Saturday, December 28, 2013

Friedman, CSR and Coal India Limited

Milton Friedman, the Nobel Laureate wrote a piece entitled 'The Social Responsibility of Business is to Increase its Profits' in the New York Times Magazine dated September 13, 1970. It is still relevant and an interesting reading. Throughout the article, Friedman argues against corporate social responsibility (CSR). Most authors and experts believe that  his arguments against CSR are not relevant in the present day context. I do not subscribe to their views. Even today, it is true that the social responsibility of a business is to increase profits.

Friedman says  "in a free society there is one and only one social responsibility of business - to use resources and engage in activities designed to increase its profits so long as it stays within the rules of the game, which is to say, engages in open and free competition without deception or fraud." He also said that owners (shareholders) generally desire to make as much money as possible while conforming to the basic rules of society both those embodied in law and those embodied in ethical custom.

Thus, Friedman says that a company should comply with the law, adopt ethical practices and be transparent while making profits. It should be able to defend its position and actions against legal and ethical norms.

Friedman says that the purpose of business is to earn profits. I am sure that he does not mean short-term profits. He uses the term profits to refer to what is called 'shareholder value'. What Friedman says is that whatever activities a business undertakes, all should aim at creating shareholder value. There cannot be any activity that is de-linked to shareholder value.

Friedman says "Of course, in practice the doctrine of social responsibility is frequently a cloak for actions that are justified on other grounds rather than a reason for those actions". He illustrates the point with an example. It is in the long run interest of a corporation that is a major employer in a small community to provide resources to providing amenities to that community or to improving its government. That may make it easier to attract desirable employees, it may reduce wage bills or lessen losses from pilferage or sabotage or have other worthwhile effects.

Friedman observes "in the present climate of opinion, with its wide spread aversion to 'capitalism', 'profits', the 'sole-less corporation and so on, this is one way for a corporation to generate goodwill as a by-product of expenditures that are entirely justified in its own self-interest." 

Is the present day perspective on CSR different from the perspective presented by Friedman? It is not. Even the perspective of the Indian government, which has mandated CSR spending of two per cent  of average net profit of the previous three years by profitable and large companies, is not different from that developed by Friedman.

Section 135 of the Companies Act 2013 stipulates that CSR fund should be spent preferably in the local area and areas around it where it operates. This implies that the government wants companies to take up projects in the local community to ensure that they benefit the company and help increasing profits.

The Board's CSR Committee that is to be constituted under the Companies Act 2013 should go by the thesis presented by Friedman, that is, 'the social responsibility of business is to increase its profits'. In formulating CSR policy it should abide by that philosophy. It should evaluate each CSR project applying the same principles that the Board applies in evaluating investment proposals and in allocating resources to capital expenditure, except that it cannot quantify return on investment (ROI) or net present value (NPV). This will take time. Therefore, in the first year, many companies will not be able to spend the amount allocable to CSR activities and shall transfer the same to the CSR corpus.

Should speed take precedence over identification of projects and judicious allocation of resources? A recent news on the displeasure of the 'Parliamentary Committee on Coal and Steel' on Coal India Limited's (CIL) inability to spend CSR funds is disturbing. CIL accounts for eighty per cent of the domestic coal production. It is a listed public sector enterprise (PSE). During the year 2011-12, CIL could spend only Rs 82 crores (US $ 13 million), which is just 15 per cent of the total fund allocated for CSR spending as per the guidelines issued by the Department of Public Enterprises (DPE), government of India. The Committee said it was a failure on the part of the officials responsible for CSR spending. We do not know the reasons for that failure. But this public rebuke by a political committee should not be construed as a signal that speed of spending is more important than other aspects of CSR spending. Slow CSR spending is a much lesser crime than squandering shareholders money in the name of CSR.

Wednesday, December 4, 2013

Infosys Example: Independent Director's Role in Strategy Formulation and Implementation

I was going through the article entitles 'Infy's Many Faces' published in 'Fortune India' (November 2013 issue, pp. 70-77). I have not verified the facts stated in the article. I presume that the information provided is correct.

While reading the article, it came to my mind that if the Board's role in strategy formulation is so minimal in Infosys, which  is rated at top in corporate governance, what could be the role of the Board in other companies.

The Companies Act 2013 (Code for independent directors) requires independent directors to bring independent judgement in the board room discussion on strategy. Thus, their responsibility  does not end with performance evaluation of the company. It is much more than that. They are expected to play a key role in strategy formulation and implementation.

The story published in Fortune India emphasises  that Infosys strategy reflects the aspirations of Mr. Narayan Murthy even after his departure. The company could not modify the business model to respond to the changing business needs. The article writes "Current CEO, S.D. Shibulal's visions of PPS (products, platforms and solutions) has lost focus with Murthy's return." The article presents few more examples.

In formulating strategies, companies must consider the aspirations of the CEO and other executives who are responsible for implementing those strategies. Therefore, one important aspect of strategy formulation is to balance aspirations of different individuals involved in the implementation of strategies. It is as important as matching alternative strategies with core competencies and the risk appetite of the company. Articulation of risk appetite, mapping of core competencies and balancing different aspirations are three critical aspects in strategy formulation.

If, we examine the Infosys example, it is clear that the company did not give due consideration to the aspirations of those who are responsible to implement strategies. Infosy's strategy was Mr. Murthy's strategy. Similarly, it could not detect the symptoms of the failure of the current strategy well in time. Is it  Board'd failure to balance the aspirations and views of everyone who are responsible for implementing strategies? 'Failure' may be a strong word. But, the Board's decision to invite Mr. Murthy to take charge of Infosys, which has lost its leadership position, vindicates the fact that the company's strategy was Mr. Murthy's strategy and the Board did not play any substantive role in formulating strategies.

The situation in Infosys is not unique. Conventional wisdom is that independent directors do not have adequate knowledge of the business and industry and therefore, they cannot contribute effectively in strategy formulation and implementation. It is enough to communicate them new dimensions of company's strategy at the annual strategy meet.

There is no doubt that the executive management is in a better position than independent directors in  formulating strategies. Independent directors might find it difficult to provide any deep idea. They are not expected to provide the same. Their responsibility is to review alternatives, balance aspirations and review the current strategy to detect early symptoms of failure, if any. Executive management cannot takeover those functions of independent directors. Executive management is the owner of the existing strategy. Therefore, it cannot bring objectivity in reviewing the current strategy. similarly, balancing aspirations is a difficult task for the CEO as executive directors are subservient to the CEO and cannot articulate their aspirations clearly and forcefully. Independent directors should play the role of arbitrator.

Independent directors should have a clear understanding of the business and its environment to perform their duties in respect of strategy formulation and review. Unfortunately, most independent directors find themselves inadequate in handling the responsibility because they do not invest the time and efforts that is required to understand the business and its environment.

Let us hope that the things will change.

Saturday, November 23, 2013

Companies Act 2013: Public-financed Companies and Ornamental Provision

The Companies Act 2013 and Draft Rules framed under the Act has brought the concept of 'public-financed  companies'. The Act, read with Draft Rules, requires that one-third of the total number of directors shall be independent directors in the Board of:
(i) listed companies,
(ii) public companies having paid up share capital of Rs 100 crores (approximately US $ 16 million), and
(iii) public companies, which have in aggregate, outstanding loans or borrowings or debentures or deposits exceeding Rs 200 crores (Approximately US $ 32 million),

Those companies, which are required to appoint independent directors in the Board, shall constitute an Audit Committee, and a Nomination and Remuneration Committee. The Audit Committee shall have a minimum of three members, majority of whom shall be independent directors. The Nomination and Remuneration Committee shall have three or more non-executive directors, one-half of whom shall be independent directors. The Chairman (executive or non-executive) may be  a member of the Committee but shall not chair the Committee.

Listed companies and companies, including private companies (also called closely held companies), that accept public deposit or borrowed money from banks or financial institutions in excess of Rs 50 crores (US $ 8 million) shall establish a vigil mechanism. The vigil mechanism shall operate through the audit committee. Companies that are not  required to constitute the audit committee shall designate one of the directors to act as the audit committee.

Why the government mandates appointment of independent directors and constitution of  Audit Committee and Nomination and Remuneration Committee in an unlisted public company, which has a paid up capital of Rs. 100 crores or  outstanding loans or borrowings or debentures or deposits, in aggregate, exceeding Rs 200 crores ? We may surmise that the government expects independent directors in such a company to protect the interest of both equity shareholders and debt holders. If, this is the spirit of the law, independent directors in listed companies shall also be accountable to both shareholders and debt holders.

This new dimension in the Companies Act 2013 will not cause any  problem when the going is good for the company. But, independent directors will find it extremely difficult to perform their duties when the company is going through a crisis, particularly financial crisis. They shall be confused as to which group enjoys the primacy in the company. The law does not provide any clarity.

By definition, debt holders are less risk averse than shareholders. The Board has the responsibility of establishing and articulating 'risk appetite', which is the amount of risk, at a broad level, a company is willing to take in pursuit of value. Risk-appetite  of a company depends on the profile of  shareholders, particularly that of the controlling shareholder group. In a professionally managed company, it reflects the risk-appetite of of the executive management, which, at least in theory, is the agent of shareholders. Should the Board reduce the level of risk-appetite  when the going is bad to protect debt holders from loss? Should the Board act little more aggressively in pursuit of value to protect the interest of shareholders ?

The conflict of interest between debt holders and shareholders surfaces when the company goes through the financial crisis. Assume that a company has to submit proposal to the bank for financial restructuring. The Board is required to predict the future. The executive management will tempt to take an optimistic view due to its natural bias towards shareholders and also due to its propensity to entrench control. The bank will tempt to take a pessimistic view to protect itself from the down side risk. Theoretically, independent directors should help both the groups to arrive at a balanced view. It is not an easy task. After all, forecast is judgemental. Only a highly independent director who enjoys respect from the promoter, executive management and lenders will do a good job in a crisis situation, provided he has the  skill of framing sound judgement in a crisis situation.

Will unlisted companies be interested to appoint such individuals as independent directors? Will they be able to induce such individuals to join the Board? I guess that the answer to both the questions is negative? If it is so, the provisions related to public-financed companies is just ornamental. I wish that I am proved wrong.

I see reason for establishing vigil mechanism in unlisted public companies and private companies which have significant borrowings. Vigil mechanism is a tool for fraud management and helps to get an indication that some fraud is being committed. The moot question is whether unlisted public companies and private companies shall have adequate motivation to ensure that the vigil mechanism is adequate and operating effectively. I have my own doubts.

Sunday, November 17, 2013

CSR Issues Continue to Remain Unresolved

My column in today's Business Standard
CSR Issues Continue to Remain Unresolved

Companies Act 2013: Woman Director

The Companies Act 2013 and Draft Rules mandate that every listed company shall have at least one woman director in the Board within one year from the commencement of the relevant provision of the Companies Act 2013 [section 149 (1)]. Every other company, including a private company, having paid up capital of Rs 100 crores (about US $ 16 million) shall have at least one woman director in the Board within three years from the commencement of relevant provision.
When I conduct training programmes for directors often two issues come up for discussion. First, why this quota? Second, whether companies will be able to comply with this provision within the short period allowed for compliance?
First, 'quota' is not mandated as  an  affirmative action to benefit a under-privileged or under-represented groups, although in Indian sciety  women form an under-provileged group. This quota will not touch those women who suffer due to inequality in the social status and privileges between men and women. The aim of the the mandatory provision in the Companies Act 2013 does not aim to benefit women, as a group. The aim is to bring gender diversity in the Board. It is believed that gender-diversity adds to the effectiveness of the Board. It is generally believed that women have more empathy and interpersonal skills than men. Most issues that are placed before Boards have peole and relationships dimensions in them. Therefore, a woman director is expected to bring different perspectives on critical issues that Boards are required to address. In addition, in order to break the glass ceiling, women have to pass through more and tougher hurdles compared to their male counter parts. Therefore, women who reach top positions in corporates and other professions develop better skills in handling difficult situations. Therefore, they are likely to take tough decisions while being sensitive to human issues. However, the proposition that gender-diversity will improve the Board effectiveness is still at the hypothesis stage. A hypothesis is an educated prediction. The hypothesis is not yet tested to come to a definitive conclusion. We should not expect that companies, except enlightened companies, will bring gender-diversity in the Board voluntarily as they do not see the benefits. Mandatory inclusion of at least one director in the Board of listed and large companies might provide enough data to researchers to test the hypothesis in future.
BSE has 5,281 listed companies as at November 14, 2013.  If we take this number as an estimate of listed companies, within one year  5,300 women, who qualify (in terms of technical and soft skills) for induction in the Boards, are to be identified.  Will it be difficult to search those 5,300 women?  I do not think that it will be difficult provided there is a will to comply with the provision in spirit, without compromising on the 'fit and proper' criteria. There are large number of women who occupy senior positions in companies or are doing well in different professions, although the number is low as a percentage of total female population in India. Companies may appoint executive search firms to identify potential candidates. The law does not stipulate that the woman director should be an independent director. Therefore, may companies may find it easier to to induct a female as an executive director or a non-executive (not independent) director, may be from acquaintances and top executives within the company. The danger is that some companies may  appoint some one who does not qualify to be appointed as a director just to comply with the provision. I am hopeful the number of such companies will be small.
The number of unlisted companies with paid up capital of Rs 100 crores is not significant. They should not find it difficulet to comply with the provision within three years.
In this context I like to draw attention to the HBR (June 2013) article entitled 'Diversification in the Board Room' authored by Groysberg and Bell. The article describes the US experience and provides interesting insights on gender diversity in Boards. It is a good reading. 

Friday, October 18, 2013

Do not demoralise the CBI

The recent FIR by the CBI in Coalgate Scam has drawn flaks from industry associations and IAS lobby. The reason is simple. It has named two respectable and powerful persons in the FIR -  Kumar Mangalam Birla and former buereaucrat P.C. Parekh, both of whom belong to to the high echelon of the society.

Some argue that naming Mr. Birla in the FIR will demonish business and naming Mr. Parekh will demotivate bureaucrats. This will will move businesses outside India and will lead to decision paralysis in the governmnet. If business persons find greener pastures outside India, they will move there irrespective of whether FIRs name business persons or not. Bureucrats who aspire high positions will seldom be whistle blowers. Decision paralysis occurs due to political reasons and not at the will of governmnet officials. While saying so, we should accept that actions causing demotivation to governmnet officials or harrassment to honest entrepreneurs hurts the economy and the society. However, the dysfunctional effects should not be magnified.

Another news that is published today (October 18, 2013) is regarding Supreme Court's order  to the CBI to probe Radia tape criminality. SC has used harsh words. Radia tape scandal also involves respectable business houses.

Society needs businesses and entrepreneurs as businesses serve the needs of the society. Therefore, entrapreneurship should be encouraged. Political parties need funds for financing election campaign in a democracy and business provides a large part of the financial support. Therefore, nexus between political parties and business cannot be avoided. Bureaucrats often takes decisions on the direction of the political boss. Therefore, they should not be blamed for incorrect decisions. Perhaps, these are inevitable outcomes of democracy.

The hullabaloo on the FIR shows the CBI on a poor light. It may not be wrong to assume that the CBI has done its homework before filing the FIR. Therefore, to declare, at this stage, that the CBI action is foolhardy is laughable. We need institutions like CBI, Election Commission, CAG and judiciary to protect the interest of common citizens against corruption, criminalisation of politics and crony capitalism. Let us protect their independence. This is  the responsibility of all the citizens, who are powerful and opinion leaders irrespective of their profession or vocation.

It is quite likely that Mr. Birla,  business houses involved in Radia tape scandal and Mr. Parekh will come out clean. It is not that every one named in a FIR is found guilty. Naming a powerful person in a FIR makes a sensational news. Therefore, media tempts into magnifying the issue and that makes those who are named  to worry about blemish on their social stature. But creating a fuss on a FIR that names powerful will demoralise the officials working for those institutions that are pillars of democracy. Let us stop demoralising them. Media has to take the lead.

India Inc Performance Below Par In Corporate governance?

The story published in the Business Standard today (October 18, 2013) reports that the 'India Inc performance below par in corporate governance'. The report is based on a study by InGovern Research Services, a proxy advisory firm. The firm analysed top 100 companies that form part of the Nifty and Junior Nifty indices.

The study draws conclusions from the following facts (as mentioned in the report):

10 per cent of the companies have less than seven or more than sixteen directors;
17 per cent of directors on an average attend less than 75 per cent of board meetings;
Average number of board meetings held was seven;
The number of independent directors in 13 per cent of the companies is less than 50 per cent;
22 per cent of independent directors have served the company for more than nine years; and
36 companies have had the same auditors for more than 10 years.

Can we draw any definitive conclusion from the above facts?

The Companies Act 2013 provides that the number of directors in the Board should not exceed 15, unless approved by shareholders by a special resolution. It is difficult to establish that the optimum size of the Board is 15. Literature says that smaller the Board, better it is. Deliberations in a Board meeting is not effective if the size of the Board is large. At the same time it says that a Board that has diversity in terms of  knowledge and skills, and experience works better than a Board that lacks such diversity. We must appreciate that the same size does not fit all. The size of the Board depends on the nature of its businesses. A company that is engaged in different types of businesses should have a larger Board than the same of a company that is engaged in a single business. The size also depends on the complexity of the business. The size stipulated in the Companies Act 2013 is only indicative. That is the reason why the Act enables a company to have a larger Board with the approval of shareholders by a special resolution. It is unlikely that shareholders would bother too much about the size of the Board. Their main concern is the performance of the company. If a company consistently performs as per the market expectation, shareholders would not bother about the Board size. More likely that they will leave the decision on the size of the Board to the management.

The fact that 17 percent of directors, on an average, attend less than 75 per cent of Board meetings does not throw much light on the state of corporate governance. To me, 17 per cent is not a large number to ring warning bell about the state of corporate governance in India.

The fact that Average number of Board meetings was seven signals positive aspect of corporate governance. The Companies Act 2013 requires minimum four meetings a year. Again it cannot be said that four is the optimal number. It depends on the requirements of the company in a particular year. Too long a gap between two meetings signals poor governance as it reflects management's attitude towards the Board and lack of oversight on executive decisions.

The fact that the number of independent directors in 13 per cent of the companies is less than 50 per cent reflects non-compliance. Any kind of non-compliance with laws and regulations cannot be defended. However, the brighter side is that 87 per cent of companies complied with clause 49 of the Listing Agreement.

The fact that 22 per cent of independent directors have served the company for more than nine years does not reflect poorly on Indian corporate governance. In most Indian companies the dominant shareholder group controls the company. The controlling shareholder, who manages the company, takes the Board as the sounding board and look at board members for advises. The monitoring role of the Board is less prominent than it is in companies where shareholding is dispersed and the company is managed by professional managers. Therefore, long tenure of dependable independent directors serve Indian companies better. The Companies Act 2013 stipulates that an independent director can serve a maximum of two terms of five years each. He/she will be eligible for reappointment after cooling off period of three years. This will not change the scenario significantly. The controlling shareholder will continue to consult the retired independent director, whom he/she considers friend, philosopher and guide, outside the Board and will reappoint him in the next available opportunity.

It is not a surprise that 36 companies have the same auditors for more than ten years. It is no different from the situation prevailing in developed countries. Indian Companies Act 2013 has introduced the rotation of auditors. We should take it only as an experiment. The debate whether the rotation of auditors improves the audit quality is yet to be settled. We have to wait to see the result. However, it will be difficult to estimate the result because a number of provisions have been introduce, at the same time,  in the Companies Act 2013 to improve the audit quality and the quality of financial reporting by companies. Perhaps, we shall live with it in years to come without knowing the actual result. It will definitely increase the cost of audit and will create hardship for audit firms, particularly small firms.

I do not agree that we can conclude that Indian companies are lagging in corporate governance based on the above facts.

The same news paper (Business Standard) reports on the same day (October 18, 2013) that Indian companies have performed best among companies in emerging market economies in terms of transparency in corporate reporting based on a report by Transparency International.

The Report says that India is an exception among BRIC countries.

The Companies Act 2013 has incorporated many of the so called best corporate governance practices adopted by developed countries. This will enhance the confidence of international investors in Indian companies. It may not improve corporate governance. Measuring quality of corporate governance is always illusive. It is better to measure outcomes of corporate governance, such as, quality of financial reporting and outcome of CSR activities.

Tuesday, October 8, 2013

NSEL: A Fit Case For Lifting The Corporate Veil?

Business Standard has reported that the NSEL Investors Forum, a body that represents investors of the National Spot Exchange Limited (NSEL), have  written to the Securities and Exchange Board of India (SEBI) and the Forward Markets Commission (FMC) seeking liquidation of foreign assets of Financial Technologies (India) Limited (FTIL) to pay investor dues. It argues that investment by FTIL in businesses that are making losses is against prudent business practices.

FTIL owns 99.99 percent stake in NSEL. In law FTIL is the promoter-shareholder of NSEL. In Salomon Vs. Salomon & Company Limited, in 1897, the House of Lords established the fundamental principle that a limited liability company must be treated like any other independent person with its right and liabilities appropriate to itself. Therefore, the company is an entity different from the shareholder who owns all the shares of the company. According to this fundamental principle, FTIL is not liable to pay to the creditors of NSEL. The liability of a shareholder of a company is limited to the amount unpaid on shares that the shareholder owns.

Courts some time disregard this fundamental principle. This is known as 'lifting the corporate veil'. There is no bright line for deciding situations in which courts pierce through the corporate veil and make shareholders accountable for the omissions and commissions of the company. Therefore, courts take a view depending on the facts of the case.

Generally, courts lift the corporate veil if the company is a sham and is created to perpetrate fraud or the company is an agent of the shareholder. Sometime, the courts consider group which consists of the holding company and its subsidiaries, as a single entity. For example, if we consider FTIL group companies as a single entity, FTIL will be held liable to pay NSEL's creditors. 

Courts pierce the corporate veil of subsidiaries only in special circumstances. They consider the Group as a single entity only if the separate entity is a facade, that is, the outer appearance is maintained to conceal facts.

Section 542 of the Companies Act 1956 provides that if in the course of winding up of a company, it appears that any business of the company has been carried on with intent to defraud the creditors of the company or any other person or for any fraudulent purpose, the persons who are knowingly parties to the carrying on of the business, in the manner aforesaid, shall be personally responsible, without any limitation of liability for all or any of the debts or other liabilities of the company, as the court may direct.

Let us examine if NSEL is a fit case for lifting the corporate veil. My view is that it is not a fit case for lifting the corporate veil. It was not created for a fraudulent purpose. Its intent was not to defraud creditors. It was not an agent of FTIL. On the face of it the company was created as subsidiary of FTIL because of the totally different nature of business and not to conceal the reality. In order to apply the provisions of section 542, investors have to establish that the business was carried on to defraud creditors and FTIL was a party to that.

The deciding factor will be whether the amount collected from investors was tunneled to FTIL to support its investments. On the basis of the available information, it appears that the money collected from investors did not flow to FTIL. Borrowers used it to create assets or for working capital.

In conclusion, FTIL can not be held liable to NSEL's creditors unless it is established that funds collected from investors were used by FTIL for investments in different businesses.

I am also not sure whether investors are NSEL's creditors. If the contract is between investors and borrowers, investors are not NSEL's creditors unless NSEL has guaranteed payment to investors by borrowers.

Monday, October 7, 2013

Companies Act 2013: Fiduciary Responsibility of the Board to Stakeholders

The Code For Independent Directors (Schedule IV of the Companies Act 2013), among other things, describes the role and function of independent directors. It says that one of the roles of independent directors is to "safeguard the interest of all stakeholders, particularly minority shareholders'. Another role is "balance the conflicting interest of the stakeholders".

Section 178 (5) of the Companies Act 2013 provides that "The Board of directors of a company which consists of more than one thousand shareholders, debenture-holders, deposit-holders and any other security holders at any time during a financial year shall constitute a Stakeholders Relationship Committee consisting of a chairperson who shall be a non-executive director and such other members as may be decided by the Board." Section 178 (6)  provides that "The Stakeholders Relationship Committee shall consider and resolve the grievances of security holders of the company". Quite interestingly, although independent directors are responsible to balance the conflicting interest of stakeholders, the Committee may not have independent directors.

Section 177 (9) of the Companies Act 2013 provides that "Every listed company or such class or classes of companies, as may be prescribed, shall establish a vigil mechanism for directors and employees to report genuine concerns in such manner as may be prescribed." As per the Draft Rules, companies which accept deposits from the public and companies which have borrowed money from banks and other public financial institutions in excess of fifty crores rupees (Rs 500 million) shall establish a vigil mechanism.

The Companies Act 2013 has not defined the term 'stakeholder'.

When we read all the provisions together, it appears that the Companies Act 2013 considers shareholders as the primary stakeholder group. Other security holders come next. Some may consider that the Act has considered  employees as stakeholders, because the vigil mechanism covers them. The vigil  mechanism is an important tool for fraud risk management and for monitoring compliance with ethical code. Therefore, in strict interpretation of the vigil mechanism, employees are agents who  protect the interest of shareholders and other security holders by blowing the whistle. The mechanism does not directly benefit employees. Therefore, it is incorrect to say that the Act  considers employee group as one of the stakeholder groups.

The Act requires independent directors to balance conflicting interest of stakeholders. We may interpret that independent directors are required to balance the interest of controlling shareholders and minority shareholders. Thus, the Act requires independent directors to address principal-to-principal issues.

independent directors are also required to balance the interest of  shareholders and other security holders. As per law, the Board has fiduciary relationship with shareholders. It should ensure that funds entrusted to the company by shareholders are used for the benefit of shareholders. Courts, particularly, US Courts do not recognise fiduciary relationship with other stakeholders, even debt holders. It appears that the Companies Act 2013 brings a departure from this established principle. In other words, the Companies Act 2013 requires independent directors and the Board to protect the interest of both the debt holders and shareholders and in a situation of conflict of interest they should endeavour to establish a balance between the two. We have to wait for Court's interpretation of this provision. However, if this interpretation is correct, the provision will definitely make the job of independent directors very difficult. It may be argued that in the long term shareholder's interest is protected if debt holder's interest is protected because unreasonably high gearing affects the valuation of the company and might lead to the demise of the company. But in practice, controlling shareholder group and managers, in order to entrench control, invest in speculative projects particularly when the going is bad. It is difficult to identify the right stage when the independent directors should act to strengthen the scrutiny of new projects.

There are examples galore when bad projects are financed by banks and other financial institutions. It is the primary responsibility of the lender to protect its interest. Often non-performing assets (NPA) arise due to poor internal governance of the lender. It would be inappropriate to make independent directors of the borrower for NPA arising from the failure of the borrower to repay the loan as per agreed terms. A question arises that if the law has not made independent directors responsible to protect the interest of vendors, customers and employees, why should it hold them responsible to protect the interest of lenders. Is it because banks and other large financial institutions are controlled by the government? We do not have the answer.

Stakeholder groups are those that are affected by or can affect the company's operations. Stake holder groups include the local community. The concept of stakeholders in the Companies Act 2013 is quite narrow, presumably because it is difficult to provide legal protection to all stakeholders under the corporate law without creating undue hardship to companies. CSR provisions indirectly protect the interest of the local community. Thus, law makers have not undermined interests of that stakeholder group.

Saturday, October 5, 2013

NSEL: Let us not cry for investors, rather worry about the auditing profession and regulators

Economic Times reports that the Economic Offence Wing (EOW) of the Mumbai Police reported that thirty of the sixty warehouses it raided  were found to be empty. The EOW official also revealed that four warhouses that are on documents siezed by it did not exist.

It might be a revelation to some but not to the Forward Market Commission (FMC). Business Standard reports that it was known to FMC for more than a year.

The show cause notice issued by the Ministry of Consumer Affairs in April 2012 mentions "NSEL has not made it mandatory for the seller to actually deposit goods in the warehouse before taking a short-position through a member of the exchange. The exchange system has no stock check facility that validates the member's position. The exchange allows trading on the exchange platform without verifying whether the seller member has the stocks with him or not. In this way the exchange has violated conditions stipulated that no short-sale for the members of the exchange will be allowed."

NSEL replied within fifteen days from the receipt of the notice. FMC took fifteen months to issue instructions for stopping the launch of new contracts and for settling all contracts with open position.
We know that files in government departments move slowly. But speed of response of FMC iraises suspicion that officials of FMC and Ministry of Consumer Affairs connived with the management of NSEL and borrowers to defraud investors (!).

It is quite possible that investors knew the fact that the warehouses were empty. They were happy with the rate return on investment which was higher than the return that investors earn on unsecured long -term deposits with companies. The return on investment was attractive. It is difficult to believe that lenders (investors) are naive and do not understand that there is a correlation between risk and return. They are high net worth individuals and each must be holding a portfolio of investments.  Therefore, it might be incorrect to say the investors have been defrauded by lenders and NSEL management.

Quite likely that the auditor of NSEL also knew that some warehouses were empty. In 2012 Mukesh P Shah & Company was appointed as the auditor in place of S V Ghatalia & Associates, which expressed unwillingness to continue as the statutory auditor. As per the Code of Ethics issued by the Institute of Chartered Accountants of India, an incoming auditor must communicate with the outgoing auditor.   S V Ghatalia & Associate might have communicated the reasons for their unwillingness to continue as statutory auditor. This should have alterted the incoming auditor. Even if the outgoing auditor had not communicated transparently the reasons for its unwillingness to continue, the incoming auditor was responsible for applying additional procedure to assess the audit risk. Change of auditor itself is a red flag. An auditor is espected to approach an audit assignement with skeptical approach. It should be more cautious when taking over an assignment that was handled by another auditor. It is unlikely that the auditor (Mukesh P Shah & Company) did not verify warehouse stocks. Although a conjecture, we may reasonably assume that the auditor knew what was going on.

Everyone was happy so long as the crisis did not erupt. Let us not cry for the investors. However, the Institute of Chartered Accountants of India should investigate the auditor to protect the credibility of the auditing profession. Similarly, government officials need to explain the delay in issuing instructions to NSEL.

Friday, October 4, 2013

De-criminalisation of Politics - Is Democracy Working?

We hailed Supreme Court verdict that a law maker would be disqualified immediately on being convicted in a criminal case punishable with more than two years in jail. The Supreme Court had struck down section 8(4) of the Representation of People Act 1951. This subsection of Section 8 provided for the suspension of the disqualification if within the next three months an appeal or revision was brought against the order. Most convicts, if they are wealthy or otherwise powerful, appeal against the conviction pronounced by the lower court at a higher court. Consequently, in most cases, in the past, disqualifications were suspended.

Then we learned that the Government would bring an Ordinance to nullify the Supreme Court verdict. We thought it was a step in retrograde. Subsequent events proved that the President is not a paper tiger. The government withdrew the Ordinance after Mr. Rahul Gandhi, the Vice President of the Congresses had condemned the Ordinance as 'nonsense'. We do not know whether Mr. Gandhi's sharp criticism of the Ordinance in a public forum came from his personal conviction or was simply a damage control exercise. We were subsequently explained that even attaining the age of forty, you remain a kid and you should be excused even if you disrespect the highest office in the Government due to wrong choice of words and expressions.

Mr. Lalu Prasad Yadav has been sentenced for five years and consequently he has lost his seat in the parliament. He is disqualified immediately to context elections for the next six years.

The whole episode took the nation through different shades of excitement. Some said that the Supreme Court judgement was a big leap forward in de-criminalisation of the Indian politics. Some perceived Mr. Gandhi's outburst as the expression of the anguish of the young generation driven by their concern for the increasing criminalisation of politics. As a whole that nation believed that something 'good' is happening.

Today the Times of India reports that Mr. Lalu Prasad Yadav seems to have been enjoying the jail stint as other inmates are providing services to him. The report also says that he is "as good as he was outside the jail."

None  other than a political leader of Mr. Yadav's stature can understand the implications of his imprisonment. His coolness signifies that he could see a silver lining in his punishment. Perhaps it will accelerate the process of achieving political ambition of his son. May be that his party will benefit not only from the induction of a young face and brain at the helm of the party and by declaring himself as a martyr.

We in India believe too much on conspiracy theory. We smell conspiracy whenever an unpleasant event affects any one, particularly if it happens to a political leader of Mr. Yadav's stature. Moreover, the mass do not give weight to corruption issues or criminal acts of leaders. Quite likely that Mr. Yadav's supporters believe that he is jailed for a small crime due to the criminal conspiracy of opposition political parties.

Those who are marginalised in the society find it difficult to trade off between development and corruption or criminalisation of politics. They take corruption as a 'way of life' of those who enjoy power. More importantly, development is the priority for them because the aspire for a better quality of life. This phenomenon is reflected in past election results. Therefore, political parties thrive even if their leaders are convicted.

The Supreme Court judgement shall have a marginal effect if the government fails, intentionally or otherwise, to convict political leaders who are involved in crimes.

We have to wait for future elections, particularly the general election of 2014, to understand the mood of masses. After the general election we shall see if the number of members with criminal background in the new parliament is reduced substantially and the number of voters who rejected all the candidates.

My conviction is that nothing will change significantly. At present I take Supreme Court's verdict as a small step towards de-criminalisation of Indian politics and not a big leap forward. I shall wait for a surprise.

Thursday, October 3, 2013

Risk Averse Independent Directors

As I conduct workshops for directors I see that  the Companies Act 2013, has made independent directors jittery. In the garb of providing immunity, the Companies Act enhanced the accountability of independent directors and rightly so. If one takes up a responsibility, whether voluntarily or otherwise, he/she makes himself/herself accountable for his/her decisions. When an individual joins a Board he/she enters into an implicit contract with shareholders that he/she will act diligently to protect the interest of the company, meaning thereby that he/she will not be biased toward a particular group of shareholders. If, he/she fails in his/her commitment, he/she should be held responsible for the loss suffered by shareholders due to his/her negligence.
What is the expected impact of the new provisions of the Companies Act 2013 that hold an independent director responsible for the omissions and commissions by the company if it is established that the independent director could stop occurrence of those omissions or commissions had he/she acted diligently? Quite likely, extremely risk averse independent directors will stay away from Board membership. Some, who are not so risk averse will assume the role of policing the executive management and will be eager to record dissent to protect themselves from any liability that might arise in future. Those who have leadership qualities and who are able to devote time to the job shall act diligently.
Liabilities will arise for fraudulent activities of the company. No liability will arise if with hindsight it appears that a business decision should not have been taken. Therefore, independent directors should not get worried unnecessarily. Recording of dissent should be the last resort when the independent director believes that the proposal under consideration is blatantly wrong.
It is true that the role of the Board is to monitor the executive management. But in practice, independent directors role is to bring independent judgement in Board deliberations. Independent directors role is to encourage entrapreneurship in the company rather than bringing an additional layer of control that has the potential to damp the entrapreneurship spirit.
We create confusion when we consider executive directors as insiders and independent directors as outsiders. This divide within the Board is unfortunate. Transparency within the Board gets adversely affected with this divide. This also has dusfunctional affects becuse insiders become zealous to defend their decisions and outsiders examine decisions with the 'audit approach'. Board should work as a single unit. All Board members are insiders. Independent directors should appreciate that executive directors have better understanding of the business and the environment within which it operates. Executive directors should appreciate that thay cannot review their own decisions objectively and therefore, they are benfitted by the critical evaluation of their decisions by indpendent directors.
When questions, such as 'how close should I be with executive director and members of the top management' come from from indpendent directors we should accept that the divide real, at least in the mind of directors. The first task of everyone of us is to change this perception to improve corporate governance.

Wednesday, September 18, 2013

Manufacturing excellence on board agenda - Ranbaxy, a case in hand

As reported in the Business Standard in its September 18, 2013, issue, The US Food and Drug Administration (FDA) has extended the ongoing consent degree with the company for its Paonta Sahib (Himachal) and Dewas (Madhaya Pradesh) units to its third and newly commissioned manufacturing facility at Mohali (close to Chandigarh),which had attracted an import alert from the regulator on Friday. As a result  three major units of Ranbaxy are now barred from supplying drugs to the US. Ranbaxy gets more than 40 per cent sales from that country.The decisions of the FDA will hurt the company hard and shareholders will lose value.

Japan's Daiichi Sankyo owns 63.5 percent shares of Ranbaxy. Daiichi acquired Ranbaxy in June 2008. Thus, Ranbaxy is being controlled by the Japanese company for  five years now. The problem of failure to compply with good manufacturing standards could not be sorted out by the new owner during this period. This shows how deep rooted is the culture of accepting small deviations from the standard operationg procedures (SOP). If that approach is prevalent in an industry which is under the surveillance of a strict regulator, it may not be incorrect to assume that such deviations are not uncommon in other manufacturing companies.

Penalty and loss of contribution from lost sales are not the only costs of  deviating from SOP. Deviations from SOP always increases the cost of operations due to increase in waste in many forms. Companies, often do not calculate the same and allow such deviations to be reported and settled at the lower level of management. This 'chalta hai' ( it is OK) approch costs India dear in terms of low productivity of resources and in many other ways. For example, US ban on the import of drug from three facilities of Ranbaxy is not only a loss to the company but a loss to the country in terms of lost opprtunity to earn foreign exchange, lower utilisation of productive capacity and incresing concerns about quality of India's products.

This 'chalta hai' approach might become a major road block in achieving the mission of achieving manufacturing excellence even when India will create right infrastructure and manufactiring facilities.

Board of directors should own up the responsibility to change the ;chalta hai' culture at the shop floor. Board members should look back to see how many times 'achieving manufacturing excellence' was on the Board agenda and how many hours were spent on this issue in the Board meetings.

Independent Director - Is he/she required to blow whistle before the government?

The Companies Act 2013 has introduced certain provisions to strengthen the vigil mechanism. Section 143 (12) requires the auditor to blow whistle if he/she, during the course of audit, finds that a fraud is being or has been committed against the company by the officers and employees of the company. The auditor is required to report the matter to the Central Government.

Section 177 (9) requires that every listed company and certain other specified companies shall install a vigil mechanism for directors and employees to report genuine concerns. The vigil mechanism should provide adequate safeguard agains the victimisation of the whistle blower and should provide direct access to the chairperson of the Audit Committee in appropriate and exceptional cases.

One of the duties of the independent directors as par the Code For Independent Directors under the Companies Act 2013 [Schedule IV, clause (III)(11)] is to report concerns about unethical behaviour, actual or suspected fraud, or violation of the company's code of conduct or ethics policy. The Code does not mention to whom the independent director shall report.

Reading the Code with section 177 (9) gives the impression that the indpendent director should report the matter to the chairperson of the Audit Committee. As per the Companies Act 2013, the chairperson of the Audit Committee should not necessarily be an independent director. Therefore,  an executive director or the CEO, if he/she is a Board member, can be appointed as the chairperson of the Audit Committee. This mechanism is not effective to correct a situation where a senior executive, in connivance with the CEO or with the consent of the CEO, violates the code of conduct or code of ethics or perpetrates fraud.

Therefore, it should be be clarified that whether an independent director should blow the whistle before the governmnet or a regulator or any other governmnet authority if he/she believes that blowing the whistle before the chairperson of the Audit Committee will not be effective. The second question is whether the governmnet expects independent dorectors to report such matters to the governmnet and/or a regulator. If that is the expectation, what is the penalty if an independent director fails to do so.

The governmnet should clarify the position.

A danger of imposing penalty on indpendent directors if they fail to blow the whistle is that they will adopt policing approach rather than focusing on improving the performance of the company. Perhaps, it was enough to make the auditor accountable for informing the central governmnet of frauds that comes to his/her notice in the course of audit.

Monday, September 16, 2013

Kill the CSR - Chattisgarh Government Policy

The Hindu in its September 16, 2013 edition published a story on the CSR policy of the Chattisgarh government under the title 'Chattisgarh wants all CSR spending to go to CM Development Fund'. According to the report, the Chattisgarh government has advised all the private sector companies that are covered under the CSR provisions in the Companies Act 2013 not to undertake CSR activities on their own. They have been asked to contribute the amount (two-percent of the average net profit of past three years) to the CM's Development Fund. Such a contribution will be considered as CSR spending for the purpose of the Companies Act 2013. But the policy is ridiculous.

A directive to contribute to a fund created by the governmnet tentamounts to imposition of tax. This is not the spirit of CSR.

When a company executes CSR projects, either using its own resources or in partnership with another organisation that has experience in executing social projects, it derives number of benefits. It can use CSR projects to develop skills that are required in its business, which serve the both the community and the business. It can build social and relationship capital and earn the goodwill of the local community through developmental projects. Through engagment with stakeholders it can feel the social undrcurrents and social needs that help in identifying business opportunities and threats. It can involve employees in deciding CSR projects and executing them. This helps to sensitise employees to social issues and to develop leadership qualities in them. There are numerous other benefits that flow from CSR initiatives. The Chattisgarh CSR policy robs companies of those benfits.

Companies also should control the temptation to include purely business expenditure in CSR spending. Companies should also not include in CSR that are simply business initiatives. For example, engaging village women to sell company's products cannot be considered a CSR initiative, although it enhances earnings of women and to an extent, empower them by providing a kind of financial independence. Similarly, activities that benefit employees and their families are not CSR.

There is a great need to develop common understanding of CSR.

Sunday, September 15, 2013

Celebrate the creation of National Financial Reporting Authority

Today I have watched the Bengali movie 'Alik Sukh' based on the novel with the same title authored by Suchitra Bhattacharya.

'Alik Sukh' means 'fleeting happiness'. The protagonist of this film is a well known and very successful gynaecologist. He had failed to reach his patient in time when she was sinking after cesarean delivery causing her death. He was busy in signing an agreement with a real estate developer to buy an apartment to gift  his wife on the occasion of their marriage anniversary. This was the first occasion when his patient died. The protagonist could rationalise the death through intelligent arguments to himself and his wife. His wife was not convinced. She could not make the doctor husband realise that the patient had to die due to his professional negligence in spite of her best efforts. In the climax, the doctor relaised his negligence when his wife needed immediate surgery and the arrival of the anaesthetist was getting delayed exposing his wife to the risk of losing life due to delayed surgery.

Although the story of the movie is about the medical profession, this phenomenon of negation and rationalisation of actions through intelligent arguments is common among professionals of every hue. While this is true, in many occasions, what appears to be a professional negligence to the affected person and non-specialists, is not actually so. Only specialists can rightly evaluate cases which do not involve blatant violation of professional standards. Therefore, most professions are self-regulated. Unfortunately, self-regulation has an important limitation. Professionals are not god. They are human beings. Therefore, they sometime err in judgement in discharging their professional duties.  It is quite possible that those who are assigned the task of deciding a case of professional negligence, at some time or the other, might have rationalised some of their professional negligence. This obscure their objectivity. Moreover, they might be biased in favour of their professional colleague in order to protect the credibility of the profession. Complaints of professional negligence that fall in the grey zone are often decided in favour of the member of the profession. This adversely affects the credibility of the profession. Credibility is also lost as non-specialists perceive bias in almost every judgement which goes in favour of the member because of the real possibility of bias creeping in the decision-making process. The auditing profession is no different.

In recent times, globally, the credibility of the auditing prfoession has taken a beating due to detection of significant number of accounting frauds. India is no different. In USA, the Sarbanes-Oxley Act 2002 created the Public Company Accounting Oversight Board (PCAOB) to restore investors' confidence in the auditing profession. The formation of the National Financial Reporting Authority (NAFRA) under the Companies Act 2013 is also an initiative in the same direction. It should not be viewed as a judgement against the capability of the Institute of Chartered Accountants of India to enforce  professional standards. It is the right initiative by the government to improve the perceived audit quality. Moreover, it addresses the  inherent weakness in the mechanism of self-regulation.  

Saturday, September 14, 2013

CSR: India Moving Away From Philanthropic Approach

The Companies Act 2013 and the Draft Rules on CSR are over emphasizing the nexus between CSR and business. Section 135 of the Companies Act 2013, which requires large and profitable companies to spend two percent of the average profit of previous three financial years in CSR activities, says that a company should carry out CSR activities in the area where it operates and in areas closer to that area.
The Draft Rules explains the nature of CSR. It says: “CSR is not charity or mere donations.” It further explains: “CSR is a way of conducting business, by which corporate entities visibly contribute to the social good. Socially responsible companies do not limit themselves to using resources to engage in activities that increase only their profits. They use CSR to integrate economic, environmental and social objectives with the company’s operations and growth.”
I fail to understand how an organisation that is created to make money by servicing some social needs can have environmental and social objectives. Yes it has responsibilities in ensuring that natural capital will be available and affordable in distant future and that it is not adversely impacting the social fabric in general and the social fabric of the local community by its operation or the product or service. It also has the responsibility to adequately compensate outside stakeholders who bear the cost imposed on them by the company through unavoidable negative externalities. Perhaps, lawmakers in their zeal to establish that CSR is a business case used the term ‘objective’ instead of ‘responsibility’. I believe that CSR makes a business case when it is considered as a risk management tool.
By over emhasising the nexus between CSR and business, we are taking away the touch of philanthropy that was inherent in CSR activities of Indian business houses. If, we look at past records of business houses that are engaged in CSR activities, of course not as a PR initiative, much of those activities were guided by the urge to do some thing voluntarily in our ‘love for humanity’. Now, we are directing companies not to take up activities only for the ‘love of humanity’. The CSR Committee shall be accused of failing in applying due diligence process if it fails to establish the nexus between CSR and the business.