Unit 4

Corporate Governance

4.1 Conceptual framework of corporate governance

Generally, Corporate Governance refers to practices by which organisations are controlled, directed and governed. The fundamental concern of Corporate Governance is to ensure the conditions whereby organisation's directors and managers act in the interest of the organisation and its stakeholders and to ensure the means by which managers are held accountable to capital providers for the use of assets. To achieve the objectives of ensuring fair corporate governance, the Government of India has put in place a statutory framework.

Regulatory framework on corporate governance

The Indian statutory framework has, by and large, been in consonance with the international best practices of corporate governance. Broadly speaking, the corporate governance mechanism for companies in India is enumerated in the following enactments/ regulations/ guidelines/ listing agreement:

1. The Companies Act, 2013 inter alia contains provisions relating to board constitution, board meetings, board processes, independent directors, general meetings, audit committees, related party transactions, disclosure requirements in financial statements, etc.

2. Securities and Exchange Board of India (SEBI) Guidelines: SEBI is a regulatory authority having jurisdiction over listed companies and which issues regulations, rules and guidelines to companies to ensure protection of investors.

3. Standard Listing Agreement of Stock Exchanges: For companies whose shares are listed on the stock exchanges.

4. Accounting Standards issued by the Institute of Chartered Accountants of India (ICAI): ICAI is an autonomous body, which issues accounting standards providing guidelines for disclosures of financial information. Section 129 of the New Companies Act inter alia provides that the financial statements shall give a true and fair view of the state of affairs of the company or companies, comply with the accounting standards notified under s 133 of the New Companies Act. It is further provided that items contained in such financial statements shall be in accordance with the accounting standards.

5. Secretarial Standards issued by the Institute of Company Secretaries of India (ICSI): ICSI is an autonomous body, which issues secretarial standards in terms of the provisions of the New Companies Act. So far, the ICSI has issued Secretarial Standard on "Meetings of the Board of Directors" (SS-1) and Secretarial Standards on "General Meetings" (SS-2). These Secretarial Standards have come into force w.e.f. July 1, 2015. Section 118(10) of the New Companies Act provide that every company (other than one person company) shall observe Secretarial Standards specified as such by the ICSI with respect to general and board meetings.

Key legal framework for corporate governance in India

The Companies Act, 2013

The Government of India has recently notified Companies Act, 2013 ("New Companies Act"), which replaces the erstwhile Companies Act, 1956. The New Act has greater emphasis on corporate governance through the board and board processes. The New Act covers corporate governance through its following provisions:

1. New Companies Act introduces significant changes to the composition of the boards of directors.
2. Every company is required to appoint 1 (one) resident director on its board.
3. Nominee directors shall no longer be treated as independent directors.
4. Listed companies and specified classes of public companies are required to appoint independent directors and women directors on their boards.
5. New Companies Act for the first time codifies the duties of directors.
6. Listed companies and certain other public companies shall be required to appoint at least 1 (one) woman director on its board.
7. New Companies Act mandates following committees to be constituted by the board for prescribed class of companies:

1. Audit committee.
2. Nomination and remuneration committee.
3. Stakeholders’ relationship committee.
4. Corporate social responsibility committee.

4.2 Corporate Governance Reforms

Approval of all material related-party transactions by independent shareholders (i.e., related parties have to abstain from voting) is standard in many markets around the world and considered a best practice. Now, listed companies in India will abide by this rule beginning in October 2014 as part of a slew of corporate governance reforms announced recently by the Securities and Exchange Board of India (SEBI). Will these new measures bring much-needed relief to minority shareholders, or is it just old wine in a new bottle?

SEBI consulted industry participants in January 2013 to revise and overhaul Clause 49 of the Equity Listing Agreement that deals with the corporate governance norms for listed companies in India. CFA Institute, in conjunction with the Indian Association of Investment Professionals (IAIP), officially responded to the consultation by highlighting our policies and global best practices. The recently revised SEBI norms are expected to enhance the corporate governance framework to reflect global best practices. The requirements in certain areas, including independent directors and related-party transactions, are more stringent than the new Companies Act 2013.

Some of the significant changes are discussed below.

Aligning Listing Agreement with the Companies Act 2013

Companies Act requirements on issuing a formal letter of appointment, performance evaluation, and conducting at least one separate meeting of the independent directors each year and providing suitable training to them are now included in the revised norms of SEBI. Independent directors are not entitled to any stock option, and companies must establish a whistle-blower mechanism and disclose them on their websites.

Restricting Number of Independent Directorships

Per Clause 49, the maximum number of boards a person can serve as independent director is seven, and three in case of individuals also serving as a full-time director in any listed company. The Companies Act sets the maximum number of directorships at 20, of which not more than 10 can be public companies. There are no specific limits prescribed for independent directors in the Companies Act.

Although SEBI reforms seem to be moving in the right direction, these limits may initially pose challenges in sourcing qualified independent directors for listed companies.

Maximum Tenure of Independent Directors

Based on the Companies Act as well as the new Equity Listing Agreement, an independent director can serve a maximum of two consecutive terms of five years each (aggregate tenure of 10 years). These directors are eligible for reappointment after a cooling-off period of three years.

Can a director who has served two five-year terms be considered independent after a cooling period of three years? CFA Institute recommends that board members limit their length of service on a specific company board to no more than 15 years to ensure new board members with fresh insights and ideas are elected.

Board-Mix Criteria Redefined

Per Clause 49 of the Equity Listing Agreement, 50% of the board should be made up of independent directors if the board chair is an executive director. Otherwise, one-third of the board should consist of independent directors. Additionally, the board of directors of a listed company should have at least one female director.

While it is a welcome change that SEBI mandates a female director, will it make a huge difference to the effectiveness of boards?

CFA advocates that diversity should be embraced from all angles, such as diversity of backgrounds, expertise, and perspectives, including an increased investor focus to improve the likelihood that the board will act independently and in the best interest of shareholders.

Role of Audit Committee Enhanced

The SEBI reforms call for two-thirds of the members of audit committee to be independent directors, with an independent director serving as the committee’s chairman. While the Companies Act requires the audit committee to be formed with a majority of independent directors, SEBI has gone a step further to improve the independence of the audit committee.

The role of the audit committee also has evolved to incorporate additional themes from the Companies Act, such as reviewing and monitoring auditor independence, approval of related-party transactions (RPTs), scrutiny of inter-corporate loans, valuations, and evaluations of internal financial controls and risk management systems.

More Stringent Rules for Related-Party Transactions

The scope of the definition of RPTs has been broadened to include elements of the Companies Act and accounting standards:

1. All RPTs require prior approval of the audit committee.
2. All material RPTs must require shareholder approval through special resolution, with related parties abstaining from voting.
3. The threshold for determining materiality has been defined as any transaction with a related party that exceeds 5% of the annual turnover or 20% of the net worth of the company based on the last audited financial statement of the company, whichever is higher.

Since SEBI Clause 49 requires shareholder approval for all material RPTs, with no exception for transactions in ordinary course of business or at arms-length, companies feel that this will result in practical difficulties (i.e., compliances costs and delays), particularly for those that regularly transact business with subsidiaries.

The ultimate effectiveness of such legislation will depend upon the degree and quality of enforcement, or the monitoring capabilities of the regulator.

Improved Disclosure Norms

In certain areas, SEBI resorts to disclosure as an enforcement tool. Listed companies are now required to disclose in their annual report granular details on director compensation (including stock options), directors’ performance evaluation metrics, and directors’ training. Independent directors’ formal letter of appointment / resignation, with their detailed profiles and the code of conduct of all board members, must now be disclosed on companies’ websites and to stock exchanges.

E-voting Mandatory for All Listed Companies

Until now, resolutions at shareholder meetings in listed Indian companies were usually passed by a show of hands (except for those that required postal ballot). This means votes were counted based on the physical presence of shareholders. SEBI also has changed Clause 35B of its Equity Listing Agreement to provide e-voting facility for all shareholder resolutions.

We think this is a pertinent change as it will allow minority shareholders to express their voices at shareholder meetings without having a physical presence. CFA Institute has advocated for company rules that ensure each share has one vote.

Enforcement

SEBI is setting up the infrastructure to assess compliance with Clause 49 to ensure effective enforcement. Companies need to buckle up and assess the impact of these reforms and step-up compliance.

4.3 Major Corporate Scandals in India and abroad

Corporate frauds have emerged as the biggest risks which companies are exposed to, and are increasingly becoming a big threat. Incidents of frauds are increasingly at an alarming rate and in the process:

1. Destroy the confidence of investors in stock markets.
2. Results in enormous destruction in wealth of investors.
3. Damage the reputation of the affected company, its management and board of directors.
4. Erode ability of affected company to borrow and thus creating financial stress.

In case of frauds involving large amounts causing going concern issues (raising doubts in the ability of the company to continue its operation in the near- future)-e.g., Enron, Lehman brothers.

Regulations are being regularly tightened to ensure monitoring, vigilance and disclosure mechanisms including whistle blowers’ complaints. It is a universal truth that fraudsters are always a step ahead of regulators.

We must accept that frauds are inevitable, and companies should lay down strong systems, processes, corporate governance practices and a robust recruitment process to ensure that right people with integrity and value systems are hired.

It is also important to create awareness among employees through rigorous training mechanisms, as to areas exposed to fraud and ensure that frauds are impartially investigated and culprits are punished, in time.

MAJOR CORPORATE FRAUDS IN INDIA

1. Satyam computer (Satyam)

Satyam was the first major fraud of its kind, which shocked the country and led to tightening of regulations, reporting and governance mechanisms. The fraud had the same shock and awe effect like what Enron and Lehman brothers had in the USA. The enactment of strictest ever regulation, namely, Sarbanes and Oxley, was the outcome of these frauds and many countries followed with enactment of similar regulations.

Promoters of the company had devised ingenious methods to commit frauds with large scale dummy billings for services rendered to foreign clients. As a logical step forward, fake proceeds were shown to have been received in multiple bank accounts, opened in various countries. Many of these accounts were later found to be non-existing.

The company was consistently showing large bank balances in its financial statements, which were not consistent with other IT companies considering the size of its business. The whole of these operations was overseen by the promoter with the assistance of a separate staff working on this, what I would call a fraud factory.

At the closure of financials and to satisfy auditors, fake bank confirmations and statements were generated and produced as evidence of balances to auditors. The amount involved in the fraud was around USD 1 billion.

Surprisingly, Satyam received awards for excellence in corporate governance, conferred by some reputed organisations. Its promoter had over a period acquired respect of the industry and an overwhelming persona. In this background, sudden admission of fraud by the promoter, came as a rude shock to the country,

All said and done, Satyam had a sound business model and portfolio of large international clients. Government had to initiate an unprecedented rescue mission to save the company, by first dismissing the board members of the company, followed by the appointment of professionals as board members led by Deepak Parikh. Ultimately, the company was sold to Mahindra group and is now a major part of the successful technology business of the Group.

2. Kingfisher Airlines (KLA)

KLA was another corporate fraud, which was first of its kind in the Airlines industry, which ultimately led to fall of the empire of King of good times. The airline was launched by flamboyant Vijay Mallya, well known as King of good times. Over a short period of time KLA established a reputation of finest private airline of the country, with high quality service standard and was enjoying second highest market share after Jet Airways.

The company resorted to borrowing funds by all possible means, including related parties and pledge of Kingfisher brand by over-valuation of brand value. Good times did not last long, and Vijay Malia had to sell its family jewel liquor and beer business to liquidate part of its debts.

Currently Vijay Malia is in the UK and fighting battle in courts to stop his repatriation into India. Consortium of banks led by SBI has exposure of around Rs, 9000 crores to now a virtually bankrupt airline. Most employees lost or quit jobs as salaries were nor paid for months together. The company went to the extent of defaulting in depositing statutory dues like PF, TDS deducted from salaries to government authorities.

Kingfisher seems to me more of a case of business failures rather than corporate frauds. There were a lot of red flags which could have been picked by lenders and regulators, which were ignored and could have saved airlines which had good potential. Lending against a brand which had never been a practice is a glaring example. A Satyam type quick rescue operation could have parachuted the airline into safety and saved lenders money and employees’ jobs.

3. Jet Airways

The airline, which was once India’s pride, landed in IBC for rescue. After multiple bidding over 18 months, Jet finally had a bidder (with an investor), who is non- experienced in the airlines business.

Jet had acquired an unassailable position in the industry and was a preferred airline for the business community, top industrialists and CEOs of the country. Its service standards were its USP.

Lenders’ exposure to the airlines, amounts to around Rs 8500 crores and total liabilities of around Rs.25000 crores including dues to vendors, employees, AAI, lessors of aircrafts.   

The company indulged in multiple fraudulent practices of -

1. Overstating commission paid to a Dubai related party based in Dubai for years. This resulted in significant overstatement of expenses and underreporting of profits.
2. Diversion of funds by giving loans of around Rs.3353 Crores.
3. Accounting of invoices of fake on Jet miles.
4. Other similar transactions.

Employees lost jobs with huge arrears of salaries. Further, acquisition of low-cost service airline, Sahara Airlines - in hindsight, the acquisition proved to be its nemesis and accelerated the downfall of Jet Airways.

4. Bhushan Steel

Bhushan Steel was an unprecedented case of defrauding major banks of India. The company was acquired by Tata Steel, though matter is still under litigation.

Promoters of the otherwise profitable company, with modern large-scale plants, indulged in multiple fraudulent practices of:

1. Transfer of   funds borrowed by the company to various related parties by way of loans or advances.
2. Accounting of bills for capital and other purchases, which were never incurred and funds so generated were misappropriated by promoters for their benefits.
3. Amount involved was around Rs. 50000 crores.

Bhushan Power and Steel (BPSL), another group company is currently under IBC. JSW Steel is expected to acquire BPSL.

According to the CBI, BPSL diverted around Rs 2,348 crore through its directors and staff from the loan accounts of various banks, into the accounts of more than 200 shell companies without any obvious purpose.

5. PNB

PNB was the first major banking fraud reported in the country, involving a massive amount of around Rs. 15000 crores. Fraud was committed by Nirav Modi and Mehul Choksi, (through Gitanjali Gems, a listed company owned by him). Both were in the business of importing rough diamonds and exporting polished diamonds.

Over a period, both had built retail chains of diamond business in India and at famous international destinations. Nirav was, particularly, PR and showmanship savvy.

At that time no one questioned the source of his funding. It was only after a few years, that this unprecedented fraud came to light, which shocked the nation as never before.

He was defrauding PNB and other bankers by opening LCs of large amounts without any underlying transactions (paper money in essence), with the connivance of a few junior level banking officials. He exploited an elementary deficiency in the IT systems of non-reconciliation of LCs opened with the underlying transactions. LCs opened were not recorded in the RTGS system as was the requirement applicable to all banks. Hence, existence of such LCs was not known till the time the fraud was unearthed.

Amounts involved are estimated to be around Rs 16000 crores (including dues of Mehul Choksi). Here again, there were multiple red flags, which were ignored by banks management and regulators, which could have unearthed the fraud much earlier. Periodic inspection reports of RBI, highlighting this deficiency, which were placed before the board, were not actioned, RBI also issued red alert to all banks several times, instructing banks to set right these system deficiencies (mainly RTGC and non-reconciliation). But these also went unattended.

Nirav and Mehul managed to fly out of India and currently India is trying hard in international courts to bring them back to India.

6. ILFS

ILFS fraud was the largest corporate fraud in India and triggered a showdown in the economy, as the company was a key vehicle for infrastructure development of the country. Fraud occurred, in spite of marquee shareholders like LIC, SBI etc., being the largest shareholders, having representatives on board. ILFS had the largest debt exposure of around Rs. 91000 crores (including Rs, 20000 crores invested by PF and pension funds),

Fraud was perpetrated mainly by:

1. Diversion of borrowed funds to related entities of some of members of top management team.
2. Imprudent lending to parties who were not credit worth for ulterior motives.
3. Evergreening of loans by routing money from one group company to another through an unrelated party.
4. Over invoicing of project costs by vendors, accounting of fake expenses etc. and difference being routed back to related entities of some of members of top management team.
5. Overstatement of profits by non- provisioning of loans, accounting of fake expense, inappropriate recognition of project revenue etc.
6. The company had unprecedented number of subsidiaries and group companies, (346) which were used to route above transactions.
7. Non – disclosure of some of these companies as related parties.
8. Non-disclosure some of subsidiaries, associates, joint ventures.

Most of the mutual funds, insurance companies and PF gratuity funds had invested large sums in its debt issuance, due to the high credit rating of the company. It was a case of negligence by reputed credit rating agencies that rating was not downgraded in spite of clear signs of financial stress in the company. Rating was downgraded abruptly to lowest level from the highest only after the company defaulted in its repayment obligations.

Surprisingly, this public interest entity, was run for years by the same top management team, who were treating ILFS as personal property. Their subordinates and even Board were so overawed by their overpowering persona that no one dared to challenge their decisions. Fraud was going on for years, but could not be detected till the damage was done.

Like Satyam, the government suspended the board and appointed eminent experts to the board chaired by reputed and seasoned banker, Uday Kotak. Currently the company is under resolution process and some of its infrastructure has been sold. However, progress has been slow. Hence, the extent and timing of recovery is uncertain.

7. DHFL

DHFL was the first ever fraud in a housing finance company, which happened mainly due to active involvement of promoters in syphoning of funds and alleged money laundering.

How fraud was committed:

a)  Granting of loans to related parties of promoters.

b) Loans granted to parties, who were not credit worthy or were unknown having same addresses in obscure locations.

c)  Evergreening of bad loans.

d)  Creation of around 6 lacs dummy accounts at one branch, using name of borrowers who had already repaid loans. These accounts were used to grant loans which were used to siphon funds to promoter companies. These loans ultimately turned out to be non-recoverable.

e)  Utilization of borrowed funds for personal purposes, such as acquiring personal properties, yachts etc.

f)    Consequently, huge amounts were shown as recoverable in the balance sheet, which were not recoverable.

8. PMC Bank

Promoters of DHFL were de-facto controlling operations of PMC bank, (a cooperative bank), perpetuated frauds by adopting identical methods. The bank had larger deposits of middle-class depositors, who had deposited their hard-earned savings with the bank for various requirements like medical treatment, education cost of children, retirement, and emergency needs. More than 60% of its customers had small deposits of around ₹10,000 each in the bank.

During investigation, it was found that:

a)  Around 70 percent of its total loan book of Rs 8,383 crore as on March 31, 2019, had been taken by real estate firm HDIL.

b) The bank had been allegedly running fraudulent transactions for several years to facilitate lending to HDIL through fictitious accounts and violating single-party lending rules.

c)  Depositors are struggling to recover their money and some of them committed suicide. Authorities are in the process of recovering properties acquired by the promoters and progress is tardy.

As per latest newspaper reports, the bank has invited expression of interest for investment and equity participation in the bank for its reconstruction.

9. YES Bank

Fraud led to the unexpected and sudden fall of a private bank which was emerging as a good competition to other private banks. The bank had a differentiated business model, with focus on technology, branches network, focus on retail loans etc.

Promoter of the bank, Rana Kapoor had, over a short period of time, built an overwhelming image in the industry and had developed contacts with top industrialists of the country. Most of the decision making on key matters including large loans was centralised in his hands. He had the ambition to make YES Bank the largest private bank of the country. It was this ambition which perhaps led to the sharp downfall in fortunes of the bank, steeper than its rise to an eminent position in the banking industry.

How fraud was committed:

a)  Imprudent lending practices.

b) Evergreening of loans.

c)  Practice of charging high commission to borrowers, which was not in line with industry practices.

d)  Overstatement of profits due to front loading of commission income.

e)  Gross under provisioning of NPAs compared to RBI guidelines.

During special inspection carried out by RBI (Asset quality reviews-AQR which was carried for all banks), significant differences were observed between actual and required provisioning for various years.

Finance ministry acted swiftly to restore the confidence in the banking system and a majority stake in the bank was acquired by SBI. Efforts are still on to ensure that the bank is restored to its original health by significant equity infusion by institutional investors and other measures.

10. Cafe Coffee Day (CCD)

CCD was the first company to set up a large chain of coffee shops across India and a trend setter. Over-leveraging to find expansion of the chain and diversion of funds to non-core business led to the downfall of the Company, which had a sound business model from growing coffee in its own fields to serving a wide variety of coffee to customers.

The debacle of company resulted in unfortunate suicide by its promoter. Amounts due to banks are around Rs. 2500 crores to Rs. 3000 crores. Currently, Tata group is in talks with CCD for acquiring its coffee outlets, which if materialises, will rescue the company, and put it back on the recovery path.

11. Spot Exchange of India

The company lured Investors with high assured returns by raising money bills purported to represent purchase of commodities. These stocks were subsequently sold back to investors at a predetermined rate to give assured returns.

There were no physical stocks available with the exchange. The whole transaction was in substance a pure investment transaction without any underlying stocks.

It was a case of teeming and lading, where money invested by one investor was utilised to pay another investor with assured returns. Regulators banned such transactions, when these wrongdoings came to their notice. Sudden ban closed the taps and in the absence of fresh inflow from investors, the Exchange intermediaries could not honour the transaction of sales back to investors.

As of now, most of investors’ money is stuck and part payments had been made from sale proceeds of attached assets of promoters. Ultimate recovery, both time and extent, is currently uncertain.

4.4 Common Governance Problems noticed in various corporate failures

Corporate governance is the term used to describe the balance among participants in the corporate structure who have an interest in the way in which the corporation is run, such as executive staff, shareholders and members of the community. Corporate governance directly impacts the profits and reputation of the company, and having poor policies can expose the company to lawsuits, fines, reputational damage, and loss of capital investment. Here are five common pitfalls your corporate governance policies should avoid.

1) CONFLICTS OF INTEREST

Avoiding conflicts of interest is vital. A conflict of interest within the framework of corporate governance occurs when an officer or other controlling member of a corporation has other financial interests that directly conflict with the objectives of the corporation. For example, a board member of a solar company who owns a significant amount of stock in an oil company has a conflict of interest because, while the board he or she serves on represents the development of clean energy, they have a personal financial stake in the success of the oil industry. When conflicts of interest are present, they deteriorate the trust of shareholders and the public while making the corporation vulnerable to litigation.

2) OVERSIGHT ISSUES

Effective corporate governance requires the board of directors to have substantial oversight of the company’s procedures and practices. Oversight is a broad term that encompasses the executive staff reporting to the board and the board’s awareness of the daily operations of the company and the way in which its objectives are being achieved. The board protects the interests of the shareholders, acting as a check and balance against the executive staff. Without this oversight, corporate staff might violate state or federal law, facing substantial fines from regulatory agencies, and suffering reputational damage with the public. 

3) ACCOUNTABILITY ISSUES

Accountability is necessary for effective corporate governance. From the top-level executives to lower-tier employees, each level and division of the corporation should report and be accountable to another as a system of checks and balances. Above all else, the actions of each level of the corporation are accountable to the shareholders and the public. Without accountability, one division of the corporation might endanger the success of the entire company or cause stockholders to lose the desire to continue their investment.

4) TRANSPARENCY

To be transparent, a corporation must accurately report their profits and losses and make those figures available to those who invest in their company. Overinflating profits or minimizing losses can seriously damage the company’s relationship with stockholders in that they are enticed to invest under false pretences. A lack of transparency can also expose the company to fines from regulatory agencies.

5) ETHICS VIOLATIONS

Members of the executive board have an ethical duty to make decisions based on the best interests of the stockholders. Further, a corporation has an ethical duty to protect the social welfare of others, including the greater community in which they operate. Minimizing pollution and eschewing manufacturing in countries that don’t adhere to similar labour standards as the U.S. Are both examples of a way in which corporate governance, ethics, and social welfare intertwine.

References:

1. “The Essential book of Corporate Governance” by G.N. Bajpai.
2. “Corporate Governance in India” by Arindam Das.