Background

Today, good governance practices are an essential ingredient for boosting investor confidence and are a sign of a safe and robust market conducive for investment, across the globe. Although India has made several changes to overhaul its corporate governance regime from time to time, new cases of governance lapses have brought the shortcomings of the law to light.

In this context, in June 2017, SEBI constituted the Committee on Corporate Governance, chaired by Mr. Uday Kotak (the Committee). Its main objective was to enhance fairness and transparency, strengthen an independent board, improve disclosure standards and to recommend reforms on corporate governance and compliance of the law on paper as well as in sprit.

On 5 October 2017, the Committee submitted its report (the Report) identifying key governance issues and proposing amendments to the Securities & Exchange Board of India (Listing Obligations & Disclosure Requirements) Regulations, 2015 (LODR).

Key Committee recommendations

Some of the key recommendations made by the Committee are discussed below:

  1. Institution of independent directors (IDs)
  • Minimum number: The Committee has proposed that at least 50% of the board should comprise of IDs. The top 500 listed companies are required to comply with this from 1 April 2019 and all other listed companies by 1 April 2020. Currently, this is applicable only for companies which do not have a non-executive chairperson.
  • Lead ID: It has been recommended that if the chairperson is not independent, a lead ID should be identified to coordinate the role of all IDs. The lead ID should be a member of the Nomination & Remuneration Committee (NRC). The lead ID is required to chair exclusive meetings of the IDs, while remaining available for direct communication with significant shareholders upon their request. Additionally, he also has the power to preside over meetings where the chairman is not present, and be available for direct communication with the shareholders.
  • Eligibility: In addition to existing eligibility conditions, it is proposed that IDs cannot be persons who constitute promoter group of a listed entity or are appointed pursuant to a ‘board inter-lock’ arrangement. Board inter-lock is a situation where A, a non-independent director in X Ltd, is appointed as ID on Y Ltd in return for B, a non-independent director in Y Ltd, getting appointed as ID on X Ltd. Further, IDs will be required to give declarations and the board shall have to separately assess and certify the independence of IDs.
  • Minimum remuneration: A minimum remuneration, comprising of annual compensation (INR 5,00,000 for top 500 companies) and sitting fees (INR 50,000 for top 100, and INR 25,000 for next 400 companies) for board meetings of top 500 companies has been recommended to incentivize appointment of qualified IDs. Separate sitting fees have been proposed for committee meetings as well.
  • ID protection measures: It is proposed that IDs must receive formal training once in every 5 years to keep them abreast of changes to the laws. To mitigate liabilities on the IDs, obtaining D&O insurance for IDs of top 500 listed companies is recommended. Further, in case an ID resigns, he is required to provide to the company detailed material reasons for such resignation. The company must further report these reasons to stock exchanges.
    • : The changes to the eligibility norms are indeed positive. However, the regulations are still found wanting to adequately empower the IDs. The recommendation regarding disclosure of reasons of resignation does not incorporate requirement of disclosures in case of removal of IDs. Given the power of the majority shareholders to remove them at will, IDs would find it difficult to remain truly independent.

Separately, while D&O insurance is a positive step, the exceptions to such policies may not be sufficient to protect IDs from legal non-compliances. From a practical perspective, with the increased obligations recommended for IDs and the lack of protection accorded to them, it may be difficult to find individuals with the right expertise willing to accept ID appointments.

2. Board and its functioning

  • Structural changes
  • Separation of key positions: For listed companies which have more than 40% public shareholding, it is recommended that the roles of chairperson and Managing Director/Chief Executive Officer be separated by 1 April 2020. As opposed to a guiding principle earlier, the Committee, borrowing from governance codes of countries like the UK, Germany and the Netherlands, has proposed to make such separation of key positions mandatory.
  • Matrix reporting: Acknowledging that several large corporates may follow internal matrix reporting structures (i.e., reporting along functional lines to relevant group heads), the Committee has sought to reinstate the board’s overall responsibility towards the corporate’s affairs. It has recommended that a confirmation be provided by the board that it “has been responsible for the business and overall affairs of the entity” and that “the reporting structures of the listed entity, formal and informal, are consistent with the above”.
  • Expertise of directors: It is recommended that the board should list the competencies/expertise that it believes its directors should possess, and the ones the directors possess, in the annual report. In addition to the disclosure of competencies/expertise, the Committee has suggested that a guidance note be issued by SEBI in relation to disclosures on observations of board evaluation and further actions pursuant to evaluation. Further, the listed entity is also required to undertake a formal updation programme for the board at least once every year, to keep them updated on regulatory and compliance related changes.
  • Role of board committees: The Committee has proposed more extensive roles for the existing board committees. For instance, the Audit Committee is expected to scrutinize the end use of funds from primary issuances. The NRC will also recommend payments to employees even one level below the board. The Stakeholders Relationship Committee (SRC) is required to actively engage with all security holders and the chairperson of the SRC is to be present in general meetings to answer questions. The Risk Management Committee is also specifically expected to consider cyber security threats. In this regard, setting up of an Information Technology Committee has also been suggested.
    • : Although separate individuals exercising positions of the chairman and the MD/CEOs is a welcome step, the effectiveness of such step in the Indian context would again depend on the willingness of promoter-run companies to embrace the suggestion in spirit. Regarding matrix reporting, the Committee’s intent was to ensure that the board remains in overall control and to eliminate all informal group level reporting structures - it is unclear how a mere confirmation rather than the requirement to adopt a formal reporting structure will help achieve the desired result. Further, the suggestion on having identified competencies of directors is a step in the right direction, as it would help define a role of each individual director, and evaluate whether suitable persons fit the position.
  • Board and committee composition
  • Board composition: Increase of the board strength to a minimum of 6 directors, as opposed to the current position of 3, has been suggested. In relation to the requirement of appointing 1 (one) woman director, it is now proposed that at least 1 (one) woman director should be “independent”. Further, to align the appointment of executive and non-executive directors (NEDs), it is proposed to permit persons who are NEDs to continue beyond 75 years of age, subject to a shareholder’s special resolution. The NEDs must also have formal interaction with the senior management at least once every year.
  • Limit on directorships: Considering the onerous task and importance of position of a director, it is proposed that the maximum number of directorships (including alternate directorships) be reduced to 8 listed entities (of which independent directorships shall not exceed 7), by 1 April 2019 and not more than 7 listed entities by 1 April 2020. Presently, the restriction is 10 for public companies.
  • Committees’ composition: The Committee has recommended the NRC should have two-thirds of its members as IDs. The SRC, as recommended, is required to have at least 3 (three) directors on board, with at least one ID. Presently, the NRC is required to have at least 50% of its members as IDs, and it is not mandatory for an ID to be a member of the SRC.
    • : From a practical perspective, all the above suggestions once implemented would have a significant impact on listed companies as they would need to re-evaluate their existing board structures to meet the prescribed requirements. Further, the recommendation regarding NEDs’ interaction with senior management is ambiguous. While such interaction is considered necessary for the NEDs to keep abreast with the affairs of the company, the scope of such interaction is unclear in the recommendation.
  • Board and committee meetings
  • Board Meetings: A minimum of 5 board meetings in a year has been recommended, as opposed to the existing requirement of 4 meetings. It has been recommended that at least once a year, the Board shall discuss strategy, budgets, board evaluation, environment sustainability and governance, risk management and succession planning. In addition to this, the quorum of the board is proposed to be a minimum of 3 directors or one-third of the total strength of the board, whichever is higher, including at least one ID. Further, it is proposed that directors must attend at least half of the board meetings in two consecutive financial years, to honor their fiduciary duties. Non-compliance with this would require their continuance on the board to be ratified by the shareholders.
  • Committee meetings: In line with recommendation for board meetings, a minimum of 5 audit committee meetings have been proposed, as opposed to the current requirement of 4. The Committee has also recommended that all other board committees meet at least once a year.
    • : The mandatory discussion of corporate governance issues in a board meeting is a welcome change as it will force the board to budget specific time for corporate governance matters and may help bring about greater ‘in-spirit’ compliance of the law. However, this needs to be enforced in practice and not become mere lip service.

3. Promoters and related party transactions

  • Sharing of confidential information: The Committee acknowledged that there are inevitable instances of flow of information to promoters/significant shareholders through informal channels. Given their importance as decision makers, the Committee has recommended amendments to allow flow of information to any counter party who: (i) is part of the promoter group; (ii) is in direct or indirect control of the persons under (i); or (iii) has a nominee director on the board. The information should be pursuant to a formal agreement in accordance with the regulations. Such flow of unpublished price sensitive information (UPSI) shall be considered for ‘legitimate purpose’, and not an offence under the SEBI (Insider Trading) Regulations 2015 (Insider Trading Regulations). Further, communication of information must comply with the Insider Trading Regulations.
  • Promoters’ re-classification: Being a ‘promoter’ has several implications under Indian law, including a lock-in on shareholding. Under the present regime, a promoter can be re-classified as a public shareholder when replaced by a new promoter, or when the company becomes professionally managed, after receipt of necessary approvals from shareholders and stock exchanges. Additionally, post such re-classification the promoter cannot hold more than 1% of the listed company’s shareholding. Moreover, the LODR does not deal with a single person, forming part of the ‘promoter group’, seeking to apply for re-classification. In this regard, the Committee has proposed a change at two levels: (a) a promoter post re-classification can continue to hold up to 10% of aggregate shareholding; and (b) reclassification of a specific person/entity which is a part of the ‘promoter group’ is permitted, to ensure that persons who may have been promoters but are no longer in control of the entity and have a low shareholding, can ‘opt-out’ of being ‘promoters’.
  • Disclosures and approvals for related party transactions: Disclosures for RPTs are proposed to be half yearly, instead of annual disclosures that take place currently. The definition of related parties shall now include promoters/promoter group entities that hold 20% or above in a listed company. As a significant change, royalty/ brand usage payments to related parties exceeding 5% of consolidated turnover of the listed entity are proposed to be deemed material, and would require shareholder’s approval.
    • : The rationale for legitimizing information flow to promoters appears to be flawed. Considering that the Committee has emphasized on a matrix structure of governance with the board at the top as the decision maker in the affairs of the listed companies, legitimizing sharing of UPSI with any entity outside the board would undermine the matrix structure of governance. Moreover, if UPSI is shared to the promoter/significant shareholder, they are likely to be in possession of UPSI and consequently, not deal in the securities of the listed entity – practically, no entity would then opt to use this regime.

Regarding related party disclosures, the proposed recommendation would bring in a lot of cheer with shareholder activist groups who have been mooting for stricter governance norms for related party transactions.

4. Audit & Accounts

  • External opinion: To boost the independence of auditors, it is proposed to grant the auditors a right to independently obtain external opinions from experts, when they do not agree with experts appointed by the listed entity.
  • Increase in Disclosures: Disclosures regarding audit qualifications are proposed to be made mandatory, except for matters of going concern or sub-judice matters. Other disclosures are to include reasons for resignations of auditors, audit and non-audit services undertaken, auditor fees etc.
    • : The various disclosures regarding auditors and their functioning contribute to an independent external auditor, and audit committee. These are positive measures to check alleged fraud, misrepresentation, and the financial position of a listed entity at regular intervals. This comes in the back drop of increased cases of fraud and companies approaching near insolvency in India.

5. Governance of material subsidiaries

  • Scope of unlisted material subsidiaries: It is proposed to widen the ambit of material subsidiaries covered under the LODR by reducing the thresholds of consolidated income or net worth from 20% to 10%.
  • IDs on off-shore material subsidiaries: The Committee has recommended extending the requirement of appointment one of the IDs as a director on the board of off-shore material subsidiaries. Under the present regime, this is limited to Indian subsidiaries.
  • Good Governance Unit and secretarial audit: The Committee has recommended issuance of a guidance note by SEBI to listed companies for better monitoring of governance practices of all material subsidiaries. Further, it is also suggested to make secretarial audit mandatory for all material unlisted subsidiaries.
  • Group Audit: The Committee recommended that the auditor for listed company should be made responsible for audit opinion of all material unlisted subsidiaries. The blessing of the ICAI would be necessary for these recommendations to be effective.
    • : The reforms suggested are much needed from a group good governance perspective. From a practical viewpoint, if all these recommendations are implemented, there may be significant cost implications on the listed companies to comply with the regulations.

6. Disclosures and transparency

  • Broadening scope of existing disclosures: To increase transparency, it is proposed to have the board disclose non-acceptance of committee recommendations, if any, along with reasons. Further, disclosure of consolidated financial statements is proposed to be made mandatory on a quarterly basis as opposed to an annual basis presently.
  • Additional disclosures: Additional disclosures have been proposed for key changes in financial ratios, appointment and disqualification of directors, utilization of proceeds for preferential issues, holders of Global Depository Receipts etc.
  • Ease in compliance: Hard copies of annual reports submitted to various regulators, shareholders and stock exchanges, are proposed to be replaced with e-copies to the extent possible. Further, the Committee has recommended that disclosures across stock exchanges as well as regulatory agencies such as SEBI, MCA etc. should be harmonized to avoid multiple disclosures of similar information.
    • : The Committee has made a strong emphasis on increasing transparency by way of disclosures. From a compliance perspective, this should be followed-up with efforts by the regulators to streamline and harmonize disclosures to reduce costs and ensure better adherence. Doing away with hard copies of documents would be a measure appreciated by all companies.

7. Investor Relations

  • Shareholder meetings: The AGMs for top 100 listed entities are proposed to be held within 5 (five) months as opposed to 6 (six) months currently. Also, to enable shareholders to make informed decisions based on discussions in meetings, live one-way webcasts of all meetings and e-voting till 11:59 p.m. have been introduced for top 100 listed entities.
  • Stewardship Code: In line with the amendment brought by IRDA for insurance companies and to better investor relations, the Committee has proposed a Stewardship Code for institutional investors. The code may include provisions on discharge of stewardship responsibilities, voting and disclosures, managing conflicts of interest etc.
  • Treasury Stock: Based on SEBI’s position in relation to suspension of voting on shares held by employee trusts, it is proposed that a listed entity holding its own shares by way of a treasury stock shall not have voting rights attached to such shares from 1 April 2021.
    • : Though the changes on frequent AGMs and live meeting webcasts are favorable measures for increasing investor participation, the scope and enforcement of the Stewardship Code remains uncertain.

8. Recommendations to Government agencies

  • Governance of Public Sector Enterprises (PSEs): For better governance of PSEs, the Committee has focused on securing their independence from the administrative Ministry. It is recommended that the Government stake in listed PSEs must be consolidated under holding entity structures with an independent board. This would help resolve the biggest problem of conflict of ownership and management in PSEs.
  • Capacity building and stricter enforcement: As a tool for capacity building, the Committee has recommended SEBI to (a) increase its human capital, (b) use data science and risk prediction for review of financial filings and statements, and (c) coordinate with other regulators and agencies for better enforcement of governance norms. The Committee has also called for stricter enforcement by other regulators such as ICAI in relation to auditors’ norms.
    • : The recommendations of the Committee in relation to role of regulators have not been taken well by the regulators – they have dismissed these as being beyond the terms of reference of the Committee. In our view, for an improvement in corporate governance practices, as is with all legal reforms, a robust enforcement mechanism to implement such reforms is imperative.

Way forward

SEBI has sought public comments on the Report from all stakeholders before 4 November 2017. Once all comments are collated and deliberated, SEBI is likely to issue amendments to the LODR based on the Committee Report.

The Report has elicited mixed responses from other regulators in the country. The Ministry of Corporate Affairs in its letter to the Committee has observed that some of the additional prescriptions in company law matters may hamper the ease of doing business initiatives by the Government of India. Though the Ministry of Finance has accepted changes such as disclosure of skills of directors and increase in number of minimum directors, they have raised concerns regarding removal of alternate directorship for IDs.

The recommendations of the Committee are set to overhaul the existing corporate governance regime in India. Some of the suggestions such as laying down expertise of directors, requirement of a woman independent director, emphasis on governance as a board agenda item, separation of powers at the board, increasing disclosures etc., are all steps in the right direction.

It must be noted that, there are certain governance issues which remain a missed opportunity. The Report does not adequately deal with procedure for removal of IDs, performance evaluation of directors, curbs on founders’ control. From a company perspective, the recommendations will have a significant impact on existing business practices.

Given the impact the Committee recommendations seek to bring about in Corporate India and market participants, it is important that all stakeholders utilize this opportunity and make suitable suggestions to help the reforms achieve their true intent.