Challenges_and_issues_for_corporate_gove.pdf

For The Institute of Company Secretaries of India – Centre for Corporate Governance, Research and Training (ICSI-CCGRT)

“Corporate governance- a way forward”

Contemporary concerns in Corporate Governance

Challenges and Issues for Corporate Governance with reference to Role of Reputational Agents and Independent Directors

Presented by Dr. Navin Mukesh Punjabi Assistant Professor H R College of Commerce & Economics BMS, M Com, PGDBA, UGC NET (JRF) Pursuing Ph.D under the able guidance of Prof. Dr. P.S. Rao, University of Mumbai Residence: 249, Kirpa Niwas, 1st Floor Sion East, Near Premier High School, Mumbai 400022 Mobile: +91 9920177199 Residence: +91 022 24094345 E-mail: [email protected] Office: H R College of Commerce and Economics. 123, Dinshaw Wachha Road, Churchgate Mumbai 400020 Tel: +91 022 22876115 / 22042195

Research Assistant- Abhimanyu Kasliwal, TYBFM, H R College of Commerce and Economics, studying Corporate Governance under the guidance of Prof Navin Punjabi

ABSTRACT Investment is, at the end of the day, an act of faith- the rational investor gives the company money because he or she believes that the company can make better and more productive use of it. Once this faith is shaken, as knowledge about unreliable and treacherous corporate practices becomes public, it undermines the integrity of corporations and discourages the use of public markets as a means to intermediate savings. The areas of transparency and disclosure have been major factors behind instability in the financial markets across the globe in recent years- Enron and Satyam are just two names that come to mind. On the other hand, good corporate governance is an essential pre-requisite for the integrity and credibility of capital market players. It contributes to the development of a vibrant economy and robust capital markets. Does performance depend on governance? There is an observable correlation- companies that have outperformed their peers and the market in the last 25 years have good governance structures. It is also noted that governance alone cannot ensure performance- yet, it does create an entity to which investors find it easier to entrust their money, and still get a peaceful night’s sleep. The 2011 Survey of Global Investors by McKinsey reported an overwhelming 66% of investors responding to the question “Would you pay more for the stock of a well governed company” with the answer “Yes’. Recent events have repeatedly proven the importance of corporate governance standards, including the collapse of large global corporations. But good governance practises have only begun being taken seriously in India since 2008, with the implosion of Satyam Computers and the subsequent arrest of its CEO Ramalinga Raju and two of its auditors at Pricewaterhouse Coopers. The Satyam scandal is notable because, as late as December 2008, over 9 notable brokerage houses and investment advisory firms had placed a “buy” rating on the Satyam share. Either the analysts have been severely negligent, or guilty of collusion. Moreover, the company was awarded the Golden Peacock award for the excellence in Corporate Governance in 2008; just weeks before January 2009, when the scam broke out- which raises questions on the methodology and the parameters on which the jury decided to present this award. So what has been going wrong with companies? There are several factors and reasons to consider, such as1) The loss of moral fiber and ethical behavior in corporations- the business environment is characterized by cut-throat competition, and the need to struggle with the new economy. This leads to ignored ethics and value systems when a much hyped business strategy failed to deliver as expected and articulated to Wall Street 2) Incentives that focus only on short term results- These include stock option heavy compensation structures, bonuses linked to short-term revenue growth, EPS and stock price, compensation linked to stock-price movement, etc. This leads to an excessive focus by pressurized management on beating the street and quarterly estimates. As expected, this leads to aggressive interpretation of accounting standards and manipulative accounting practices, which hurts the investor and the company in the long run.

3) This problem is compounded by reputational agents such as stock analysts, who indulge in ever-greening of reports with an eye on investment banking assignments. Independence is compromised to obtain lucrative consulting assignments. Independent directors fail to their duty in return of short term benefits. The research paper attempts to address the unholy nexus between companies and analysts, in order to protect the interests of the small investor and increase trust in the Indian financial markets. The author attempts to define the Role of Reputational agents like auditors, credit rating agencies, and lawyers etc. who have to act as a trustee of the Investors Wealth. The paper also addresses the role of the independent directors, and the reasons why most top corporate executives such as Deepak Parekh of HDFC Ltd are reluctant to join boards as independent directors. It also touches aspects of liability of independent director. The paper details the steps that need to be taken, in order to make the role of independent director truly independent; and gives suggestions related to the criteria mentioned in clause 49 of the SEBI manual (related to the requirements to be an independent director). Seeing the current state of corporate affairs), several questions arise how did the Analyst give a buy recommendation on a stock which has series of governance failures, and how did the auditors turn a blind eye to these issues. And while the answers to the above two questions may be relatively simple, the answer to the next one is not so- how can such corporate governance failures be discouraged and prevented in the future? Also, what was the role of independent directors in this above case? And interestingly, on what basis did the Jury decided to give this company the Golden Peacock award for best practices in corporate governance, two months before it imploded? The paper indicates that for good governance, it is essential for policy makers to define the role of reputational agents and ensure they are adequately compensated, and have accountability and responsibility for their actions. Recently, a senior analyst of a leading Credit Rating agency downgraded the sovereign rating of the most developed (or at least, most powerful militarily) country in the world, the United States of America. The reasons on which he had based his recommendation were good and valid- and yet, he was asked to step down from his position and leave. This leaves the common man with the question thathow independent are “independent” credit rating agencies-are they just puppets of large companies and powerful corporations? Who can the investor trust? The paper presents suggestion with regards to the role of reputational agents like auditors, credit rating agencies, lawyers and independent directors and also attempts to suggest a compensation structure which is non-conflicting. The paper also touches upon the liability of the independent director. Keywords: Reputational Agents, Independent Directors, Auditors, Governance, Transparency, Disclosures, Clause 49. Introduction"Corporate governance involves a set of relationships between a company’s management, its board, its shareholders and other stakeholders. Corporate governance 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." (OECD, 1996.) Reputational agents are those whom the investors look upon and their opinion /disclosures of the company help the investors make key decisions on

investments examples are Analysts, Auditors, Lawyers, Independent Directors, Credit Rating agencies etc. Corporate governance refers to a set of processes or laws that directly or indirectly affect the way a company or corporation is directed and controlled. It is the internal system that encompasses polices, processes, people, and which makes sure the needs of shareholders and other stakeholders are met in full. It relates to the relationship between stakeholders, as well as the goals for which the corporation is governed. What are the benefits of good corporate governance? To enumerate a few- good governance leads to good performance in a business. It creates an open and transparent system, and it improves communication and breaks down systematic barriers to flow of information. Good governance allows decision making based on data. It reduces risk. Finally, good governance helps in creating a brand and creates comfort for all stakeholders and society What is useful is good- and in today’s world, what is good is expensive. Audit fees for Fortune 500 companies are expected to climb 88% in the next 3 years (Public Accounting Report, 2004). Top accounting firms already look healthier, considering we have just emerged from a worldwide financial crisis. Ernst & Young booked a 17.4% revenue increase in its 2010 fiscal year, to $5.3 billion. Grant Thornton booked a 21% increase, to $485 million. Moreover, there is a role conflict, as the revenue that the audit firm expects will be directly proportional to the ease provided by the auditors to the client in compliance with statutes- in other words, the ease with which the accounting firm rubber stamps and puts its seal of approval on the actions of the client (no matter how unethical, disreputable or harmful to shareholder interests it may be). This means that the auditor, who will bring out many queries, might lose out his business to another auditor who will make the CFO’s life easier. The role of reputational agents is important- however, it is also controversial, as these reputational agents are supposed to look at the company’s balance sheet and give independent opinions. However, revenue pressure might lead the auditor to turn a blind eye to many issues which might later blow out of proportion; as in the case of Satyam computers, where the auditors were instrumental in the ratification of the window dressing of accounts. Effective corporate governance can be accomplished by directing and controlling managing activitiesusing good business practices, objectivity, accountability and, of course, integrity. It relies on certain laws to be passed, as well as a certain commitment from the marketplace. And also a healthy board culture, as this will make sure policies and processes remain constant. Yet, companies in India are not known for their corporate governance. Examples of poor corporate governance abound. For instance, very recently(on January 7 th, 2012), the chairman and senior executives of Jaiprakash Associates were fined Rs. 60 lakhs by SEBI, for trading on the basis of their possession of unpublished price sensitive information in October 2008. Insider trading is basically the use of price sensitive information by corporate management, which is not available to the public at large and the director make use of this information to profit from their position. And the problem in India is that most cases of insider trading go undetected, as the insider utilises proxies to illicitly profit at the expense of other shareholders. The case of Satyam Computers is also well known- in late 2008, the promoters of Satyam admitted to falsifying accounts, reporting non-existent profits and illegally funnelling funds to Maytas

Infrastructure. What is not so well known is that whilst the promoter Ramalinga Raju is in jail right now, the independent directors M Rammohan Rao, Krishna Palepu and TR Prasad are escaping were some of the leading names from industry and academia, however could not detect/report such a big scam in the making. The notable observation in the case of Enron is that the chairman of the audit committee of ENRON was no less a person than the Dean of Stanford Business School. It is hard to believe that he had not been able to spot the murky goings on in the company. Same has been true of its auditors. Why had auditors of the stature of Arthur Andersen allowed the deception to continue? Another interesting observation, this time in the case of Satyam Computers, was that the Chairman of the audit committee, Mr. M R Rao who was none other than the Dean of the Indian School of Business. Both these instances of independent directors feigning unawareness of their ships burning have raised concerns about the academic community (serving as independent directors) kowtowing to corporate wrong-doings and turning a blind eye. What is an independent director? As per Clause 49 of the Listing Agreements an ‘independent director’ shall mean non-executive director of the company who: - Apart from receiving director’s remuneration, does not have any material pecuniary relationships or transactions with the company, its promoters, its senior management or its holding company. - is not related to promoters or management at the board level or at one level below the board; - has not been an executive of the company in the immediately preceding three financial years; - is not a partner or an executive of the statutory audit firm or the internal audit firm that is associated with the company, and has not been a partner or an executive of any such firm for the last three years. - is not a supplier, service provider or customer of the company. - is not a substantial shareholder of the company. Independent directors are supposed to be guardians of public faith. They have power- but with power come responsibility. And far too many independent directors have misused their power and neglected their responsibilities. On the other hand, many corporate titans are giving up on their independent directorships. For example, Deepak Parekh, the chairman of HDFC ltd, in an interview to the Economic Times, cited the example of how Keshab Mahindra, who had been on the board of Union Carbide as non-executive chairman, was jailed for “corporate irresponsibility” and for not preventing the Bhopal gas tragedy from happening. Mr. Parekh argued as to “how can a non-executive chairman predict the occurrence of an accident”- if this was the case, several rail accidents take place every year in the India, but we have never put a railways minster in the Jail. The Author suggest that academic community is independent they do not have any business interest in any company as they are governed by the Maharashtra Universities Act of 1994, UGC and AICTE, they have sound knowledge of finance and in many cases have highly intellectual published reports which go on to win Nobel laurels. The Author suggest that academic community is the best source of Independent directors and company’s should explore, however companies should understand there is a need for formal training to make them effective independent directors who can give true, unbiased opinion to the executive directors. Also the remuneration of Independent directors should be good enough for them not

to just act as dummies or teddy bears on the board and just sign the pages and enjoy the dinner/cocktail meetings. The author suggests that the government should review the liability of independent director and should have role clarity for them- it should not be that companies keep independent directors only for the compliance perspective. In many developed nations like Australia and USA Board/ Remuneration committee purchase a Directors and Officers Liability Insurance for protecting the Interest of the non executive board members and attract the best talent to the board. The remuneration of Independent director is another area of concern as most of the companies look at Independent directors as compliance and as not a Critical Success Factor and also Independent director act as dummies and try to be on cooperative with companies. The remuneration of the Independent directors should not be a token of sitting fees it should be good enough for the them to protect the interest of the shareholders. A percentage of the shareholders capital should be kept aside for remuneration of independent directors as they are mainly on the board to protect their interest. Recently, a senior analyst of a leading Credit Rating agency downgraded the sovereign rating of the most developed country in the world, the United States of America. The reasons on which he had based his recommendation were justified and mentioned clearly in the report yet, he was asked to step down from his position and leave. This leaves the common man with the question that- how independent are “independent” credit rating agencies-are they just puppets of large companies and powerful corporations? This shows that the word ‘independence’ in case of Independent director and Credit Rating Agencies is just on paper. Credit Rating Agencies should be truly independent and should be allowed ‘Freedom of speech’, which is a constitutional right. However they should be justifying the recommendation as investors take the ratings very seriously. Fortis Healthcare is another recent example of poor corporate governance. On September19, 2011, Fortis Healthcare India announced it was buying the overseas healthcare business of its promoters, Malvinder and Shivender Singh This, very obviously, is a scenario that would lead to a conflict of interests between the promoters (who happen to own another business) and the other shareholders. While (predictably) this has lead to its stock price tumbling 25%, the transaction is still going to take place- even though many analysts have expressed doubts regarding the fairness of pricing for shareholders of the listed company, basis of valuation, standard of disclosures and related-party dealings But we are now reaching a juncture wherein it is also in the interests of companies to follow good corporate governance and disclosure principles. In the recent years, more and more Indian companies are looking to raise funds by listing on foreign markets. These efforts have been accompanied by the Indian Government’s drive to attract more Foreign Direct Investment (FDI). Considering the pace at which FDI is growing in India, KMPG in a recent report estimated the FDI in 2011-12 may cross $35 billion. Both factors together have contributed to the increasing importance in the Indian markets for transparency and improved corporate governance. This is simply because foreign investors (especially those belonging to the more developed American and European markets) have much higher corporate governance standards for their foreign investments. The Securities and Exchange Board of India (SEBI), keeping in mind the increased importance of corporate governance, has taken a major step in 2005-06, with the implementation of Clause 49. SEBI introduced Clause 49 as a listing agreement between the stock exchanges currently operating in India, in order to formulate regulations for the improvement of corporate governance in all of the listed

companies. Some of the regulations include the appointment of independent directors, presence of an audit committee, and important disclosures in the financial statements prepared. There are specific requirements for having independent directors on the board, who have absolutely no monetary interest in the company, so that there are no malpractices. One of the major concern for the government, even though clause 49 has been implemented is the effectiveness of this regulation. Even after six years of the regulation, more than 73% of the companies in India are not complying by it. The main challenge for the Government is for companies operating in India to become 100% compliant. Even though more than half are compliant, 27% yet is a major proportion. It is the suggestion of the authors that a stricter implementation of Clause 49, including the formation of a separate independent body by the company’s law board, in order to enforce clause 49, may yield beneficial results. The US-version of Clause 49 was the Sarbanes-Oxley Act of 2002, which required major changes in how companies are governed and how their auditing functions. The set of regulations Even though the act was introduced in 2002, it was not fully functional in the United States until 2009, where the companies listed on the NYSE were about 95% compliant. This has led us to believe that it may take some time in India, before all the compliance measures for Clause 49 are met, but the change would be brought about eventually. From long-term prospective, major Indian public listed companies would have no other choice but to adopt the standards in order to make a reputable stature. Another concern relating to Corporate Governance is the lack of due diligence by the analysts in the market. The lack of importance to Corporate Governance causes analysts to recommend stocks which have not managed to comply by all the laid out requirements. One of the recent examples include HDFC Mutual Fund, which was alleged to be giving ‘buy’ calls on stocks which they were looking to clear out of their portfolio. The author would like to make the slightly controversial recommendation of holding analysts liable in case they make recommendations to buy or sell a stock, when sufficient proof exists that they hold a completely contrary viewpoint. Also, they must clearly specify in the very beginning of each research report as to what exactly are their independent sources of data- are they making a buy recommendation solely on the basis of the data provided to them by the company itself. An orderly increase in the compliance measures by the SEBI is also expected to be implemented in the first half of 2012, which would make it more difficult for Investment banks to influence recommendations of analysts by the means of strict new rules. This is often referred to as the Chinese Firewall – which looks to strengthen barriers under which the firms have to operate, and thereby ensuring effective corporate governance. Which means the investment advisory side will have a Chinese wall with the sales side and hence no party will have vested interests. The proposal that we believe (if implemented) would really help to improve corporate governance in India, is the formation and role-expansion of Self-Regulatory Organizations or SROs. The SROs would be organizations which would have a person from the board of directors of all the companies in a given industry, and by the means of cross-monitoring would ensure that all the companies in the industry follow the code of conduct as prescribed under Clause 49, and ensure that there are no malpractices of frauds in the industry. These SROs would be monitored by the government. This would help ease off some difficulties from the government, and promote self-regulation and cross-regulation all around the country. Currently, several SROs are active in India, such as Association of Merchant Bankers of India (AMBI), Association of Mutual Funds of India (AMFI), Association of Custodial Agencies of India (ACAI) and Registrars Association of India (RAIN). As of now, all the SROs collectively try to promote

healthy business practises and service provision, and encourage rule compliance amongst its members. The problem is that they have very little powers when it comes to compensation, de-recognition and punitive actions for non compliance. Corporate Governance and transparency is vital for attracting foreign investments in order to grow the capital market in India. This is not a task which can be completed overnight, or only by the government. This would require a substantial amount of time, public-private partnerships, and self-regulation monitoring to overcome this concern. Governments all around the globe are looking to address this concern in order to safeguard retail investors and bring about orderly growth in the capital markets. Reputational agents like Auditors, credit rating agencies, investment analysts and Independent directors should have a Chinese wall to protect the flow of price sensitive information. The author suggests the government should review the liability of independent director and should have role clarity for them and not having them only from a compliance perspective. In many developed nations like Australia and USA Board/ Remuneration committee purchase a Directors and Officers Liability Insurance for protecting the Interest of the non executive board members and attract the best talent to the board. However all these measures can only reduce chances of frauds and not eliminate them. Frauds and governance failures are inevitable. I believe that Independent directors and audit committees need to have enlarged responsibilities. Stricter independence standards are required for audit committees, to avoid the repeat of a SatyamPricewaterhouse Coopers- in the sense that collusion between the auditor and the company being audited should be prevented and controlled at all costs. There should be a repeal of self regulation for the auditing profession. Independent directors should have greater liability if there is sufficient evidence that they were aware of corporate wrongdoings of the company they had been appointed by, but did nothing about it. As the same time, we need to enhance the role of the whistle blower. The primary reason why so many reputational agents agree to play along with public deception is because they usually have a disincentive attached to the act of whistle blowing. This is a complex matter with a large gray area. One suggestion is that the whistleblower should be given a certain percentage of the fines collected by the government from the erring company, in order to give him or her incentive to bring out matters of corporate skullduggery out into the open. Also, if the whistleblower had him been involved in the crime, he could be provided partial amnesty. A new level of discipline should be brought to SEC reporting and under Clause 49. Compulsory CEO and CFO certifications should be required. Improved processes and controls have connected the board to the day to day functioning of the company. Finally, an independent entity such as SEBI can maintain a register of stock buy/sell recommendations and research reports. While analysts can by no means be held liable for the accuracy or inaccuracy of their recommendations, the practice of maintaining a public register can at least help the small investor to make more informed investment decisions- by analyzing the analysts. Corporate governance has been gaining momentum across the world due to corporate failures, unethical business practices and insufficient disclosures. The prevailing inequality, glorification of greed, lack of concern for society, feudal mindset and manifold regulations, are some reasons responsible for increase

in the rate of scams. Though a lot of new standards have been set, changes in accounting and reporting have been made, with a focus on the process of enforcement and compliance, but the need of the hour is to build a highly committed workforce to observe good corporate governance in practice. Thus, a major responsibility lies on the shoulders of academicians who are considered as intellectuals in imparting the concept of corporate governance in the minds of young professionals. The problem with corporate India, and with money, is that it manages to corrupt. Kautilya‘s Arthashastra, has an interesting but cynical observation where we can draw an analogy of Governance and Corporate India: ―Just as it is impossible to know when a fish moving in water is drinking it, so it is impossible to find out when servants (Trustees) in charge of undertakings misappropriate money. And thus good corporate governance has become indispensable- for the management are the guards for the company- and as the famous Greek philosopher Socrates said 2000 years ago, “Who will guard the guards?”

List of References 1. Jayanth Rama Varma, “Corporate Governance in India: Disciplining the Dominant Shareholder”, 1997, IIM-B Management Review 2. John Samuel Raja, (2011), ‘Fortis Hit by Governance ISssues’ The Economic Times 3. Maulik Vyas, (2011), ‘Governance Issue to play Spoil sport for Fund Inflow’, The Economic Times 4. Mehra Madhav, 2003, Making Difference through corporate governance, World council for corporate governance. 5. Punch, Maurice;“Dirty Business- exploring corporate misconduct; 1996; Sage Publications 6. Rajad John, (2011) Fortis hit by governance issues, The economic Times, 12 th Dec 2011Voluntary guidelines issued by Ministry of Corporate Affairs on Corporate Governance and CSR 7. Richard Rekhy and Neville Dumasia, “State of Corporate Governance in India- A poll”, 2009, KPMG 8. Reena Zachariah, (2011), ‘SEBI will soon set rules for analyst’, The Economic Times, 12 th Dec 2011. 9. SEBI Manual – Clause 49 of Listing Agreement. 10. Vipul Prakash, “Corporate Governance in India: the IFC perspective”, 2004, International Finance Corporation Journal 11. Vyas Maulik, (2012) Governance Issues to Play Spoilsport for Fund Inflows, The Economics Times, o3rd Jan 2012. 12. Zacharian Teena, (2011), Sebi will soon set rules for analyst, The Economics Times, 12 th Dec 2011 13. http://www.dalalstreet.biz/forum/india-mutual-funds/hdfc-fund-managers-not-supporting-goodcorporate-governance/ retrieved on 16th April 2012 14. http://knowledge.wharton.upenn.edu/india/article.cfm?articleid=4152 retrieved on 23rd March 2012. 15. http://soniajaspal.wordpress.com/2011/02/17/reflections-on-definition-of-corporate-governancein-india/ retrieved on 10th March 21012 16. http://www.dnaindia.com/money/report_good-corporate-governance-boosts-indian-stocks-s-andp_1296645 retrieved on 02nd April 2012

17. http://economictimes.indiatimes.com/news/news-by-company/corporate-trends/govtshouldnt-hound-independent-directors-deepak-parekh-hdfcchairman/articleshow/6061611.cms http://economictimes.indiatimes.com/news/news-bycompany/corporate-trends/govt-shouldnt-hound-independent-directors-deepak-parekh-hdfcchairman/articleshow/6061611.cms