Sustainability - Environment, Social and Governace Issues

What should be the objective function of a  firm? My answer is 'creating shareholder value'. A business firm creates shareholder value while complying with applicable laws and regulations and social norms. When we discuss business sustainability, we often, argue that 'creating shareholder value' is a 'dumb idea'. It is unfortunate. A business is sustainable only if is able to earn return on invested capital (ROIC) that is higher than the cost of capital. We have to apply the traditional accounting and financial measures to calculate value created by a  firm. A  firm that creates 'social value', but fails to create 'shareholder value' is not sustainable. One may argue that a firm that creates social value, necessarily creates shareholder value. This is not correct. For example, a  firm that is manufacturing cigarettes might be destroying social value but creating shareholder value. So long the government does not ban the cigarette business a firm may see opportunity in cigarette business and invest in the same to create shareholder value. Similarly, a firm that creates negative externalities with the permitted level might be destroying social value but creating shareholder value.

Is sustainability a fad? No, it is not a fad. Enlightened firms integrate sustainability in their business model and strategic decisions. Sustainability initiatives of business firms are driven by the regulations or likely future regulations, government priorities, community and consumers. Firms are pushed to focus on sustainability by global concerns (e.g., climate change), government priorities (e.g., solar energy),  regulations (e.g., environmental laws) and  consumers (who demand sustainable products or products produced using sustainable process) and community (which demand reduced negative externalities and increased positive externalities).  Sustainability is pushed through advocacy by voluntary organisations and other institutions, as that creates awareness among consumers and community. Firms' sustainability initiatives aims at managing risks  (managing threats arising from sustainability concerns), building reputation, taking advantage of opportunities arising from sustainability concerns and reducing wastes and costs.

Business sustainability should not be confused with corporate social responsibility (CSR). There is no social responsibility of business. It should engage only in those activities that are required to implement firm's business strategy. For example, it should develop only those skills that will be useful in doing business, directly or indirectly, may be, in the long-term. It cannot and should not take the position of a central planner, assess skill requirements in the country and invest in building those skills. Similarly, it invests in social projects to build social and relationship capital (including reputation) that it will leverage in doing business more efficiently in future. It cannot and should not take the position of a central planner, assess the priorities of the country and invest in community development in priority areas.

Therefore, both the sustainability strategy and CSR strategy should aim at creating shareholder value. Value-driven firms balance short-term, medium-term and long-term.

Corporate Governance - A Case of S Kumars Nationwide Limited

As reported in Business Standard and other business news papers, some shareholders of S Kumars Nationwide Limited (SKNL) have convened an Extra Ordinary General Meeting to remove Mr. Nitin S Kasliwal the CMD and the whole Board. Mr. Nitin S Kasliwal at present holds only 3.59 per cent stake in the company. The stake has been reduced due to redemption of shares pledged by promoters. The company has fallen in bad times because of over ambition of the promoters.

I tried to look into the the constitution of the board of directors. I found that the web site is not updated. Money and Control shows the updated information on the constitution of the Board. The Board does not have any independent director. Therefore, none can expect the the Board to be independent. This is gross violation of SEBI Corporate Governace Code and the requirements of Companies Act 2013. The web site shows that the last annual report presented by the company is that of 2012-13. Perhaps, the company failed to present annual report for the year 2013-14. Even quarterly financial results for 2013-14 are not available on the web site.

This is an example of a listed company the promoters of which do not care for good governance and  do not believe that they are accountable to shareholders who are part owners of the company and with whose money they build the empire.

Board's Responsibilities - Reserve Bank of India's prescription

The Reserve Bank of India (RBI) in its First Bi-Monthly Monetary Policy Statement, 2015-16 has emhasised that the board of directors should focus on strategic issues. It observes that Boards spend time on routine matters and do not focus on strategic issues.

It has mandated that Board's of banks should focus on the following seven critical themes: business strategy, financial reports and their integrity, risk, compliance, customer protection, financial inclusion and human resources. Banks' Boards shall determine other list of items that they would deliberate.

What is true for Board of banks is also true for Boards of non-banking, non-finance companies. All the themes, other than financial inclusion, are important for all the companies. However, meaningful deliberation on all those themes requires Board's independence and competence. Unfortunately, most Indian Boards lack both. Therefore, they prefer avoiding discussion on those themes and spend time on trivial issues. Promoters of private companies are happy with the situation. They prefer to have a 'rubber stamp board'.

The situation has to change. Will it change? I am hopeful.

Promoters and CEOs will have to take initiatives. The first step is to invest in the training of directors. The return on that investment will be much higher than the cost of capital. The Board will start contributing in creating value. The second step is to empower the Nomination and Remuneration Committee. Empowering the Committee in no way will take away the discretion of the promoter and management. It is unlikely that the Committee will not consult the promoter and management in recommending appointment of directors, Key Managerial Personnel and senior management. Empowering the Committee will ensure that collectively the Board is independent and competent.

In days to come, some promoters and management will see the benefits of empowered Board. Those who will continue to work  with a dumb Board will miss the opportunity to understand how empowered Boards create value. 

Internal Financial Controls_Directors' Responsibility Statement_Fabindia

Section 134 of the Companies Act 2013 requires that every  company shall attach to its Board's report a Directors' Responsibility Statement. The Statement, in case of a listed company, shall include, among other things, a statement that "the directors had laid down internal financial controls to be followed by the company and that such internal financial controls are adequate and were operating effectively."

Explanation to section 134 (5) defines the term internal financial controls as follows:

"The term 'internal financial controls' means the policies and procedures adopted by the company for ensuring the orderly and efficient conduct of its business, including adherence to company's policies, the safeguarding of its assets, the prevention and detection of of frauds and errors, the accuracy and completeness of the accounting records and the timely preparation of reliable financial information.'

Section 143 of the Companies Act 2013 requires the auditor to state whether the company has adequate internal financial controls system in place and the operating effectiveness of such controls. This requirement will be applicable from the fiscal year ending on or after March 31, 2016. The Institute of Chartered Accountants of India had issued Guidance for its members. However, it withdrew the same subsequently.  The definition is quite broad and it is difficult for the auditor to comment on the same. Auditors are usually concerned with internal financial controls relating to the preparation of financial statements.

The Board is responsible for the orderly and efficient conduct of business. Therefore, it is responsible for internal financial controls that ensure the company achieving its objectives. The Board develops mechanisms to get the assurance that internal financial controls are adequate and effective. The Board should always be in a position to provide an assurance to shareholders that internal financial controls are adequate and operating effective.

It is reported in Times of india the MD and the CEO told the Crime Branch  officials that they are policy makers and others implement the same. Perhaps that is the correct statement. But that is an incorrect approach. The Board is responsible for ensuring effective implementation of policies. Directors, including independent directors, should not sign on dotted lines under the Directors' Responsibility Statement. They should get the assurance, may be through the internal auditor, that internal controls are adequate and operating effectively. Otherwise they will be held liable for not applying due diligence.

Fabindia is a private limited company. Therefore, its directors' accountability is not as stringent as that of directors of listed companies. Listed companies cannot afford to adopt the Fabindia approach.

Corporate Governance - Independent Director's Remuneration - RBI Perspective

The Reserve Bank of India (RBI) in its  First Bi-Monthly Policy Statement 105-16 has dealt with the issue of remuneration to non-executive directors. The Statement states "In order to attract and retain professional directors, it is essential that they are adequately compensated." RBI proposes to issue guidelines to private sector banks on a policy on remuneration for the non-executive directors (other than part-time Chairman) that will reflect market realities and will be within the parameters specified in Banking Regulation Act 1949 and the Companies Act 2013. It will also discuss with the Government the adoption of a similar remuneration policy for the non-executive directors of the public sector banks. The issue raised by RBI is equally applicable to non-finance companies. 

Compensation to independent directors is a contentious issue. If, compensation is a high proportion of the total income of an independent director, there would be subtle pressure on the independent director to compromise with his/her independence. Although, non-financial motivating factors(such as, opportunity to learn, opportunity to contribute and self-actualisation) are important, financial compensation is also an important motivating factor. Therefore, if, the compensation is very low relative to the opportunity cost of the director, he/she will lack motivation to contribute and with increase in accountability it will be difficult to attract right individuals. It is difficult to decide what is the appropriate amount of compensation, particularly because independent directors include variety of professionals, such as, retired government officials, retired professionals, active professionals and senior management personnel. Current income differs among different groups and  a particular amount is relatively low or high depending on the current income.

The Companies Act 2013 has established a cap on sitting fees (Rs 100,000) and commission (1 per cent of net profit to all the non-executive directors together if there is a MD, whole time director or manager) payable to non-executive directors. We may assume that the limit is fixed after due deliberation and therefore, that is the appropriate amount of compensation, although the limit is arbitrary. 

Unfortunately, in PSEs the amount being paid as sitting fee is between Rs 10,000 to Rs 25,000 and there is no practice of paying commission. This needs revision. Similarly, private companies, which can afford to pay should pay a decent amount towards sitting fee and commission. Earlier director's job was a cushy job with  prestige and therefore, companies could retain directors without paying right compensation. Suddenly the job has become demanding and therefore, companies will do better to pay right compensation to attract talent. Independent directors should raise the issue in Board meeting.

We have to wait for RBI Guidelines to appreciate its perception of 'market realities'.

Reputation Risk - Board's responsibility - Fabindia case

The discovery of CCTV camera focused on trail room in one of the stores in Goa of Fab India, which is a highly reputed fashion stores chain, has caused lot of embarrassment to the company.

Time of India reported that the Goa Chief Minister told reporters "Fabindia is supposed to be a reputed company. I personally feel that it must not be the company's fault but mischief played by its staff members. Some womanizers must have done that,"

The Goa CM might be right. But the management and the board of directors have to take the responsibility for any thing that occurs in any of its establishments and establishments of its business partners and providers of outsourced services or goods. More importantly, the reputation of Fab India is tarnished.  The case is under investigation. Truth will come out in due course. If it comes out that it was a false alarm, the company will be able to recover very quickly. In case it turns out to be an intentional act of one or more employees of the store, the company will find it difficult to earn back its credibility fast. It will be established that the company has failed to initiate field-level employees to its standards of conduct. This will hurt the reputation of the company and its business badly and shareholders will hold the management and the board responsible for failing to identify the risk and install adequate internal control.

This case again brings to fore the necessity for establishing an ethical culture in the organisation and appropriate programme for initiating every employee of the organisation to standards of conduct. It is also necessary to establish a robust 'whistle blower mechanism'. Unfortunately, most companies often do not pay adequate attention to those aspects of corporate governance. 

Woman director - BSE 200 companies

Business Standard in its April 6, 2015 edition reported that BSE 200 companies are keen to follow the Rule for mandatory appointment of woman director in spirit. It reported that 90 companies already had at least one woman director and 80 companies have appointed one woman director after announcement of the new Rule. It has also reported that out of the 80 newly appointed directors, only seven are related to promoters. The news is silent about the balance thirty companies. Presumably, they have failed to comply with the new rule.
Does it augur well for the quality of Indian corporate governance? The answer is no. There are 5,628 companies listed in BSE, of which 4,268 are eligible for trading. Prime Database research shows that out of 1478 companies listed in NSE, 987 companies had no woman director when the new rule was announced. Out of those 674 have since then appointed woman directors of which a majority appointments are from the promoter family.
The Business Standard report shows that most listed companies in India are not serious about complying with corporate governance norms. This is a bad news.

Corporate Governance 2014-15 in Retrospect

My column in today's (Apriil 6, 2015) Business Standards