.

24. Managers may also try to play one group against the other strategically to avoid

accountability. The ability of management to leak out information which only they haveto certain stakeholder groups helps them do this.

25. The problem with major stakeholder groups other than trade unions is that they are

generally very poorly organised and hence cant exercise direct control over themanagement. A probable solution may be stakeholder representation on the board. On the

contrary, shareholders are in a better position to control the management.

26. Hence, considerable reforms are required with respect to corporate governance forCSR in manner by which shareholders interests are not neglected as well.

2.1.2 Corporate and Social Responsibility-

1. This is mainly to serve the interests of the community as a stakeholder.

2. It is not a compulsion on the company.3. This helps develop a positive attitude by people towards the company and it makes

them favour the company while purchasing products, applying for jobs, etc.

4. It also helps companies to get skilled labour from amongst the local population in thefuture especially when then establish educational institutions, hospitals, etc.

5. Although, it provides only long term benefits, it instills a sort of confidence amongst

the public at large.


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6. However, a company must necessarily incorporate CSR in its MoA. In Lakshman

Swami Mudaliar v. LIC, it was held that if the MoA doesnt specifically talk about CSR,

the directors of the company would be made responsible for any spending done withrespect to the same.

7. CSR is very closely connected with human rights as can be seen from the case of Nike

who exploited the labour market in 3rd

world countries due to lack of stringent labour andenvironmental laws. Other examples are those of the carpet weaving business in India

wherein shipments were sent back as the industry employs child labour. Another such

example is that of the fireworks industry.8. Recently, the Norms on responsibilities of Transnational Corporations and Other

Business Enterprises with regard to Human Rights were approved by the UN Sub-

Commission on Promotion and Protection of Human Rights. These have been submitted

to the UN Commission on Human Rights for approval.9. Previous examples of human rights violations by companies include Krupp Industrial

firms using slave labour in Nazi Germany, IG Farben Industry in Germany using slave

labour for producing poison gas used in concentration camps, forced labour practices

followed by companies in Congo during the civil war, the Bhopal Gas Tragedy (readhandout), etc.

10. Such rights to be protected by companies have been impliedly realized by the UDHR,ICCPR, International Convention on All Forms of Discrimination against Women,

International Convention on All Forms of Racial Discrimination, etc.

11. Other attempts are guidelines given by the OECD, UN Commission on Transnational

Corporations, ILO, the Global Compact initiated by Kofi Annan, etc.12. Some of the major problems associated with such norms were non-enforceability, a

very broad view of human rights with respect to companies taken, problems as to whether

the norms should relate to TNC s or other businesses as well, etc.13. Some NGO s and organisations like Amnesty International, Barclays have been trying

to create awareness and lay down norms with respect to CSR and Human Rights.

2.2 Corporations and need for Good Governance

2.2.1 Good Governance and ethics in Corporations

1. The three main aspects of good governance are transparency, accountability and

fairness.2. It is generally the board of directors or the auditors who may be made accountable for

acts done.

3. Fairness involves protection against insider trading and protection provided toinvestors. Insider trading involves exchange of inside information by employees and

others within the company with outsiders. Such information may then lead to unfair

advantage to outsiders who would deal with shares based on the information provided.Another component of fairness is equal pay for equal work.

4. Corporate Governance came about somewhere in the late 70s and the 80s. It grew

majorly in the 90s. Every governance mechanism has seen to have developed after some

corporate scam. For e.g. SEBI made new rules after the Harshad Mehta scam.


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5. Corporate Governance may have said to have started after the Watergate scandal

wherein there was a lot of political spying which on investigation revealed had been

funded by several corporates. President Nixon resigned after the incident and the UnfairTrade Practices Act was brought into the picture. Thereafter, companies had to

compulsorily provide accounts about what they were doing with peoples money.

6. In UK as well in the 80s a number of companies went bankrupt and thus the LondonStock Exchange appointed the Cadbury Committee to make recommendations for the

same.

7. The main problem was that huge companies showing large profits collapsed. Thismade the public question management practices in such companies. Hence, it affected

public confidence.

8. There are 3 stages in the downfall of a company, namely-

(a) Bad management- This is the first stage when profits start dipping, the confidence ofshareholders and creditors go down, etc. This is an early stage of detection and can be

managed with the help of internal controls. Further, shareholders might still want to stay

with the company.

(b) In the second stage, the profits dip further, shareholders start selling their shares andmoving out, creditors become more conscious and start charging higher rates of interest,

credit rating agencies which rate corporate performance also give bad reviews, there arenegative reviews by the media, etc. At this stage it becomes a little more difficult for the

company to bounce back. If the company still does nothing it goes into the 3rd stage.

(c) In this stage revival is difficult and the company may ask for external help from the

government and its agencies like the BIFR. This also comes under S.424 of theCompanies Act. This is the stage when the company goes in for revival and

rehabilitation. Generally there is a fund for the same wherein all companies contribute

about 1% of their profits.

9. Some important provisions under the Companies Act as regards good governance

include-(a) S.425- Voluntary winding up of companies or winding up by tribunals. After the 2002

amendment, winding up by courts has been omitted. (check)

(b) S.292A- Audit Committees (new addition after 2002 amendment)(c) S.192A- Postal Ballot system. It was suggested by the Kumarmangalam Birla

committee that this system be used for AGM s. There is as such no compulsion on

companies to go for the same. In 1997, a working committee was set up to look into this

system. It pointed out certain drawbacks like the problem of the mail reaching within acertain time period, lesser scope for discussion, etc. Also, since the method of present and

voting is followed in AGM s, the problem is that if the votes dont come in time, the

actual result may never be ascertained.(d) S.10- National Company Law Tribunal to decide all disputes in place of the Company

law board. From this tribunal the case would go to the appellate company law tribunal

and finally to the Supreme Court. However, this tribunal has not been set up as itsvalidity was challenged in the President Bar Associations case (2004) which is still

pending in the Madras High Court. Hence, the Company law board has been settling

disputes as of now.

(e) S.56- Prospectus which must give a true and fair picture of the company.


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(f) S.5- meaning of officer in default.

(g) S.7-interpretation of persons according to whose instructions directors are supposed to

act.(h) S.12- formation of an incorporated body

(i) S.13-requirements of MoA

(j) S.14- form of MoA(k) S.15-Printing, signatures of subscribers of MoA. Subscribers automatically become

members of the company as well as directors.

(l) S.16-alteration of MoA(m) Ss. 26-31-AoA

(n) S.41- member of a company

(o) S.51- service of documents on company. This has to be sent to the registered office

and service of documents on directors is regarded as knowledge of the company if doneduring the course of employment.

(p) s.58-experts consent to issue prospectus

(q) S.69-allotment of shares

(r) S.71- effect of an irregular allotment. This gives one the right to avoid the contract.(s) Ss. 165-197-meetings- Includes GM, AGM, BoD meetings, Shareholder meetings,

creditors meetings, etc.S.166- AGM s. There must be atleast 1 AGM every year and the gap between 2

successive AGM s cant be more than 15 months.

S.174- Quorum. This is required for a valid meeting.

S.171-Notices. The general notice period is 21 days but the same may be changed in theAoA. Meetings are generally called by directors. But, they can also be called by

Shareholders in which case they must inform the board about the same. If one has 1/10th

of the paid up capital of a company, he may ask the directors to convene a meeting.(s1) S.205-dividends and their payment

Ss. 209-234- Accounts and Audits-

(t) S.215- authentication done by directors(u) S.217-Boards report with respect to financial matters

(v) S.221- disclosures

(w) S.224-remuneration of auditorsS.226- qualifications and disqualifications of auditors

(x) S.227- powers and duties (check)

(y) S.397 and 398-oppression and mismanagement

(z) S.433- winding up by court

10. Generally Shareholders cannot monitor the Company due to reasons mentioned

earlier and also because they are too many in number.11. Hence, there are provisions for independent directors, audit committees, etc. to

monitor directors and others. However this becomes very difficult especially in family

based companies wherein actually only one person is at the helm of affairs.12. It has been stated that both control and encouragement with respect to directors is

required. When directors are held accountable it makes them take calculated risks

because of which the business becomes profitable.


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13. Generally listed companies must follow corporate governance principles else they

would be delisted. As regards unlisted companies, they can choose what principles they

would want to follow.

2.2.2 Need for Governance in Various forms of Companies

Family Based Companies-

1. Among the most prominent corporations in the world are the ones controlled by largebusiness families. These firms are passed on to heirs and show signs of dynastic control.

2. A family firm at the apex controls publicly traded firms which then control other

publicly traded firms and so on. At each level of the pyramid, public shareholders

contribute a minority equity stake.3. In these firms, the managers serve at the pleasure of the family and not the

shareholders.

4. Although the owner of the company at the apex pyramid controls companies in the

lower tiers of the pyramid, its actual investment in such companies is often very less.Hence, these families can easily control a major part of the corporate sector as they

control assets worth a lot more than their actual wealth.5. The situation is very different in the US and UK wherein the firms are widely held and

are mainly free standing entities. They are widely held as they have no dominant

shareholder and are free standing because they own stock in no other domestically listed

firm and no other domestically listed firm owns stock in them.6. One advantage of such family based firms is that they are free from agency based

problems. This is mainly because large shareholders would rarely give a chance to

managers to neglect the firm and deal in mismanagement.7. However, the major problem is that instead of the managers, it is the controlling family

which can actually end up spending a lot of public funds. This is mainly because such

firms hold shares of other firms in the pyramid as well which are publicly traded.8. Another problem is that widely held firms are threatened by hostile takeovers which

are not possible when it comes to family based firms. Also, institutional investors cannot

force their representatives on the board where 50% of the votes are held by members ofthe family.

9. Further, in such pyramids, there is generally a lot of transfer of funds from firms to the

controlling body. This is done by way of tunneling. (Read handout for exact meaning and

example)10. However, this effect is weaker in countries where there is better legal protection for

public shareholders and in pyramid firms for outside shareholders. Both law and large

independent shareholders help reduce tunneling.11. Hence, the contention that family based firms reduced agency problems may be

rebutted as agency problems still exist in firms at the lower levels of the pyramid. Also,

the controlling firm cannot be easily ousted and also due to tunneling.12. An argument in favour of such firms is that the controlling family is able to monitor

the activities of the firm more efficiently as compared to public shareholders. However it

has also been observed that such concerns avoided risks and curtailed expansion.


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13. Another argument presented in favour of these companies is that due to family

relationships, the directors are closer and hence there is smooth functioning of the

companys activities. This however has been contradicted by the fact that most familybased companies have a lot of in-fighting going on as in case of Reliance.

14. It has been seen that in economies where there is poverty, illiteracy, corruption, etc.

such firms work the best. It has been said that in such systems pyramid group firmsprovide capital and labour to each other. They also buy and sell goods amongst

themselves.

15. However a problem associated with this is that physical capital is often over used andmore productive applications outside the organisation are neglected. The more the capital

is efficiently allocated within the firm, the more misallocation of capital is there in the

economy.

16. Also, firms like these exist in corrupt nations as they have close connections withpoliticians and are more likely to return political favours by using the publics money.

17. Such families do not like the entry of professional managers who they feel cannot be

trusted and only work to further their self interest. They are generally allowed into the

firm through marriages.18. Generally a well developed legal and regulatory system would want the families to

sell out or allow outsiders into the firm so that greater control may be exercised.19. A reason why in some countries control pyramids do not exist may be their taxation

system as in case of the US wherein a tax is imposed at every level of the pyramid

thereby discouraging such organisations. Also, in the US, the Public Utilities Holding

Companies Act banned pyramiding outright among public utility firms.20. Another way is by levying an inheritance tax as has been done in Canada in the

1970s.

21. It has also been pointed out that in economies where there are control pyramids, thepolitics is mainly socio-democratic. While in countries where firms are widely held,

liberal politics thrives.

22. Another way in which such firms may be controlled is by introducing competition byway of liberalisation and globalisation.

23. Inspite of the existence of such firms in countries like Hong Kong, controls have been

exercised and the economic crisis of the 90s was combated because of a strong bankingsystem and equity markets.

CORPORATE GOVERNANCE IN UNLISTED COMPANIES

CG CODE FOR UNLISTED COS1. Unlisted companies are a significant part of the corporate world in India.

2. A number of Indian groups have deliberately moved into the unlisted sector,

attracted by less onerous reporting and other requirements and presumably not

deterred by potentially lower access to capital.


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3. While a strong corporate governance framework is in place for listed companies,

there is a need for enhancing the focus on unlisted companies to strengthen the

overall system.4. Accordingly, it is recommended that a separate corporate governance code for

unlisted companies may be brought out under the Companies Act by the Ministry

of Corporate Affairs, which takes into account the interests of stakeholders insuch companies.

5. Unlisted companies can voluntarily evolve and adopt a code of corporate

governance.

6. Trade and industry associations such as the CII, FICCI and ASSOCHAM can

play an important role in this regard. The Ministry can also consider mandating,

in respect of unlisted companies above a particular size, compliance with

applicable provisions of Clause 49 of the Listing Agreement.7. The role and responsibilities of the Ministry of Corporate Affairs may be

crystallised in the Companies Act itself, especially in the case of mergers and

amalgamations.

8. The committee pointed that the quality of corporate governance in Indiancompanies would be a key determinant in affecting their ability to attract capital,

business, global partners and quality manpower.

NEED FOR CORPORATE GOVENANCE IN UNLISTED COMPANIES:

1. Therefore the need to consider the relevance of OECD principles of

Corporate Governance in where non listed and often family / founder ownedcompanies play a pivotal economic & social role.

2. When unlisted companies go in search of external capital like venture capital

they face many challenges. Banks and financial institutions should considerimproving their monitoring of CG in non listed companies.

3. the controlling shareholder may use his position to deprive the non

controlling shareholder of influence over major decision and / orsignificant distribution of business earnings. In the absence of the above

external mechanism an alternate framework is needed to improve the

performance of unlisted companies.

4. The composition & role of management on Boards of unlisted

companies is of significance. Corporate Governance problems could be

minimised by appointment of competent rather than independent

professional outside Directors.5. There is need to build up know how on Corporate Governance in the courts.

6. Giving non-controlling shareholders full and timely access to

information enhances the governance of both listed and unlisted companies.7. The controlling shareholders close levels of monitoring and cheaper

intervention in the event of management failure, seem to entail better

performance in non listed companies.8. The financing structure of non listed companies can bring benefits

9. Protecting non minority interest(like non controlling shareholders) from

exploitation by controlling shareholders

10. A proper legal framework can induce desired manager and shareholder


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behaviour.

DEVELOPMENTS IN INDIA:

The Indian Govt plans new guidelines to bring unlisted PSUs under corporate governanceambit:

1. New Delhi, Oct 24: Underlining the need to bring in more accountability and

professionalism into public sector enterprises (PSEs), the government is set tochalk out new guidelines for corporate governance for unlisted PSUs.

2. At present, only listed PSUs are mandated to adhere to Securities and Exchange

Board of Indias (Sebi) corporate governance guidelines. The final guidelines arelikely to be ready in the next few months.

3. The Department of Public Enterprises (DPE) is working out guidelines in

consultation with the Standing Committee of Public Enterprises (SCOPE).

4. The present DPE guidelines for unlisted companies state that at least one-third ofthe directors on a PSU board should be independent directors. According to

official sources, most of these posts lie vacant in a large number of PSUs.

5. Increasing the number of independent directors on PSE boards will facilitate more

competence and transparency in their functioning.6. According to sources, out of a total of 242 PSEs functional in 2004-05, about 200

are unlisted, implying that a majority of the PSUs are out of the ambit of Sebisguidelines for corporate governance, which stipulate that at least 50% of members

on the board of a listed company should be independent ones.

FICCI IN NEWS

1. Panel calls for constant review of code, March 31, 20092. The Committee on Financial Sector Assessment, which released its report on

Monday, suggested several measures to strengthen the corporate governance

practices in the country. The committee was jointly set up by the Government andthe Reserve Bank of India.

3. According to the committee, certain requirements of Clause 49 of the Listing

Agreement were non-mandatory. Given the fact that listed companies are requiredto disclose the extent to which the non-mandatory requirements have been

adopted, the listed companies may be required to also disclose the reasons for

non-compliance of non-mandatory requirements.4. There is a need to strengthen the existing framework with regard to risk

management in listed companies.

5. Need felt for:

i. Transparencyii. Enforcement mechanism

2.3 International Perspective on Corporate Governance

2.3.1 Corporate Governance Committees in UK

(A) Cadbury Committee Report-


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1. This was the first corporate governance committee which defined the term as a system

of policies and principles which control the company.

2. It gave a code of good practices with 19 provisions dealing with board of directors,independent directors, committees, structure of committees, remuneration of directors,

etc.

3. It was constituted by the London Stock Exchange.4. It was mainly a comply or explain code. Whenever the company filed for annual

returns, they had to submit these forms.

5. The key recommendations include-(a) The BoD should include atleast 3 outside directors.

(b) Position of chairman and CEO to be held by 2 different individuals.

(c) Full disclosure of payment of chairman and highest paid director.

(d) Shareholders approval of executive directors contract exceeding 3 years.(e) Directors should establish a sub-committee of the main board mainly comprised of

outside directors to report on the effectiveness of the companys system of internal

control including mechanism for risk assessment and management.

Important Info-

THE BOARD OF DIRECTORS1. The board should meet regularly, retain full and effective control over the

company and monitor the executive management.

2. There should be a clearly accepted division of responsibilities at the head

of a company, which will ensure a balance of power and authority, such that noone individual has unfettered powers of decision. Where the chairman is also the

chief executive, it is essential that

3. There should be a strong and independent element on the board, with arecognised senior member.

4. The board should include non-executive directors of sufficient calibre

and number for their views to carry significant weight in the boards decisions.5. The board should have a formal schedule of matters specifically reserved

to it for decision to ensure that the direction and control of the company is firmly

in its hands.6. There should be an agreed procedure for directors in the furtherance of

their duties to take independent professional advice if necessary, at the

companys expense.

7. All directors should have access to the advice and services of thecompany secretary, who is responsible to the board for ensuring that board

procedures are followed and that

8. Applicable rules and regulations are complied with. Any question of theremoval of the company secretary should be a matter for the board as a whole. _

NON-EXECUTIVE DIRECTORS

1. Non-executive directors should bring an independent judgement 10 bearon issues of strategy, performance, resources, including key appointments, and

standards of conduct.

2. The majority should be independent of management and free from any

business or other relationship which could materially interfere with the exercise


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of their independent judgement. apart from their fees and shareholding. Their

fees should reflect the time which they commit to the company.

THE CODE OF BEST PRACTICEI. Non-executive directors should be appointed for specified terms and

reappointment should not be automatic.

II. Non-executive directors should be selected through a formal process andboth this process and their appointment should be a matter for the board as a

whole.

EXECUTIVE DIRECTORSi) Directors service contracts should not exceed three years without

shareholders approval.

ii) There should be full and clear disclosure of directors total emoluments

and those of the chairman and highest-paid UK director, including pensioncontributions and stock

iii) options.

iv) Separate figures should be given for salary and performance-related

elements and the basis on which performance is measured should be explained.v) Executive directors pay should be subject to the recommendations of a

remuneration committee made up wholly or mainly of non-executive directors.REPORTING AND CONTROLS

a. It is the boards duty to present a balanced and understandable

assessment of the companys position.

b. The board should ensure that an objective and professional relationship ismaintained with the auditors.

c. The board should establish an audit committee of at least three non-

executive directors with written terms of reference which deal clearly with itsauthority and duties.

d. The directors should explain their responsibility for preparing the

accounts next to a statement by the auditors about their reporting responsibilities.e. The directors should report on the effectiveness of the companys system

of internal control. The directors should report that the business is a going

concern, with supporting assumptions or qualifications as necessary.

(B) Greenbury Committee (1995)-

1. This committee looked into the problem related with senior executives getting a major

part of profits as remuneration. This was a matter of concern for investors.

2. Some of the main issues dealt by this committee were-(a) Role of remuneration committee in setting remuneration packages of CEO s and other

directors.

(b) Required level of disclosure needed by shareholders with respect to remuneration ofdirectors and whether there is a need to obtain shareholder approval.

(c) Specific guidelines for determining remuneration policy for directors.

(d) Service contracts requiring payment of remuneration to directors in case of removal

for unsatisfactory performance.


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3. This committee also recommended the constitution of a remuneration committee

composed of non-executive directors.4. However, it didnt gain much acceptance as it didnt lay down any new policies to be

followed and merely reiterated the Cadbury Committee Report.

(C) Hampel Report (1998)-

1. It focused on increasing the long term value of shareholders.2. It also focused on preventing abuse of discretionary powers by the Board.

3. It favoured greater involvement of shareholders with the Company.

4. It looked into areas of accountability and audits to be conducted.

5. The board was regarded as an internal control mechanism and hence had to look afterthe interests of shareholders.

6. The board was to also look into mismanagement.

7. It didnt look into aspects of remuneration as it didnt think that shareholders were

connected with it.

(D) Combined Code (1998)-

1. It mainly focused on consolidating the best provisions under the previous reports.

Another code came out in 2003.

2. It looked into shareholders interests as well as the way in which the board mustfunction.

(E) Myners Report-

1. It was given by Paul Myner who was commissioned by the government to look intofactors affecting investment decision making of institutions.

2. It was observed that various problems were created due to unrealistic demands of

pension funds thereby burdening investment consultants.3. Questions on objectives of fund managers came up.

4. Recommendations were given on decision making and the flexibility with which they

perform their functions.

2.3.2 Corporate Governance Committees in the US

2.3.3 Enron and Post Enron

1. The collapse of Enron happens to be one of the biggest corporate scams in the business

world. It has been said that the auditing firm Andersen couldnt detect mismanagementby Enron due to an unconscious bias, organizational flaws and emphasis on marketing

non-audit services to clients for profits. Sherron Smith Watkins had tried to

unsuccessfully blow the whistle on Enrons aggressive accounting policies.


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2. The prime job of an auditor is to compare financial statements of a company with other

notes about the firms assets and liabilities during a given period so as to assess whether

the company has presented a fair picture of its financial condition as per acceptedaccounting principles. However, this only provides reasonable assurance about the

veracity of the financial statements.

3. It has been observed that even in the most organised audit, fraud may not be as easilydetected as compared to unintentional errors. Thus, investors expect auditors to be a lot

more careful as regards frauds in financial statements and disclosures.

4. A jury convicted Andersen on the charge of obstructing justice. Andersen stated that itsaudits failed to require Enron to mention about 2 special purpose entities (SPE) in its

financial statements. At that time, it was required that unrelated parties must own an

investment upto atleast 3% of the fair value of an SPEs asset in order to avoid

consolidation. Originally, Andersens audit team declared that the unrelated parties heldmore than 3% of the subsidiarys residual equity and thereby fulfilling the required

criteria. However, later on Andersen claimed that it had reached such judgment in error

and asked Enron to correct the error. Immediately after Andersens conviction, the Wall

Street Journal in an article highlighted inadequate disclosures, questionable transactionswith other SPE s, premature recognition of revenue, etc.

5. The reasons for such an unconscious bias on the part of Andersen were said to be dueto the following reasons-

(a) Ambiguity- Accounting is an art and depends on the degree of skill and

professionalism exercised by the auditor. Also, auditing gives a company numerous

options to choose from.(b) Attachment- The auditor may give a clean chit to the firm due to present or future

business interests with the firm.

(c) Approval- An audit essentially endorses or rejects the accounting choices that theclients management has made.

(d) Familiarity- People are often less willing to harm individuals they know and such

relationships grow with time.(e) Discounting- This is the human tendency to place more emphasis on the short term

effects of decisions rather than long term effects.

(f) Escalation- Unconscious biases may also make auditors escalate only the minormistakes in the clients financial statements. Atleast on 4 occasions Andersen allowed

Enron to hide debt and inflate earnings.

6. When fees for non-audit services amount to a large part of earnings from the firm, theaudit firms tends to have bias towards the firm in order to save its business.

7. The Sarbanes-Oxley Act which came up subsequently after this scam consists of the

following provisions to solve such problems-(a) S.301- Required SEC to prescribe rules asking securities exchanges and securities

associations to prohibit listing of companies which dont have an audit committee

consisting primarily of independent directors in place. Such a committee has the power ofhiring, firing and compensating the companys auditors. This committee has been

instituted in most publicly traded companies.

(b) S. 201- It lists several services as prohibited services and out of the scope of audit

firms such as bookkeeping services, financial information systems design, management


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or human resource services, etc. The auditor may however render tax services to the

client.

(c) S.202- This section requires the audit committee to review all audit and non-auditservices.

(d) S.203- Most accounting firms cannot perform audit services for a publicly traded

company, if the lead audit partner or reviewing audit partner has performed audit servicesfor the company in its last 5 fiscal years.

(e) S.206- It prohibits an audit firm from auditing accounts of a firm which has employed

such a person to a high level position who had served in the audit team in the past year.Thus, a year of cooling-off has been suggested by the SEC.

(f) The rules also require the rotation of the lead and concurring partners on an audit team

every 5 years.

(g) The Act also creates the Public Company Accounting Oversight Board (PCAOB) toregister, regulate and inspect public accounting firms that audit publicly traded

companies. S.102 requires such companies to register with the PCAOB and each

application must contain a statement of the firms quality control policies for its

accounting and auditing practices. The PCAOB may also conduct investigation ordisciplinary proceedings when required.

(h) S.207- It directs the Comptroller General to study the effects arising from the limitson an audit firms association with a company and submit such reports to Congressional

committees within a year from the commencement of the Act.

(i) This Act doesnt apply to closely held firms or non-profit organisations.

2.4 Corporate Governance in India

2.4.1 Various codes and Corporate Governance Committee reports in India

(A) Kumarmangalam Birla Committee Report-

1. The BoD must consist of atleast 50% non-executive directors. If the chairman is a non-

executive director, the board must consist of atleast 1/3rd independent directors but if thechairman is an executive director, the board must consist of atleast 1/2 independent

directors.

2. An independent audit committee must be set up by the board.

3. The board should set up a remuneration committee to determine the companys policyon specific remuneration packages for executive directors.

4. The board should set up a committee under the chairmanship of a non-executive or

independent director to look into shareholders issues.5. The board should delegate share transfer responsibilities to an officer or committee or

to the registrar and share transfer agents who must look into the same atleast once every

fortnight.6. The Corporate Governance section of the Annual Report should contain details of

every form of remuneration paid to the directors including salary, incentives, etc.


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7. Board meetings must be held atleast 4 times a year with a maximum gap of 4 months

between 2 successive meetings. All information recommended by the SEBI committee

must be placed before the board.8. The Directors Report, Management Discussion and Analysis Report must all form

part of the annual report to shareholders.

9. All company related information like quarterly results and presentations made by thecompany to analysts must be put on the official website.

10. A special section must be dedicated to Corporate Governance in the Annual report

with details of the level of compliance achieved by the Company. This must highlightnon-compliance with any mandatory requirements and extent upto which non-mandatory

requirements have been adopted.

11. The non-executive chairman must be allowed to keep an office at the companys

expense and be reimbursed for expenses incurred in performing his duties.12. No director should be a member of more than 10 committees and chairman of more

than 5 committees across all companies of which he is a director. All directors must

disclose to a company about their membership of committees of other companies.

13. Disclosures to be made by the management to the Board as regards all material,financial and commercial transactions which includes dealing in company shares,

commercial dealings with bodies that have shareholders, etc.14. The half yearly declaration of financial performance shall be sent to each shareholder.

15. Financial institutions as such must not influence the decision of the board or nominate

any members to the board. However, this is allowed in case of term lending associations

in order to protect the interests of creditors.16. A certificate from auditors on compliance should form part of the Annual report and

Annual return. A copy of the same must be sent to the Stock Exchanges.

17. This committee was set up under SEBI.

Extra- SEBI had constituted a Committee on Corporate Governance under the

Chairmanship of Shri Kumar Mangalam Birla, Member, SEBI Board to promote andraise the standard of Corporate Governance in respect of listed companies.

The SEBI Board in its meeting held on January 25, 2000 considered the recommendation

of the Committee and decided to make the amendments to the listing agreement inpursuance of the decision of the Board, it is advised that a new clause, namely clause 49,

be incorporate in the listing agreement

(B) Confederation of Indian Industry (CII) Report (1996)

1. The full board must meet atleast 6 times a year with an interval of 2 months between

each meeting.2. A listed company with a turnover of Rs. 1 billion must consist of competent and

independent non-executive directors who must form 30% of the board if the chairman is a

non-executive director and 50% of the board incase the chairman is an executive director.3. No single person should hold directorships in more than 10 companies.

4. Non-executive directors must play an active role and must have defined tasks.

5. The non-executive directors must get a commission of 1% of the net profits incase

there is an MD or 3% incase there is no MD. They must also be offered stock options.


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6. While reappointing members, the resolution being put to vote must specifically

mention instances when directors were absent for half or more than half of the meetings.

7. The following information must be placed before the board- (only 5 mentioned)(a) Annual operating plans and budgets.

(b) Capital budgets, manpower and overhead budgets.

(c) Quarterly results for the company as a whole or its various business segments.(d) Internal audit reports including material cases of theft and dishonesty.

(e) Details of any joint venture or collaboration agreement.

8. Listed companies which have a turnover of 1 billion or a paid up capital of 200 million

must set up audit committees consisting of atleast 3 members all drawn up from the

companys non-executive directors who are financially literate within 2 years.

9. Audit committees must assist the board in its task related to corporate accounting andprovide effective supervision of the financial reporting process.

10. The audit committee must interact with statutory and internal auditors to ascertain the

quality of the companys accounts as well as the capability of the auditors themselves.

11. The management must ensure that the committee has full access to the financial dataof the company, its subsidiaries and associated companies.

12. Listed companies must provide information about high and low monthly averages ofshare prices in a major stock exchange where the company was listed in the reporting

year.

13. Major Indian companies must ensure that their company issues a compliance

certificate signed by the CEO and CFO which must clearly state that the company haspresented a fair picture in the financial statement and annual report.

14. For all companies with a paid up capital of 200 million or more, the quality and

quantity of disclosure that accompanied a GDR issue must be the norm for any domesticissue.

15. Government must allow more funding towards the corporate sector against the

security of shares and other paper.16. Financial institutions as creditors must not have nominee directors on the company

except in case of serious debt defaults.

17. If any company went to more than 1 credit rating agencies, it must declare the ratinggiven by all of them in its prospectus and issue document.

18. Companies making foreign debt issues cannot have exhaustive disclosure norms for

foreign entities and a miniscule one for the Indian entities.

19. Companies which defaulted on fixed deposits must not be allowed to accept furtherdeposits and make inter corporate loans or investments until the default is made good.

20. Financial institutions must take a policy decision to withdraw from boards of

companies in which their individual shareholding was 5% or less or where their totalholdings was under 10%.

21. This report didnt have any legal backing and hence lacked enforceability.

(C) Naresh Chandra Committee Report-

1. Non-executive directors must be exempted from various civil and criminal liabilities.


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2. There must be not less than 50% of independent directors and they must be made

responsible.

3. If the board consisted of 7 members, atleast 4 must be independent directors.

MANDATORY RECOMMENDATIONS

1. Disclosure of Contingent Liabilities2. Management should provide a clear description in plain English of each

material contingent liability and its risks, which should be accompanied by the

auditors clearly worded comments on the managements view. This sectionshould be highlighted in the significant accounting policies and notes on

accounts, as well as, in the auditors report, where necessary.

3. This is important because investors and shareholders should obtain a clear view of

a companys contingent liabilities as these may be significant risk factorsthat could adversely affect the companys future financial condition and results of

operations.

4. For all listed companies, there should be a certification by the CEO (either

the Executive Chairman or the Managing Director) and the CFO (whole-timeFinance Director or other person discharging this function) which should state

that, to the best of their knowledge and belief: They have reviewed the balancesheet and profit and loss account and all its schedules and notes on accounts, as

well as the cash flow statements and the Directors Report; These statements do

not contain any material untrue statement or omit any material fact nor do they

contain statements that might be misleading; These statements together presenta true and fair view of the company, and are in compliance with the existing

accounting standards and / or applicable laws / regulations;

5. They are responsible for establishing and maintaining internal controls andhave evaluated the effectiveness of internal control systems of the company; and

they have also disclosed to the auditors and the Audit Committee, deficiencies in

the design or operation of internal controls, if any, and what they have done orpropose to do to rectify these;

6. They have also disclosed to the auditors as well as the Audit Committee,

instances of significant fraud, if any, that involves management or employeeshaving a significant role in the companys internal control systems; and

7. They have indicated to the auditors, the Audit Committee and in the notes on

accounts, whether or not there were significant changes in internal control and / or

of accounting policies during the year.8. All audit committee members shall be non-executive directors

The Committee makes the following recommendation:

1. Legal provisions must specifically exempt non-executive and independent

directors from criminal and civil liabilities under certain circumstances.

SEBI should recommend that such exemptions need to be specifically spelt outfor the relevant laws by the relevant departments of the Government and

independent regulators, as the case may be.

2. However, independent directors should periodically review legal compliance

reports prepared by the company as well as steps taken by the company to cure


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any taint. In the event of any proceedings against an independent director in

connection with the affairs of the company, defence should not be permitted

on the ground that the independent director was unaware of this responsibility.

(D) NARAYAN MURTHY REPORT (2003)Mandatory recommendation

1. Audit committees of publicly listed companies should be required to review

the following information mandatorily:i) Financial statements and draft audit report, including quarterly /

half-yearly financial information;

ii) Management discussion and analysis of financial condition and

results of operations;iii) Reports relating to compliance with laws and to risk management;

iv) Management letters / letters of internal control weaknesses issued by

statutory / internal auditors; and

v) Records of related party transactions.2. All audit committee members should be financially literate and at least one

member should have accounting or related financial management expertise.3. In case a company has followed a treatment different from that prescribed

in an accounting standard, management should justify why they believe such

alternative treatment is more representative of the underlying business transaction.

Management should also clearly explain the alternative accounting treatment inthe footnotes to the financial statements.

4. A statement of all transactions with related parties including their bases

should be placed before the independent audit committee for formal approval /ratification. If any transaction is not on an arms length basis, management

should provide an explanation to the audit committee justifying the same.

5. The term related party shall have the same meaning as contained inAccounting Standard 18, Related Party Transactions, issued by the

Institute of Chartered Accountants of India.

6. Procedures should be in place to inform Board members about the risk assessmentand minimization procedures. These procedures should be periodically reviewed

to ensure that executive management controls risk through means of a

properly defined framework.

7. Management should place a report before the entire Board of Directors everyquarter documenting the business risks faced by the company, measures to

address and minimize such risks, and any limitations to the risk taking capacity

of the corporation. This document should be formally approved by the Board.8. Companies raising money through an Initial Public Offering (IPO) should

disclose to the Audit Committee, the uses / applications of funds by major

category (capital expenditure, sales and marketing, working capital, etc), on aquarterly basis.

9. It should be obligatory for the Board of a company to lay down the code of

conduct for all Board members and senior management of a company. This code

of conduct shall be posted on the website of the company.


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10. All Board members and senior management personnel shall affirm

compliance with the code on an annual basis. The annual report of the

company shall contain a declaration to this effect signed off by the CEO andCOO.

11. There shall be no nominee directors.

12. Where an institution wishes to appoint a director on the Board, suchappointment should be made by the shareholders.

13. An institutional director, so appointed, shall have the same responsibilities and

shall be subject to the same liabilities as any other director.14. Nominee of the Government on public sector companies shall be similarly elected

and shall be subject to the same responsibilities and liabilities as other directors.

15. All compensation paid to non-executive directors may be fixed by the

Board of Directors and should be approved by shareholders in general meeting.Limits should be set for the maximum number of stock options that can be

granted to non-executive directors in any financial year and in aggregate. The

stock options granted to the non-executive directors shall vest after a period of at

least one year from the date such non-executive directors have retired from theBoard of the Company.

16. Personnel who observe an unethical or improper practice (not necessarily aviolation of law) should be able to approach the audit commitee without

necessarily informing their supervisors

17. Companies shall take measures to ensure that this right of access is communicated

to all employees through means of internal circulars, etc. The employmentand other personnel policies of the company shall contain provisions

protecting whistle blowers from unfair termination and other unfair prejudicial

employment practices.18. Companies shall annually affirm that they have not denied any personnel access

to the audit committee of the company (in respect of matters involving alleged

misconduct) and that they have provided protection to whistle blowers fromunfair termination and other unfair or prejudicial employment practices.

19. The appointment, removal and terms of remuneration of the chief internal

auditor must be subject to review by the Audit Committee.20. Such affirmation shall form a part of the Board report on Corporate Governance

that is required to be prepared and submitted together with the annual report.

21. The provisions relating to the composition of the Board of Directors of the

holding company should be made applicable to the composition of theBoard of Directors of subsidiary companies.

22. At least one independent director on the Board of Directors of the parent

company shall be a director on the Board of Directors of the subsidiary company.23. The Audit Committee of the parent company shall also review the financial

statements, in particular the investments made by the subsidiary company.

24. The minutes of the Board meetings of the subsidiary company shall beplaced for review at the Board meeting of the parent company.

25. The Board report of the parent company should state that they have

reviewed the affairs of the subsidiary company also.

26. SEBI should make rules for the following:


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i) Disclosure in the report issued by a security analyst whether the company

that is being written about is a client of the analysts employer or an

associate of the analysts employer, and the nature of servicesrendered to such company, if any; and

ii) Disclosure in the report issued by a security analyst whether the analyst or

the analysts employer or an associate of the analysts employer hold orheld (in the 12 months immediately preceding the date of the report) or

intend to hold any debt or equity instrument in the issuer company

that is the subject matter of the report of the analyst.

Non-mandatory recommendation1. Companies should be encouraged to move towards a regime of unqualified

financial statements. This recommendation should be reviewed at an

appropriate juncture to determine whether the financial reporting climate is

conducive towards a system of filing only unqualified financial statements.2. It also observed that the process of Board review of business risks will

be a mandatory recommendation of the Committee. Therefore, trainingof Board members could be made recommendatory

3. Companies should be encouraged to train their Board members in the business

model of the company as well as the risk profile of the business parameters of the

company, their responsibilities as directors, and the best ways to discharge them.4. The performance evaluation of non-executive directors should be by a peer

group comprising the entire Board of Directors, excluding the director being

evaluated; and Peer group evaluation should be the mechanism to determinewhether to extend / continue the terms of appointment of non-executive

directors.

The Committee noted that the definition of independent directors should be clarified in

the recommendations. It observed that the definition of independent directors as set out

in the code of the International Corporate Governance Network may be referred to.The Committee also noted that the Naresh Chandra Committee report has attempted

to define the term independent director. The Committee was of the view that the same

definition may be used to define independent directors.

The term independent director is defined as a non-executive director of the companywho: Apart from receiving director remuneration, does not have any material

pecuniary relationships or transactions with the company, its promoters, its senior

management or its holding company, its subsidiaries and associated companies; is notrelated to promoters or management at the board level or at one level

2.5 Corporate Management and Corporate Governance

2.5.1 Role of Directors in a Company


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1. They are those who control and run the day to day affairs of the company. The

minimum directors in a public company are 3 and in a private company are 2.

2. The different types of directors are as follows-(a) Permanent and Rotational Directors-There can be a maximum of 1/3rd permanent

directors and a minimum of rotational directors on the board. Rotational directors change

every AGM unless reappointed. Incase no new appointments are made, it is presumedthat the previous directors are reappointed. They can have a maximum term of 3 years.

(b) Executive and non-executive directors- Executive directors include all executive

persons taking part in day to day affairs which includes MD s, whole-time and part-timedirectors, etc. S.23 of the Act defines the term director as any person occupying the

position of director by any name called so. S.226 defines an MD as a director entrusted

with substantial powers of management. Such MD holds office till a term of 5 years. He

may be appointed from amongst permanent or rotational directors. Legally speaking non-executive directors can become MD s but it is practically not feasible.

(c) Whole time and part time directors.

(d) Nominee directors- These are directors nominated by financial institutions who are

generally creditors of the company so as to exercise a check on the company. Theyremain in position till the time the nominating body wants them to.

(e) Additional directors- These directors are appointed to assist the board based on theirexpertise in various fields. They hold office till the next AGM.

(f) Casual vacancy filled-Casual vacancies may be created on the death, removal,

resignation, etc of directors and in such cases new directors are appointed in their place.

They hold office till the term of the original director comes to an end.(g) Alternate directors- Such directors hold posts when the original director is not

available in a state where meetings are held or will not be there for three months.

Generally if directors do not attend 3 or more meetings, they may be disqualified. Suchpersons are appointed by the original directors themselves and the board must decide

about the same. They hold office till the original director resumes office or till his term

com

corporate governance and finance(notes for exam)

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