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.

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