PRESENTATIONPRESENTATION BY BY

R. CHAKRABORTYR. CHAKRABORTY

HOW EFFECTIVE HOW EFFECTIVE INDEPENDENT DIRECTORS ? INDEPENDENT DIRECTORS ?

((B.Tech B.Tech (IIT)(IIT) , F, FICWAICWA

INDEPENDENT DIRECTORSINDEPENDENT DIRECTORS

• The Kumaramangalam Report states that:

Independent directors are directors who apart from receiving director’s remuneration do not have any other material pecuniary relationship or transactions with the company, its promoters, its management or its subsidiaries, which in the judgement of the board may affect their independence of judgement.

INDEPENDENT DIRECTORS….INDEPENDENT DIRECTORS….

AnAn overemphasis overemphasis on on monitoring monitoring and and control control risks risks Non-Executive Non-Executive

directors directors seeing seeing themselves, themselves, and and being being seen, seen, asas an an aliens aliens

policing influence detached from the rest of the Board. policing influence detached from the rest of the Board. An An overemphasisoveremphasis on on strategy risks Non-Executive directors strategy risks Non-Executive directors

becoming too close to Executive Management undermining becoming too close to Executive Management undermining

shareholdershareholder confidence confidence in in the the effectiveness effectiveness of of Board Board governance.governance.

Enron’s board members knew about and could have Enron’s board members knew about and could have

prevented many of the risky accounting practices, conflict prevented many of the risky accounting practices, conflict

of interest that led to the company’s implosion simply by of interest that led to the company’s implosion simply by

asking some obvious questions.asking some obvious questions.

- - US Senate Permanent Subcommittee on InvestigationsUS Senate Permanent Subcommittee on Investigations

Source : Presentation by Prof. Schwalbach at UNECE Round Table on Corporate GovernanceSource : Presentation by Prof. Schwalbach at UNECE Round Table on Corporate Governance

““It now appears that none of them [management and Andersen] It now appears that none of them [management and Andersen]

fulfilled their duty to the board. We do not manage the company. We fulfilled their duty to the board. We do not manage the company. We

do not do the auditing. We are not detectives….. I am not confident do not do the auditing. We are not detectives….. I am not confident

as I sit here today that we would have gotten to the truth with any as I sit here today that we would have gotten to the truth with any

amount of questioning and discussion.”amount of questioning and discussion.”

- - Robert K Jaedicke, Chairman of the Board Audit Committee in his Robert K Jaedicke, Chairman of the Board Audit Committee in his testimony before the Congresstestimony before the Congress

Source : Presentation by Prof. Schwalbach at UNECE Round Table on Corporate GovernanceSource : Presentation by Prof. Schwalbach at UNECE Round Table on Corporate Governance

ROLE OF INDEPENDENT DIRECTORS ROLE OF INDEPENDENT DIRECTORS -CRITICAL AREAS -CRITICAL AREAS

Following are the few critical areas Following are the few critical areas where role of Independent Directors are where role of Independent Directors are very important for the efficient very important for the efficient operations of the company:operations of the company:

Risk Management and Review Risk Management and Review

Improving Internal ControlImproving Internal Control

Adherence to Accounting StandardsAdherence to Accounting Standards

Statutory CompliancesStatutory Compliances

RISK MANAGEMENT AND REVIEWRISK MANAGEMENT AND REVIEW

Risk management’ and Review’, is the identification,Risk management’ and Review’, is the identification, analysis and economic control of all such risks that analysis and economic control of all such risks that may threaten assets, resources, or earning capacity may threaten assets, resources, or earning capacity of a company.of a company.

Major Risk Areas:Major Risk Areas: Financial RiskFinancial Risk Strategic RisksStrategic Risks Other RisksOther Risks

RISK MANAGEMENT & REVIEWRISK MANAGEMENT & REVIEW

Financial Risks: Financial Risks:

Receivables and bad/doubtful debtsReceivables and bad/doubtful debts::

Inventories:Inventories:

InvestmentsInvestments: :

Foreign exchange transactions: Foreign exchange transactions:

Strategic Risks: CStrategic Risks: Critical examination of the ritical examination of the decision making process.decision making process.

Other Risks: Other Risks: help of the concerned Departmental help of the concerned Departmental heads to critically examine the process of the heads to critically examine the process of the risk management.risk management.

INTERNAL CONTROLSINTERNAL CONTROLS

IInternal nternal controlscontrols amongst amongst otherother things things i is s a a nervous nervous system system that that activatesactivates overall overall operating operating policiespolicies and and keeps keeps them them within within practicable practicable performance performance rangesranges . . IInternal nternal control control commencescommences with with the the institution institution and and enforcement enforcement ofof top top policies policies established established by by the the board board of of directors directors and and continues continues down down through through the the organizational organizational structure structure taking taking form form in in the the development development and and operationoperation ofof management management policies,policies, administrative administrative regulations, regulations, manuals , manuals , directives directives and and decisions,decisions, internal internal auditing ;auditing ; internal internal check ; reporting ; check ; reporting ; employee employee training training and and participationparticipation and to and to provide reasonable assurance regarding the achievement of provide reasonable assurance regarding the achievement of objectives in the following categories:objectives in the following categories: Effectiveness and efficiency of operationsEffectiveness and efficiency of operations Reliability of financial reportingReliability of financial reporting

Compliance with applicable laws and regulationsCompliance with applicable laws and regulations

KEY TO IMPROVE EFFECTIVENESS OF KEY TO IMPROVE EFFECTIVENESS OF INTERNAL CONTROLS INTERNAL CONTROLS

Under the guidance of Audit Committee a cross functional team Under the guidance of Audit Committee a cross functional team of senior management of major business segments, finance of senior management of major business segments, finance and accounts personnel, IT head etc. should develop a plan of and accounts personnel, IT head etc. should develop a plan of action, which should include:action, which should include:

Organization – defining responsibilities for various team members.Organization – defining responsibilities for various team members.

Background information – documentation of business operations (locations, Background information – documentation of business operations (locations, units,subsidiaries, joint ventures etc.), copies of polices, procedures, units,subsidiaries, joint ventures etc.), copies of polices, procedures, manuals etc.manuals etc.

Scope and time of review – factors in control environment to be reviewed, Scope and time of review – factors in control environment to be reviewed, significant processes / activities to be considered, flowcharting of the significant processes / activities to be considered, flowcharting of the processes and the relevant risks and controls, planned timetable for processes and the relevant risks and controls, planned timetable for completion.completion.

Problem areas for early attention - processes that are suspected of Problem areas for early attention - processes that are suspected of containing significant deficiencies or material weaknesses, new processes containing significant deficiencies or material weaknesses, new processes or activities etc.or activities etc.

Documentation and reports.Documentation and reports.

ACCOUNTING STANDARDSACCOUNTING STANDARDS

Accounting standards are today recognized as Accounting standards are today recognized as an effective tool of corporate governance an effective tool of corporate governance because the standards prescribe for uniform because the standards prescribe for uniform treatment and mode of disclosure. treatment and mode of disclosure.

However, the accounting standards are caught However, the accounting standards are caught in debate as to whether the standards should be in debate as to whether the standards should be ‘rule based’ or ‘principle based’.‘rule based’ or ‘principle based’.

FEW IMPORTANT ACCOUNTING STANDARDSFEW IMPORTANT ACCOUNTING STANDARDS

AS 3 : An enterprise should prepare a cash flow statement and should AS 3 : An enterprise should prepare a cash flow statement and should present it for each period for which financial statements are presented.present it for each period for which financial statements are presented.

AS 4 : Contingencies and Events Occurring After the Balance Sheet Date.AS 4 : Contingencies and Events Occurring After the Balance Sheet Date.

AS 5 : ‘Net Profit or Loss for the Period, Prior Period Items and Changes in AS 5 : ‘Net Profit or Loss for the Period, Prior Period Items and Changes in Accounting Policies.Accounting Policies.

AS 14 : Deals with accounting for amalgamations and the treatment of any AS 14 : Deals with accounting for amalgamations and the treatment of any resultant goodwill or reserves.resultant goodwill or reserves.

AS 17 : Segment Reporting.AS 17 : Segment Reporting.

AS 18 : Detailed disclosure of related party transactions.AS 18 : Detailed disclosure of related party transactions.

AS 21 : Consolidated Financial Statements.AS 21 : Consolidated Financial Statements.

AS 24 : Discontinuing Operations.AS 24 : Discontinuing Operations.

STATUTORY COMPLIANCESSTATUTORY COMPLIANCES

To fulfill the societal expectations and provide good To fulfill the societal expectations and provide good governance, statutory compliance by the companies is a governance, statutory compliance by the companies is a pre-requisite. A measure of good Corporate Governance pre-requisite. A measure of good Corporate Governance lies in bridging the gap between the precept and practice lies in bridging the gap between the precept and practice of multiple statutes by the company effectively and to of multiple statutes by the company effectively and to comply with various statutes and regulations framed comply with various statutes and regulations framed thereunder, towards the ultimate aim of protecting the thereunder, towards the ultimate aim of protecting the interest of investors’ democracy.interest of investors’ democracy.

STATUTORY COMPLIANCESSTATUTORY COMPLIANCES

Brief list of the Acts applicable to the Companies;Brief list of the Acts applicable to the Companies;

Companies Act,1956 Companies Act,1956 Central Excise Act, 1944Central Excise Act, 1944 Wealth-tax Act, 1957Wealth-tax Act, 1957 Income-tax Act, 1961Income-tax Act, 1961 Customs Act, 1962Customs Act, 1962 Industries (Development and Regulation) ActIndustries (Development and Regulation) Act Factories ActFactories Act Industrial Dispute ActIndustrial Dispute Act Water/Air/Environment Pollution Control & Prevention ActWater/Air/Environment Pollution Control & Prevention Act Workmen Compensation ActWorkmen Compensation Act Employees State Insurance ActEmployees State Insurance Act Employees Provident Fund & Miscellaneous Provisions ActEmployees Provident Fund & Miscellaneous Provisions Act Foreign Exchange Management ActForeign Exchange Management Act Conservation of Foreign Exchange and Prevention of Smuggling Activities ActConservation of Foreign Exchange and Prevention of Smuggling Activities Act

STATUTORY COMPLIANCESSTATUTORY COMPLIANCES

Legislation imposes numerous duties upon directors. Legislation imposes numerous duties upon directors. The directors are responsible for ensuring that the The directors are responsible for ensuring that the company complies with all relevant legislations. company complies with all relevant legislations. Directors are presumed to know the law and it is Directors are presumed to know the law and it is Immaterial whether the director had knowledge of the Immaterial whether the director had knowledge of the law or not. (Ignorance of law is no excuse). He is bound law or not. (Ignorance of law is no excuse). He is bound to know what the law is. It will be no defence that to know what the law is. It will be no defence that the person was a sleeping director or a mere name the person was a sleeping director or a mere name lender to prosecutions for violation of the provisions of lender to prosecutions for violation of the provisions of the Companies Act or other laws. Before deciding to the Companies Act or other laws. Before deciding to become a director of a company a person should make become a director of a company a person should make himself familiar with the liabilities of the director and himself familiar with the liabilities of the director and penalties for wrongful acts. penalties for wrongful acts.

INDEPENDENT DIRECTORS (“IDs”) : INDEPENDENT DIRECTORS (“IDs”) : ROLE THEY PLAY ROLE THEY PLAY

(OR, MAY BE THEY DO NOT!!)(OR, MAY BE THEY DO NOT!!)

Optimist’s ViewOptimist’s View

Improve corporate credibility and governance standardsImprove corporate credibility and governance standards

Function as watchdogFunction as watchdog

Bring objectivity and outside expertise in decision making Bring objectivity and outside expertise in decision making processprocess

Maintain equilibrium in a promoter dominated scenario Maintain equilibrium in a promoter dominated scenario

Play a unique role in absencePlay a unique role in absence of shareholder activism of shareholder activism

Minimize the phenomenon of ‘yes men’Minimize the phenomenon of ‘yes men’

Play vital role in risk management Play vital role in risk management

Pessimist’s ResponsePessimist’s Response

““Renowned retirees living in the past and carrying on with the Renowned retirees living in the past and carrying on with the present” present”

‘‘Charmed circle’ of close friends Charmed circle’ of close friends

Demand and supply imbalance Demand and supply imbalance

““Outside directors do not mean outsized returns” - mechanical Outside directors do not mean outsized returns” - mechanical compliance defeats the purposecompliance defeats the purpose

Inverse correlation between ID remuneration and shareholder Inverse correlation between ID remuneration and shareholder return suggests inefficiencyreturn suggests inefficiency

IDs should not constitute more than 25% of Board strength – IDs should not constitute more than 25% of Board strength – promoters/major stakeholders understand the business bestpromoters/major stakeholders understand the business best

INDEPENDENT DIRECTORS (“IDs”) : ROLE THEY PLAY INDEPENDENT DIRECTORS (“IDs”) : ROLE THEY PLAY (OR, MAY BE THEY DO NOT!!)(OR, MAY BE THEY DO NOT!!)

IDs – CERTAIN CRITICAL ISSUESIDs – CERTAIN CRITICAL ISSUES

Independence – “ Defining independence is necessary, but Independence – “ Defining independence is necessary, but not sufficient to ensure independence of judgment” not sufficient to ensure independence of judgment” {Naresh {Naresh Chandra Committee Report}Chandra Committee Report}

insufficient knowledge regarding the businessinsufficient knowledge regarding the business

reliance on Executive Director/CEO for informationreliance on Executive Director/CEO for information

selective information sharing selective information sharing

personality issuespersonality issues

Commitment : Directors most eligible are most sought after – Commitment : Directors most eligible are most sought after – time becomes a precious commoditytime becomes a precious commodity

least likely to perform watchdog role effectivelyleast likely to perform watchdog role effectively

independent status takes a backseat independent status takes a backseat

IDs – CERTAIN CRITICAL ISSUESIDs – CERTAIN CRITICAL ISSUES

Qualification/Training – IDs ought to be aware of the rights, Qualification/Training – IDs ought to be aware of the rights, duties and liabilities associated with a corporationduties and liabilities associated with a corporation

clause 49 provisions relating to financial literacy/accounting or clause 49 provisions relating to financial literacy/accounting or related financial management expertise are steps in right related financial management expertise are steps in right directiondirection

need for training to keep abreast of ever evolving business need for training to keep abreast of ever evolving business practices and regulatory environmentpractices and regulatory environment

Liability – Risk and reward equations have gone unbalanced?Liability – Risk and reward equations have gone unbalanced?

apprehension of criminal liability a deterrent to attracting apprehension of criminal liability a deterrent to attracting serious candidatesserious candidates

need of the hour – establish precise standard of liability, need of the hour – establish precise standard of liability, permissible defenses permissible defenses

IDs – CERTAIN CRITICAL ISSUESIDs – CERTAIN CRITICAL ISSUES

Compensation – too little versus too muchCompensation – too little versus too much

too little may not attract the right talent too little may not attract the right talent

too much may impair independence too much may impair independence

special fees/incentives may be justified in exceptional special fees/incentives may be justified in exceptional situationssituations

establish benchmarks or rely on market dynamics? establish benchmarks or rely on market dynamics?

IDs – RESPONSIBILITYIDs – RESPONSIBILITY & ACCOUNTABILITY& ACCOUNTABILITY

Seek appropriate clarifications/informationSeek appropriate clarifications/information

Develop a spirit of partnership with the executive directors – Develop a spirit of partnership with the executive directors – balance ‘trust’ versus ‘challenge’ balance ‘trust’ versus ‘challenge’

Ensure that the concerns are adequately addressed by the Ensure that the concerns are adequately addressed by the Board or atleast recorded in the minutes Board or atleast recorded in the minutes

Empowerment – a critical component for effective discharge Empowerment – a critical component for effective discharge of responsibilitiesof responsibilities

management to be responsible for the orientation of new management to be responsible for the orientation of new ID regarding the business of the companyID regarding the business of the company

accurate, timely and clear information to be provided to the accurate, timely and clear information to be provided to the IDsIDs