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.