Tuesday, December 1, 2009

Task Force on Governance Reforms

A few days ago, the website of the Ministry of Finance carried a draft report consisting of recommendations by a Task Force appointed by the Confederation of Indian Industry (CII) to reform corporate governance norms in India. This Task Force was appointed in the wake of the Satyam scandal earlier this year, and its recommendations represent one of the most significant pieces of reform following that scandal.

Yesterday, the recommendations were put up for voluntary adoption by Indian listed companies. The reasoning is as follows:

Large, highly visible and publicised corporate scandals often provoke legislative and regulatory actions. CII advocates caution against overregulating. It needs to be recognised that while the super-structure of corporate governance is built on laws and regulations, these cannot be anything more than a basic framework. Much of best-in-class corporate governance is voluntary – of companies taking conscious decisions of going beyond the mere letter of law. The spirit of this Task Force Report is to encourage better practices through voluntary adoption - based on a firm conviction that good corporate governance not only comes from within but also generates significantly greater reputational and stakeholder value when perceived to go beyond the rubric of law.

Therefore, it is only natural that this report should focus on recommendations, which are being placed before corporate India for adopting voluntarily. It is the belief of CII that Indian Industry would respond spontaneously and help set standards, which would define global benchmarks in the medium term.
This is similar to the approach followed by the voluntary code initiated by CII in 1998 that spearheaded the corporate governance process in India.

The current set of recommendations touches upon a number of reforms that were long overdue.

1. Appointment of independent directors

Although the requirement of director independence is now well recognized in India, there is a fundamental flaw in that independent directors continue to be appointed by the majority shareholders (or promoters), and this impinges upon the independence in fact of the individuals so appointed. The requirement of a nomination committee is not mandatory under Clause 49 of the listing agreement. The Task Force recommendations call for the constitution of a nomination committee consisting of a majority of independent directors (including chairman) to evaluate, shortlist and recommend appropriate candidates for the position of independent directors and non-executive directors. Although this is a welcome move, a lot depends on the process followed by the nomination committee and the extent to which the nomination process is transparent.

The following is an example of the exacting standards required to be followed by nomination committees that may provide some guidance:

The [nomination committee requirement] significantly expands the disclosures relating to the director nomination process. A company is … also required to: make the nominating committee's charter publicly available, disclose whether the nominating committee members meet … independence requirements, disclose whether the committee has a policy regarding considering nominees recommended by shareholders, describe the minimum qualifications for nominees recommended by the committee, describe the qualities and skills that the nominating committee believes are necessary or desirable for board members, describe the nominating committee's process for identifying and evaluating candidates and whether fees are paid in connection therewith, disclose who recommended the nominee, and disclose the identity of any candidate nominated by a holder of more than five percent of the voting common stock, regardless of whether the nominating committee chose to nominate that candidate.
Patty M. DeGaetano, “The Shareholder Direct Access Teeter-Totter: Will Increased Shareholder Voice in the Director Nomination Process Protect Investors?” (2005) 41 Cal. W.L. Rev. 361 at 382.

The Task Force recommendations require listed companies to issue formal letters of appointment to non-executive and independent directors that set out their duties, liabilities and remuneration. Missing in this discourse is a detailed analysis of the precise role that independent directors ought to discharge on listed companies, i.e. advisory or monitoring.

2. Remuneration of directors

This issue has acquired great significance lately. The Task Force points to deficiencies in the current practice of linking director remuneration to the profitability of companies and recommends that companies should have the option of choosing between paying a fixed contractual remuneration or continuing with the existing practice of paying a commission on a percentage basis. Appropriate caution is also to be exercised while remunerating directors through stock options, as the options are to be held by the director until one year of exiting the board. This is to prevent short-termism at the board level.

Furthermore, the Task Force recommends a fixed component (not more than 30%) and a variable component (at least 70%) for remuneration of non-executive directors, apart from additional payments for roles such as chairman, membership or a committee, etc.

3. Audit committee

Currently, two-thirds of the audit committee must be independent directors. Recognising the insufficiency of existing safeguards, the Task Force recommends that all member of the audit committee must be independent. Moreover, the role of the audit committee is proposed to be enhanced. As far as related party transactions are concerned, the role of the audit committee as presently envisaged is to ensure appropriate disclosure of the same in the financial statements. The Task Force now recommends that the audit committee (consisting of independent directors) should be given the power to pre-approve material related party transactions. This specific power of approval given to independent directors is a novelty in the Indian scenario, although that exists as a crucial safeguard in other jurisdictions such as the U.S. (Delaware) to prevent loss of shareholder value due to related party transactions, particularly those between the company and a controlling shareholder or group.

4. Other board reforms

The Task Force recommended several matters relating to the board process. These include:

- separation of the offices of the chairman and the chief executive officer;
- conduct of board meetings through tele-conferencing and video-conferencing;
- encouraging executive sessions of independent directors.

5. Audit Reforms

Noting the ambiguities in current regulations governing the auditing industry, the Task Force calls for independence of auditors, including by addressing the provision of non-audit services by auditors, recommending mandatory rotation of auditor partners as a first step, and rotation of auditors as next. Measures have also been proposed to enhance the liability of auditors.

Finally, the Task Force recommends changes to the overall corporate governance set up in India. It calls for greater emphasis on risk management (an issue highlighted by the financial crisis), harmonization in the role of various regulatory agencies governing the financial sector, creating an effective and credible enforcement mechanism and emboldening institutional investors and the press to adopt an activist stance.

While this has begun as a voluntary exercise, at least some of these recommendations can be expected to find their place in Clause 49 of the listing agreement or in the Companies Bill, 2009.

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