India has recently witnessed a series of corruption and bribery scandals – from the allocation of telecom licenses and coal blocks to the more recent allegations of kick-backs in a multi-million dollar helicopter procurement contract. This has not only dampened investor sentiment but has also raised questions about India’s status as a leading developing economy. One of the reasons most frequently put forward for the level of corruption and bribery in India is its legal and regulatory regime. Some of the key laws date back more than 50 years and have not kept pace with the changing contours of the economy. In addition, enforcement through the court system takes many years and, therefore, is not perceived to act as a deterrent to wrongdoing.

As a result of the constant media attention on corruption and activism displayed by the higher judiciary, the government is taking steps toward reform. One such significant reform, which goes to the core of corporate governance issues, is India’s new companies law.

On August 30, 2013, India enacted the Companies Act, 20131 (the “New Act”), which has replaced the more than 50-year old Companies Act, 1956. Not all the provisions of the New Act will come into force immediately as a number of them require the Government of India to draft rules and regulations for their implementation. These rules will be drafted in the coming months in consultation with stakeholders.2

The New Act is seen as an important step in bringing Indian company law closer to global standards and in improving the ease and efficiency of doing business in India. It touches on areas such as corporate governance, corporate social responsibility, auditor rotation and investor protection, all in an attempt to strengthen internal controls. When the New Act is fully implemented, it will have a direct bearing on the way companies are governed in India – improving corporate governance in a manner that, it is hoped, will reduce misconduct at and by Indian companies. The New Act holds out the possibility of reducing the risk of corrupt practices, although in some ways it also potentially increases such risks in certain respects. The principal risk in this regard arises out of newly mandated Corporate Social Responsibility (“CSR”) programs.

The main features of the new law in this regard are set out below.

Corporate Governance and Corporate Social Responsibility

  • Public companies will now be required to have independent directors on their boards, with publicly listed companies required to have at least one-third independent directors. Such directors may not be given any stock options and they cannot serve more than two five-year terms. In addition, nominee directors will not be regarded as independent.3 These provisions are significant as the lack of independent directors and/or their true independent character has always been perceived as a central reason for most corporate frauds. Indian companies are generally promoter controlled and there is no tradition of independent directors challenging the decisions of the promoter. The New Act attempts to remedy this issue.
  • The New Act codifies the duties of directors, specifically, the duties to act in good faith, to avoid any direct or indirect conflict of interest with the company, and to exercise due diligence and reasonable care in decision-making.4
  • CSR will be mandatory for a company with a net worth of INR 500 crores (approximately US$ 90 million) or more, a turnover of INR 1,000 crores (approximately US$ 180 million) or more, or net profits of INR 5 crores (approximately US$ 0.9 million) or more during any financial year. Any company meeting these thresholds will be required to spend annually at least 2% of its average net profits of the preceding three financial years on social and charitable causes.5 This is a highly innovative provision, but it could also lead to certain forms of bribery in which Indian corporates could be tempted to use CSR spending to benefit politicians in power by conducting CSR activities in their constituencies – a form of indirect lobbying.

Auditor Rotation6

  • The New Act provides for mandatory auditor rotation for listed and other prescribed companies every five years depending on whether the auditor is an individual or a firm. In addition, there will be a cooling-off period of five years after completion of such a term during which the auditor cannot be re-appointed.
  • Approval of the appointment of auditors by the shareholders at every annual general meeting of the company will be made mandatory.
  • A company’s auditor may not directly or indirectly render any internal audit, investment advisory, management or similar services to the company, its holding company or its subsidiary
  • Further, the auditor will be required immediately to report to the central government upon reasonable suspicion of any offence involving fraud that is being or has been committed against the company by its officers or employees. Presumably, this will include cases in which company funds are being diverted in violation of the company’s internal controls for the purpose of making corrupt payments, although the final contours of this auditor reporting duty in specific cases will remain to be seen.

“[The CSR mandate] is a highly innovative provision, but it could also lead to certain forms of bribery in which Indian corporates could be tempted to use CSR spending to benefit politicians in power[.]”

  • These provisions assume great significance in light of certain recent corporate accounting scams like the multi-million dollar Satyam scandal, in which the U.S. Securities and Exchange Commission (“SEC”) took action against five Indian affiliates of an international audit firm that served as independent auditors of Satyam Computer Services Limited. The SEC found that the auditors had repeatedly conducted deficient audits of Satyam’s financial statements and enabled accounting fraud to go undetected for several years.7 Although the Indian authorities filed criminal charges against the partners of the audit firms involved, they did not have legislation to regulate auditor conduct – a situation which has now been addressed.

Enforcement

  • “Class action” lawsuits will be introduced for the first time in India. The New Act provides that a class of members or depositors, in specified numbers, may initiate proceedings against the company if they are of the opinion that its affairs are being carried out in a manner unfairly prejudicial to the interests of the company, members or depositors.8 This is seen as a huge step in empowering investors to challenge prejudicial behavior. However, it is hoped that Indian courts will be judicious in entertaining these petitions as this provision could be misused for frivolous litigation.
  • Fraud will be made a new ground for seeking the winding up of a company.9
  • The new law grants additional statutory powers to the government’s investigative arm, the Serious Fraud Investigation Office (“SFIO”), to tackle corporate fraud.10 It also proposes the establishment of special courts for speedy trials.11 These measures are an attempt to create an agency similar to the Serious Fraud Office in the United Kingdom, to provide teeth to the Indian government’s efforts to tackle serious fraud and corrupt practices. However, what remains to be seen is if true independence and the necessary infrastructure and resources are given to this body.

Although the new law is attempting fundamentally to change the way companies are governed in India, in reality there may be delays before these changes are actually implemented. Nonetheless, despite the fact that other legislation more centrally targeted to bribery, such as the Lokpal Bill (as well as the Whistleblowers Protection Bill), remains stalled in the Indian national legislature, the passage of the New Act is potentially a significant vehicle for positive change as well as a source of potential new burdens and risks.

Among other things, company boards will need to be mindful not only of the risks of mandatory CSR spending, but also the risks posed by mandatory auditor rotation. If a company has had a truly independent, vigorous, and well-staffed independent audit team, the loss of expertise in the manner in which the company operates could have a negative impact. Both audit firms and companies will doubtless be working hard to address these risks.