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Total Number of Subscribers: 426 |
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Date: 5 April 2008 |
Compiled by M. Sathya Kumar |
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Clause 49 Tough regulations such as Clause 49 are the
outcome of a series of scams that have hit the corporate world. These rules
aim to shine a light on operations management and ensure that top management
is held accountable when things go wrong. The intentions are laudable but the
question remains: can Indian companies comply with such stringent
requirements? Mr. Manesh Patel looks at the
provisions of the clause and suggests ways and means of coping with it
This clause is a recent addition to the
Listing Agreement and was inserted as late as 2000 consequent to the
recommendations of the Kumarmangalam Birla Committee on Corporate Governance
constituted by the Securities Exchange Board of India (SEBI) in 1999.
Clause 49, when it was first added, was
intended to introduce some basic corporate governance practices in Indian
companies and brought in a number of key changes in governance and
disclosures (many of which we take for granted today). It specified the
minimum number of independent directors required on the board of a company.
The setting up of an Audit committee, and a Shareholders’ Grievance committee, among others, were made mandatory as were the
Management’s Discussion and Analysis (MD&A) section and
the Report on Corporate Governance in the Annual Report, and disclosures of
fees paid to non-executive directors. A limit was placed on the number of
committees that a director could serve on. In late 2002, SEBI constituted the Narayana
Murthy Committee to assess the adequacy of current corporate governance
practices and to suggest improvements. Based on the recommendations of this
committee, SEBI issued a modified Clause 49 on October 29, 2004 (the ‘revised Clause 49’) which came into operation on January 1, 2006. What’s new in Clause 49?
The revised Clause 49 has suitably pushed
forward the original intent of protecting the interests of investors through
enhanced governance practices and disclosures. Five broad themes predominate.
The independence criteria for directors have been clarified. The roles and
responsibilities of the board have been enhanced. The quality and quantity of
disclosures have improved. The roles and responsibilities of the audit
committee in all matters relating to internal controls and financial
reporting have been consolidated, and the accountability of top management—specifically the CEO and CFO—has
been enhanced. Within each of these areas, the revised
Clause 49 moves further into the realm of global best practices (and
sometimes, even beyond). To illustrate: Clarifying standards of independence
for directors. The requirements for independence have been made more stringent
by precisely defining ‘independent’ and excluding any
relatives of promoters, senior management, any former auditors or
consultants. In this area, the Indian Clause 49 is perhaps the most demanding
of any similar legislation in the world in requiring a ‘cooling-off period’ for any member of any advisory firm (not
just statutory auditors, but also lawyers, consultants and internal
auditors). The cooling-off period at three years is also the most onerous.
The standard in the western world is generally one year, and that too is
restricted to statutory audit partners who have been associated with the
company, not all consultants or advisors. It has been argued that this
stringent measure is more likely to deprive a company of competent
independent directors rather than enhance independence. The requirements relating to the number of
independent directors on a board remains unchanged from the original clause.
However, much discussion has followed a recent qualification from SEBI that
government nominees on boards should not be considered independent. This was
not explicitly stated previously. Clarifying and increasing the
responsibilities of the board of directors. Another recurring theme of the revised
clause is to enhance the responsibilities of the board. As a part of this, a
large number of matters which were not explicitly part of the board’s role have now been included. Primary among them are a company’s compliance with all applicable laws and enhanced oversight over its
subsidiaries. The board is now also required to review the company’s risk management framework. Board members also have to review all
significant transactions entered into by any subsidiary as well as review
minutes of all the subsidiaries’ board
meetings, and they have to sign-off on compliance with the company’s code of conduct as well. Improving the quality and quantity
of disclosures. There has been an across-the-board increase
in the number and quality of disclosures required. Some of these are
regarding disclosure of directors’ shareholding in the
company, disclosure of compensation paid to non-executive directors,
disclosure of all related-party transactions, use of funds raised through
public issues (in case of any use of funds for purposes other than that
originally stated in the offer prospectus), an audited statement on the
deviation to be included in the annual report, and any changes in accounting
policies and practices. These have generally been accepted by most
parties as a step in the right direction. Consolidating the primacy of the
audit committee in all matters relating to internal controls and financial
reporting. Changes in accounting policies are required
to be reviewed by the audit committee; financial statements of subsidiary
companies are required to be reviewed by the audit committee; the MD&A
section of the annual report, which was previously only a board
responsibility, now needs to be reviewed and cleared by the audit committee
before going to the board. Enhancing accountability of the CEO
and CFO. This has been done through the CEO or CFO
certification process (and inspired by the Sarbanes-Oxley Act). The CEO and
CFO are now required to certify to the board at least annually on matters
relating to the accuracy of financial reporting, evaluation of design and
operation of internal controls, disclosure of any significant changes in
internal controls, and disclosure of frauds.
Most corporate managers and investors now
agree that while it could be argued that the requirements involve a
significant amount of effort, there can be no doubt that these requirements
are an essential step towards bringing Indian capital markets and governance
standards in line with the rest of the world. What it takes Achieving compliance in many of the areas
such as additional disclosures is not likely to be difficult. But some of the
other requirements will need significant effort if a company aims to fulfill
the requirements of the clause in the right spirit. This is true with regard
to the composition of the board, for while the requirements are fairly
explicit, given the narrowing of the definition of independence and the
clarifications around government nominees, several companies will struggle to
re-do the composition of their boards in time to meet the deadline. Board and audit committee
procedures. A significant number of new responsibilities
have been added to the board’s and audit committee’s functions. As a result of this, the board and audit committee meeting
agendas will have to be carefully thought through to ensure that all the
requirements of the clause are covered during the course of a year. Legal compliance. One of the more stringent requirements is
for the board to review compliance with all applicable laws. Historically,
compliance declarations in companies have been high-level affairs with senior
management signing-off blindly on one-line catch-all declarations largely
modelled around the negative assurance concept (Example: no notices received
implies no violations). The new requirement has focussed the minds of board
members to look at specific regulations and their requirements, and on
getting a far greater degree of positive assurance. This will therefore lead
to significant effort in terms of identifying all applicable laws,
identifying all the compliance requirements within these laws, reviewing the
compliance status for each identified requirement, and following through with
a system to track this on an ongoing basis. Risk management. Boards must ensure that all significant
risks are managed through a well-defined framework. This will require
substantial effort, the task at hand being to first identify all the risks
applicable to a company, then from within these to cull out those risks that
are most significant, and finally to identify owners for these key risks and
to put in place mitigation plans. Of course, the company would also need to
put in place the structural elements of a Risk Policy (building a Risk
Register and building a framework to track progress on mitigation plans and
review the risks on a continuous basis). Internal control evaluation. While some internal controls are in place in
organisations, the real effort will be in building the evidence around the
evaluation of these controls—the specific
identification of risks and controls within processes, performing
walkthroughs to validate design effectiveness, and the testing process to
evaluate the operating effectiveness of the controls. Clearly, at least the companies with
best-in-class governance practices are steeling themselves for this process.
Most have already taken the first steps down this path. Although all of them
are concerned about the costs involved, most are aware that this is a process
which yields substantial benefits in the long run as the US experience is
beginning to show. Coutesy : Manesh Patel, The author is
Partner, Ernst & Young. |
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