Important recommendations for ensuring good corporate governance

Historically attention was paid to the subject following the collapse of Savings and Loan companies in USA in the mid 1980’s and the SEC of USA taking a tough stand on the same.  It is ironical that once again it was the US which brought in Sarbanes Oxley Act and along with it very stringent measures of Corporate Governance.  In passing, we may add that there is no corresponding legislation in India.  Later, Adrian Cadbury report was an important milestone, which spelt out 19 best practices called the “Code of Best Practices”, which the companies listed on the London Stock Exchange, began to comply with.  Some of those guidelines applicable to the Directors, Non-executive Directors, Executive Directors, and others responsible for reporting and control are as follows;

Relating to the Directors the recommendations are:

  • The Board should meet regularly, retain full and effective control over the company and monitor the executive management.
  • There should be a clearly accepted division of responsibilities at the head of a company, which will ensure balance of power and authority, such that no individual has unfettered powers of decision.  In companies where the Chairman is also the Chief Executive, it is essential that there should be a strong and independent element of the Board, with a recognized senior member.
  • The Board should include nonexecutive Directors of sufficient caliber and number for their views to carry significant weight in the Board’s decisions.
  • The Board should have a formal schedule of matters specifically reserved to it for decisions to ensure that the direction and control of the company is firmly in its hands.
  • There should be an agreed procedure for Directors in the furtherance of their duties to take independent professional advice if necessary, at the company’s expense.
  • All Directors should have access to the advice and services of the Company Secretary, who is responsible to the Board for ensuring that Board procedures are followed and that applicable rules and regulations are complied with.  Any question of the removal of Company Secretary should be a matter for the Board as a whole.

Relating to the Non-executive Directors the recommendations are:

  • Non-executive Directors should bring an independent judgement to bear on issues of strategy, performance, resources, including key appointments, and standards of conduct.
  • The majority should be independent of the management and free from any business or other relationship, which could materially interfere with the exercise of their independent judgement, apart from their fees and shareholding.  Their fees should reflect the time, which they commit to the company.
  • Non-executive Directors should be appointed for specified terms and reappointment should not be automatic.
  • Non-executive Directors should be selected through a formal process and both, this process and their appointment, should be a matter for the Board as a whole.

For the Executive Directors the recommendations in the Cadbury Code of Best Practices are:

  • Directors’ service contracts should not exceed three years without shareholders’ approval.
  • There should be full and clear disclosure of their total emoluments and those of the Chairman and the highest-paid Directors, including pension contributions and stock options.  Separate figures should be given for salary and performance-related elements and the basis on which performance is measured should be explained.
  • Executive Directors\ pay should be subject to the recommendations of a Remuneration Committee made up wholly or mainly of Non-Executive Directors.

And on Reporting and Controls the Cadbury Code of Best Practices stipulate that:

  • It is the Board’s duty to present a balanced and understandable assessment of the company’s position.
  • The Board should establish an Audit Committee of at least three Non-Executive Directors with written terms of reference, which deal clearly with its authority and duties.
  • The Directors should explain their responsibility for preparing the accounts next to a statement by the Auditors about their reporting responsibilities.
  • The Directors should report on the effectiveness of the company’s system of internal control.
  • The Directors should report that the business is a going concern, with supporting assumptions or qualifications as necessary.

The report created mixed feelings and with some more frauds emerging in UK, Governance came to mean the extension of Directors’ responsibility to all relevant control objectives including business risk assessment and minimizing the risk of fraud.  The shareholders are surely entitled to ask, if all the significant risks had been reviewed and appropriate actions taken to mitigate them and why a wealth destroying event could not be anticipated and acted upon.

The one common denominator behind the corporate failures and frauds was the lack of effective risk management and the role of the Board of Directors.  When it became clear that merely reviewing the internal processes of control were not enough and, therefore, risk management had to be embodied throughout the organization, an easy solution was found by passing on this responsibility to the internal audit.

In India, the CII came out with its own views, but SEBI, as the custodian of millions of investors came out with its guidelines and Kumar Mangalam Committee recommendations became mandatory and, therefore, all the listed companies were obliged to comply in accordance with the listing agreement with these Stock Exchanges.  The clean up of most companies has begun in a big way and the Section 49 of the SEBI Act has now almost become the hallmark of compliance in this country.

The mandatory recommendations of the Kumar Mangalam Committee include the constitution of Audit Committee and Remuneration Committee in all listed companies; appointment of one or more independent Directors; recognition of the leadership role of the Chairman of a company; enforcement of accounting standards; the obligation to make more disclosures in annual financial reports; effective use of the power and influence of institutional shareholders; and so on.

The Committee also recommended a few provisions, which are non-mandatory.  Some of the mandatory recommendations are;

  • The Board of a company should have an optimum combination of executive and non-executive Directors with not less than 50% of the Board comprising the nonexecutive Directors.
  • The Board of a company should set up a qualified and an independent Audit Committee.  The Audit Committee should have minimum three members, all being nonexecutive Directors, with the majority being independent, and with at least one Director having financial and accounting knowledge.  The Chairman of the Audit Committee should be an independent Director.  They are responsible for balance sheet compilation and clarificatory notes appearing thereto; and to ensure that sensitive information is not tucked away in small print.

The Chairman of the Audit Committee should be present at Annual General Meeting to answer shareholder-queries.

  • The Company Secretary should act as the secretary to the Audit Committee.
  • The Audit Committee should meet at least thrice a year.  The quorum should be either two members or one-third of the members of the Audit Committee.
  • The Audit Committee should have powers to investigate any activity within its terms of reference, to seek information from any employee; to obtain outside legal or professional advice, and to secure attendance of outsiders if necessary.
  • The Audit Committee should discharge various roles such as, reviewing any change in accounting policies and practices; compliance with accounting standards; compliance with Stock Exchange and legal requirements concerning financial statements; the adequacy of internal control systems; the company’s financial and risk management policies etc.
  • The Board of Directors should decide the remuneration of the non-executive Directors.
  • Full disclosure should be made to the shareholders regarding the remuneration package of all the Directors.
  • The Board meetings should be held at least four times a year.
  • A Director should not be a member in more than ten committees or act as the Chairman of more than five committees across all companies in which he is a Director.  This is done to ensure that the members of the Board give due importance and commitment of the meetings of the Board and its committees.
  • The management must make disclosure to the Board relating to all material, financial and commercial transactions, where they have personal interest.
  • In case of the appointment of a new Director or re-appointment of a Director, the shareholders must be provided with a brief resume of the Director, his expertise and the names of companies in which the person also hold Directorship and the membership of committees of the Board.
  • A Board committee should be formed to look into the redressal of shareholders’ complaints like transfer of shares, non-receipt of balance sheet, dividend etc.
  • There should be a separate section on Corporate Governance in the annual reports of the companies with a detailed compliance report.

Apart from these, the Kumar Mangalam Committee also made some recommendations that are nonmandatory in nature.  Some of are:

  • The Board should set up a Remuneration Committee to determine the company’s policy on specific remuneration packages for Executive Directors.
  • Half-yearly declaration of financial performance including summary of the significant events in the last six months should be sent to each shareholder.
  • Non-executive chairman should be entitled to maintain a chairman’s office at the company’s expense.  This will enable him to discharge the responsibilities effectively.

It will be interesting to note that Kumar Mangalam Committee while drafting its recommendations was faced with the dilemma of statutory v/s voluntary compliance.  One may also be aware that the desirable code of Corporate Governance, which was drafted by CII was voluntary in nature and did not produce the expected improvement in Corporate Governance.  It is in this context that the Kumar Mangalam Committee felt that under the Indian conditions a statutory rather than a voluntary code would be far more purposive and meaningful.  This led the Committee to decide between mandatory and non-mandatory provisions.  The Committee felt that some of the recommendations are absolutely essential for the framework of Corporate Governance and virtually from its code, while others could be considered as desirable.  Besides, some of the recommendations needed change of statute, such as the Companies Act for their enforcement.  Faced with this difficulty, the Committee settled for two classes of recommendations.

SEBI  has given effect to the Kumar Managlam Committee’s recommendations by a direction to all the Stock Exchanges to amend their listing agreement with various companies in accordance with the ‘mandatory\ part of the recommendations.

For ensuring good corporate governance in a banking organization the importance of overseeing the various aspects of the corporate functioning needs to be properly understood, appreciated and implemented.  There are four important forms of oversight that should be included in the organizational structure of any bank in order to ensure the appropriate checks and balances:

(1)  oversight by the board of directors or supervisory board;

(2)  oversight by individuals not involved in the day-today running of the various business areas;

(3)  direct line supervision of different business areas; and

(4)  independent risk management and audit functions.  In addition to these, it is important that the key personnel are fit and proper for their jobs (this criterion also extends to selection of Directors).

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