Corporate Governance: From Compliance to Culture?

Even as governments across the world push regulatory measures to drive corporate governance compliance, there is a dawning realisation that governance without culture is a paper tiger. Corporate governance must move from being compliance driven to becoming the embedded culture of a company, and in this, boards have a huge role to play. It is culture not strategy that is the foundation of sustainable governance.

In recent years, the successive waves of scandals rocking the global corporate world have led to a greater demand for transparency and accountability in the affairs of a company. Apparently, a corporate governance wave is sweeping across the globe as investors, promoters, directors, and stakeholders big and small seek a say in how a business is run. The result is a rapidly changing corporate landscape, even as governments and regulators grapple with the emerging reality and look to strengthen the regulatory framework and clean up the Augean stable. 
 
In early August, the Federal Reserve Board invited public comment on two proposals – corporate governance and rating system for large financial institutions. The proposal would refocus the Federal Reserve's supervisory expectations for the largest firms' boards of directors on their core responsibilities, which will promote the safety and soundness of the firms, according to its press release. Further the press release states, “The corporate governance proposal is made up of three parts. First, it identifies the attributes of effective boards of directors, such as setting a clear and consistent strategic direction for the firm as a whole, supporting independent risk management, and holding the management of the firm accountable. For the largest institutions, Federal Reserve supervisors would use these attributes to inform their evaluation of a firm's governance and controls. Second, it clarifies that for all supervised firms, most supervisory findings should be communicated to the firm's senior management for corrective action, rather than to its board of directors. And third, the proposal identifies existing supervisory expectations for boards of directors that could be eliminated or revised.”
 
Elsewhere in Africa, Ethiopia was scheduled to host the 11th conference of African Corporate Governance Network in Addis Ababa, to be attended by a host of policymakers and large company owners from 19 member states. The network is acknowledged to be playing a constructive role in the development of a strong fair and ethical business system in the country. 
 
India Gets Cracking: New Norms to Strengthen Governance
 
The Companies (Amendment) Bill, 2017 promises far-reaching changes in corporate governance framework.
 
The companies (Amendment) Bill, 2017 was passed recently in the monsoon session of Parliament. How will the following amendments passed by the Lok Sabha affect businesses?
 
Related Party to Include Investing Company
 
This means that for transactions with the investing company, the investee company would have to follow the due approval process as outlined by section 188(1) of the 2013 Companies Act. Special resolution may be required for certain transactions. Audit committee approval will be required for transactions, which are either not in the ordinary course of business or not at arm's length. Disclosure will be required in the board report, website and annual report.
 
Change in Definition of Subsidiary
 
The introduced change of the words “total share capital” with the words “total voting power” has the impact on the level of control the holding company has on the subsidiary company. Shares may be issued with differential voting rights. In absence of voting rights, key managerial decisions can be taken without the consent of share capital holders. Now a subsidiary would be one in which the holding company exercises or controls more than one-half of the total voting power either at its own or together with one or more of its subsidiary companies. For example recently Mr. Mark Zuckerberg made headlines of giving away 99 per cent of his wealth during his lifetime. Zuckerberg can donate 99 per cent of Facebook shares he owns while retaining the voting rights. Facebook's unique dual-class structure permits him to have special voting shares. Zuckerberg can give away ordinary shares of stock while still maintaining majority control of the social network Facebook.
 
Change in Definition of Associate Company
 
As per the Companies Act, 2013, an "associate company", in relation to another company, means a company in which that other company has a significant influence, but which is not a subsidiary company of the company having such influence and includes a joint venture company. The term significant influence and joint venture required further clarification. 
 
The amendment has further clarified the meaning of "significant influence" as control of at least 20 per cent of total voting power, or control of or participation in business decision under an agreement. Having at least 20 per cent of total voting power gives the holding company right to some of the key decisions that the company might undertake and the another company having influence over such decisions. 
 
Change in Private Placement Issuances
 
The offer of private placement can be made to a select group identified by the board. Earlier this was not clear how the persons will be selected for private placement. With this amendment, issue of shares on private placement basis can be easily distinguished from a public offer.
 
Also, the liability has been determined the return of allotment within the period prescribed under sub-section (8) the company, its promoters and directors shall be liable to a penalty for each default of one thousand rupees for each day during which such default continues but not exceeding 25 lakh rupees. Clear description of the liability is likely to increase the compliance of filing the return of allotment.
 
Change in Loan & Investment by Company
 
The amendment has clarified that loans can be given to employees of the company exceeding 60 per cent of its paid-up share capital, free reserves and securities premium account or 100 per cent of its free reserves and securities premium account, whichever is more. Hence, the term “person” has been further clarified.
 
Section 186 sub-section (3) has been substituted. According to this new sub-section, when loan or guarantee is given or where a security has been provided by a company to its wholly owned subsidiary company or a joint venture company, or acquisition is made by a holding company, by way of subscription, purchase or otherwise of, the securities of its wholly owned subsidiary company, the requirement of prior approval by means of a special resolution passed at general meeting shall not apply. This will provide ease of doing business as it is not easy to pass a special resolution.
 
In sub-section (11), the exemptions to other clauses of Section 186 except sub-section (1) were allowed to any acquisition made by a company whose principal business is the acquisition of securities. Now, this has been made broader by replacing term “acquisition” with “investment” in the amendment.
 
Related Party Transactions
 
The transactions that are not ratified by the audit committee and are with related party will make the director concerned indemnify the company against any loss incurred by it. Hence, caution must be exercised by directors while dealing with related party.
 
Independent Director
 
Earlier under section 135 of Corporate Social Responsibility, the corporate social responsibility committee of the board was required to have at least one director as independent director. Now, it has been further explained that this requirement is exempted where a company is not required to appoint an independent director under subsection (4) of section 149. Earlier a requirement of a deposit of one lakh rupees or more was there for standing for directorship and this amount to be refunded if the proposed person gets elected as a director or gets more than 25 per cent of total valid votes cast either on show of hands or on poll. Now with the amendment, this requirement of deposit shall not apply in the case of appointment of an independent director.
 
(Prof. Saurabh Agarwal)
 
A new Harvard research, published in August that studied the effects of stock index on corporate behavior of Japanese firms, suggests that the prestige associated with inclusion in the index could be a “novel mechanism” to transform long-standing corporate behaviors. In 2013, the Japanese Exchange Group and Nikkei had jointly launched JPX400, a new index to display the 400 “best” Japanese companies. The criteria for inclusion in the index included quantitative factors such as historical return on equity, operating profit, and total market cap, and also factors like the presence of multiple independent directors, earnings reports in English, and observance of IFRS accounting standards. The idea behind the Japanese government adopting the index was to bring about a change in managers’ behaviour and get the Japanese companies to spend more.
 
In India, The Companies (Amendment) Bill, 2017 tabled in the recent monsoon session of Parliament, was passed by the Lok Sabha. It seeks to amend the Companies Act, 2013 and once enacted, it will bring about far reaching changes in the corporate governance framework by strengthening governance standards, enabling strict action against defaulting companies and improving the ease of doing business in India. The bill amends more than 40 provisions of the Act.
 
India wakes up
 
Apparently, economies big and small, advanced or emerging are refocusing their lens on corporate governance to up their ranks in the ease of doing business index and also establish a clean image of their business environment. Corporate governance has taken the form of a movement across the globe. Discussions everywhere are bubbling with concerns on how to improve governance in companies. Regulations are the order of the day and different governments are mulling changes, amendments and new initiatives to take governance to another level. As UD Choubey, Director General, SCOPE and member of the Uday Kotak Committee on corporate governance, in a media article observes, “There is fresh thinking at the board level to arrive at new institutional mechanism, codes and standards, strategy formulation and its execution” and that “evaluation and accreditation of achievement of corporate governance in an enterprise is a critical issue today.”  
 
   
 
In the past more than 15 years, India too witnessed a series of initiatives aimed at strengthening the compliance framework. However, the corporate governance record remained dismissal and a series of high profile controversies involving boards, promoters, investors and stockholders has intermittently grabbed headlines. However, with a reformist and business focused government at the Centre, corporate governance is once again on the radar. 
 
From the government to the regulators, the shift in stance is obvious. In December 2016, Bombay Stock Exchange (BSE) in collaboration with International Finance Corp (IFC), a member of the World Bank Group, and Institutional Investor Advisory Services (IIAS), a leading proxy advisory firm in India, launched a Corporate Governance Scorecard for Indian corporate. There was no standard or comprehensive tool for assessing the corporate governance status of companies in India and in the absence of one, companies could not self-assess themselves or benchmark themselves against international corporate governance standards. Investors too could not measure a company’s performance on corporate governance in the absence of a standardised measure for corporate governance status. 
 
Notably, in April 2014 market regulator, Securities and Exchange Board of India (Sebi), had brought out detailed corporate governance norms for listed companies providing for stricter disclosures and protection of investor rights, including equitable treatment for minority and foreign shareholders. The new rules that became effective from October 1 that year require companies to get approval from shareholders for related party transactions. Companies also have to put in place whistle-blower mechanism, elaborate disclosures on pay packages and have at appoint at least one woman director on their boards. The new norms were aligned with the new Companies Act and aimed to promote best practices on corporate governance.
 
 
About a year later in June 2015, a Companies Law Committee set up by the government had examined the need for further amendments in the Companies Act, 2013 and invited suggestions from all stakeholders. Thereafter, it held consultations on recommendations received, and in February 2016 submitted its report to the government. In March 2016, the Companies Bill, 2016, based on the report, was introduced in the Lok Sabha. It was referred to a Standing Committee on Finance in April 2016, which tabled its report in December 2016. A revised bill based on the recommendations of the panel had been cleared by the Cabinet in March this year. 
 
In a bid to strengthen the corporate governance framework and mechanism further, in June this year, Sebi instituted a committee under the chairmanship of Uday Kotak, Executive Vice Chairman and Managing Director of Kotak Mahindra Bank. The aim is to improve the corporate governance standards of listed companies. The committee comprises representatives of Sebi, professional organisations, investor groups, stock exchanges, chambers of commerce, law firms, academicians and researchers. The panel which is to submit its report in four months will make recommendations about several important issues. The role of independent directors that has been mired in controversy recently will be addressed with the committee making its suggestions on “ensuring independence in spirit of independent directors and their active participation in functioning of the company”. It will also give its advice on steps to “improve safeguards and disclosures pertaining to related party transactions”. Issues faced by investors on voting and participation in general meetings and ways for improving effectiveness of board evaluation practices will also be reviewed and the panel would recommend steps to address these. Besides, the committee will also advise Sebi on issues pertaining to disclosure and transparency.
 
Why the amendments?
 
Amit Tandon, MD, Institutional Investor Advisory Services, explains: The many amendments to the Companies Act, 2013 became essential as “post-enactment of the Companies Act, 2013, which was made effective on 1 April 2014; companies have been facing challenges with its implementation. Further, as some of the provisions of the Companies Act, 1956, were reiterated, these had become redundant (for example, transaction of certain business items only through postal ballot in spite of mandating e-voting for certain companies). As a consequence certain provisions of the Act required a relook and the amendment is aimed at remedying several drafting errors and execution problems that companies have been facing.”
 
 
The Amendment Act is primarily to facilitate ease of doing business and to achieve this end, certain provisions have been modified, e.g., the requirement of ratification of auditors at each AGM post appointment for five years to be omitted, explains Tandon. However, the Companies (Amendment) Bill, 2017 will pave the way for improved corporate governance standards in the country. This will happen as “the amendment brings an ease in doing business for companies, thus, making compliance easier. Introducing simple and relatively less burdensome regulatory norms is expected to lead to greater compliance by companies and ultimately improve the corporate governance standards,” says Tandon. Globally too, “we see many countries moving towards a “comply or explain” model of corporate governance – giving firms greater autonomy to carry out their business,” says Tandon and adds, “This is a move in that direction.”
 
The amendment Act also seeks to increase transparency which will be achieved by the present disclosures required under the Act and the Sebi (Listing Obligations and Disclosure Requirements) Regulations, 2014, Tandon adds.
 
Earlier this year, speaking at CFO100 Conference and Felicitation Ceremony, Tandon had highlighted how “regulations are pushing governance centre stage and in different ways”. For instance, the code for independent directors contained in the Companies Act, 2013 provides that companies issue a letter of appointment to independent directors and sets out the terms and conditions covering such appointments. “Independent directors should be aware of what their responsibilities are – whether it be compliance, strategy, or others,” says Tandon.
 
Prof. (Dr.) Saurabh Agarwal, Dean & Professor of Accounting and Finance, Indian Institute of Finance, agrees: "Amendments were required to clarify or remove any doubts present in the Companies Act, 2013. Absence of these amendments would have given a window of opportunity to some wilful corporates to take benefit of the gaps in the regulatory framework. Also, honest corporates are protected by these amendments, as it limits the extent of interpretation by government officers. Greater clarity of law reduces litigation and improves the delivery of justice to the honest corporates.”
 
It is not that India has just recently woken up to the need for reforms in corporate governance. As an EY paper outlines, the history of reforms in India began with the constitution of the Kumar Mangalam Committee (1999), introduction of clause 49 in the listing agreement (2000), revision in clause 49 on recommendations of the Narayana Murthy Committee (2006), issue of voluntary guidelines on corporate governance (2009), issue of guiding principles on corporate governance (2012) based on recommendation of the Adi Godrej Committee, enactment of the revised Companies Act (2013) and the new corporate governance norms by Sebi (2014). To add to this list, we have the IFC Corporate Governance Scorecard (2016), institution of panel under the chairmanship of Uday Kotak (2017), and the Companies (Amendment) Bill, 2017. 
 
Notably, the Sebi corporate governance norms (2014) clearly indicated a shift towards enhanced transparency on board matters and spelt out various changes in the roles and responsibilities of the board, board committees and independent directors. As the EY paper notes, this move also indicated “the intent of the regulators to align with the global standards on corporate governance adopted in mature economies (such as the UK Companies Act, US MBCA, US-DGCL, UK FRC Code, Stewardship Code and SOX).”
 
Tandon, though, had pointed out that while Sebi has been on track with rules and regulation, what has evaded these from becoming effective was the question “how to operationalise them”. However, when institutional investors like FIIs engage with the company on corporate governance issues, the company behaviour starts to change. Proxy firms in the market have also been raising the red flag on governance issues and therefore there is a discussion around these changes. On account of these changes in the market the governance landscape is changing and will change very dramatically over the coming years, Tandon had explained.
 
Subtle shift – compliance to culture
 
But is a stringent corporate framework enough to ensure good corporate governance? Or should companies move away from a culture of compliance to a DNA of culture? To quote Mark Hucklesby, national technical director, Grant Thornton New Zealand,  “A phrase originated by business guru Peter Drucker, is ‘culture eats strategy for breakfast’ – and that’s an observation many involved in corporate governance would strongly agree with. Any organisations disconnecting the two are putting their success at risk.” 
 
The gleanings of a Grant Thornton survey report “Beyond Compliance: Corporate Governance 2017 - Building Blocks of Corporate Culture”, released in August point to just such thought dominating corporate governance discussions around the world. There is marked shift in the thinking of governments, regulators and companies as culture takes over from where compliance failed. The report defines “corporate culture” as a   combination of values, attitudes and behaviours that a company exhibits in its operations and relations with those affected by its conduct, e.g., employees, customers, suppliers and wider society. The report, based on a global survey of 2,500 businesses in 36 economies, found that the issue of corporate culture is receiving unprecedented regulatory attention as a foundation of good governance and today it is high on business agenda as never before. 
 
 
In tune with this line of thinking, Sebi had issued guidelines on board evaluation in January, and recommended that boards set a corporate culture and values which should be followed by the company.
 
Across the globe, the importance of instituting a corporate culture in companies is being realised, as found the survey. The Australian Prudential Regulatory Authority (APRA) has mandated board responsibility for risk culture. The Australian Securities and Investments Commission (ASIC) has also called for greater civil penalties for executives responsible for poor culture. In the UK, the Financial Reporting Council (FRC) is encouraging companies to focus on broader aspects of governance such as culture and strategy, while the Financial Conduct Authority (FCA) also encourages companies to make sure their culture supports a strong control environment. In Japan, in light of culture failings, its Financial Services Agency published a new code of governance for audit firms in March 2017 encouraging them to ‘develop an organisational culture of openness’.
 
There are more examples. The New Zealand Stock Exchange (NSX) is preparing a revised corporate governance code. Its Financial Market Authority (FMA), in a report published this year reviewing licences granted to financial services firms over the last three years, emphasised the importance of boards and senior teams leading company culture. In South Africa, King IV governance codes released in 2016 set out the importance of an ethical culture as part of effective governance. 
 
The numbers in India are not surprising given the rapidly globalising business environment and outlook in the country. According to the Grant Thornton survey, 80 per cent of the boards in India say that culture is now a standing item on their agenda as against 50 per cent globally. In fact, this was the second most cited measure in India whereas it is the third most cited one in APAC.
 
Corporate culture, like any other, must come from within companies to be sustainable. Grant Thornton’s report makes some practical recommendations for boards to work with leadership teams in order to develop such a culture:
 
1. Understand culture. This entails a culture audit to understand the positioning of the organisations culture and then working upon it from there.
 
2. Set culture. This includes code of conduct which would act as the bedrock of corporate culture.
 
3. Test culture. Culture is not a theoretical concept and should be applicable to real life business problems.
 
4. Refine and improve culture. Boards must interact with senior leaders who set the tone of corporate culture to find out how culture plays out in their day to day dealings. Culture can also be improved through diversity of the board and ways to enrich this must be explored.
 
Board – custodian of company culture?  
 
Regulations drive in a culture of compliance, but an embedded corporate culture is the key to driving corporate governance in spirit. Sebi guidelines on board evaluation recognise the need for the board to actively set culture and values for the company to follow especially in owner-managed companies. It becomes the responsibility of the board to understand the cultural rooting of the owner and engage with him/her to implement good culture benefits for all stakeholders. 
 
Little wonder then that there is increasing emphasis on the board and directors’ roles and responsibilities and evaluation in India. Tandon feels the realisation has dawned that being a director “is not about going and attending the board meeting and nodding at what the management is saying, it's also about putting your point of view and realising there are real life issues and how we change them”. 
 
IFC corporate governance officers Vladislava Ryabota and Lopa Rahman in a media interview (thehindubusinessline.com) remarked that IFC’s definition of independent directors is more stringent than India’s. The IFC criteria requires that an independent director does not receive any other compensation from the company in addition to his or her board fees; must not have been employed by the company in the recent past; has no other close links to the management or its major shareholders; has not provided significant services to the company (especially audit and legal services) in the recent past, and has no actual or potential conflict of interest with the company, including employment or other service on the board of the company’s affiliates or competitors.
 
The key changes introduced by Sebi in 2014 in the code for independent directors included – nominee director not to be considered as independent director, prohibition on stock options, mandatory performance evaluation, separate meetings of independent directors, number of companies restricted to seven, and three in case serving as whole-time director and the maximum tenure restricted to two terms of five years (see infographic for key changes). Mandatory performance evaluation was also stipulated for board of directors and its committees. 
 
But the moot question is how far have we succeeded in implementing these clauses? According to IFC experts as regards board evaluation “some just tick the box that they have done evaluation”. Additionally, most board directors in India need education as to what being on the board entails as in India “nobody is trained to be a director”.    
 
However, the IBR report points to boards taking steps to institute a corporate culture of “ethos and values” beyond the regulatory pressure. Sebi, in its guidelines on board evaluation, recommends boards set up a corporate culture and values to be followed by the company. 
 
Beyond compliance, really?
 
So is corporate governance finally moving “beyond compliance” and is now more focused on building a strong corporate culture?  To quote Anita Skipper, senior analyst – corporate governance, Aviva Investors, “Culture has always been important to governance, it’s just never been identified as such. The progress we’ve made over the years is such that where before we were talking about CSR, remuneration, tackling and avoiding controversies, [until now] we never pulled it all together.” 
 
“Indeed, the changes have been welcomed by the industry as they reduce the ambiguities present in The Companies Act, 2013. However, we are far from the levels of corporate governance we should have reached after 70 years of Independence. Corruption, bureaucratic delays and agency problem in some companies, continue to be the major problems in implementing robust corporate governance standards,” quips Prof. (Dr.) Agarwal.
 
The International Business Report of Grant Thornton seems to justify this view. In India, 85 per cent (71 per cent globally) of boards are establishing internal controls that address culture and employee behaviour. Practices such as benchmarking against peers and exploring customer relationships are also prevalent. And the more developed are expanding their internal auditors’ remit to test how embedded culture is at all levels of their company. India is the only major economy where treatment and relationship with employees and conduct of senior management team are cited as the most important factor (87 per cent) that has biggest impact on their brand.
 
Culture certainly appears to be big on companies’ agenda and businesses are not shying from investing resources to institutionalise the right culture in their company. Town hall meetings have become de rigueur for instituting an open culture of internal communication, there are codes of conduct to guide employee behaviour aligned to the vision of the company, and organisations are ensuring periodic training to keep the conversations alive. Not only this, Indian firms are also acknowledging the importance of engagement with external stakeholders in a bid to align their culture with the company vision and mission. There is increasing emphasis on recognising customers and other external stakeholders as partners in the business (66 per cent of IBR respondents in India acknowledge this). Third-party risks to company culture are being recognised and steps are being taken to minimise them, as per the report.
 
Developing the practice of healthy corporate culture, not just in words but actions also, starts at the top and boards are intrinsic to this endeavour. Corporations are ignoring the corporate governance issues as a matter of course in this new era of increased stakeholder activism.
    
Here at least, a top down approach is the most effective one. The tone of culture that a company adopts flows from the executive level and the board has to play the role of the culture guardian, through its own conduct and by becoming the facilitator of this change. It remains to be seen though what lessons India’s company boards imbibe from the Infosys saga and what role they finally assume for themselves.  One thing is clear though that in this era of increased stakeholder activism, corporations can ill afford to ignore corporate governance issues.
 
Stay tuned! We are watching this space… 
 
(Based on secondary research, media reports and interviews)
 
(Join our panel on corporate governance–Founders, Executive, Investors... : who is the new boss?–at CFO Leadership Conclave from September 15-17 at Udaipur for an exciting discussion and learn more)

 


Event date: 
Wednesday, August 30, 2017

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