In better company

But the new Companies Bill will not,by itself,improve corporate governance.

Written by Asish K. Bhattacharyya | Published: August 29, 2013 4:42 am

But the new Companies Bill will not,by itself,improve corporate governance.

After 57 years,we will finally have a modern Companies Act. Although the government has not yet enacted the Companies Bill,2013,into law,it has been passed by both Houses of Parliament. The new act will be a milestone in achieving the ministry of corporate affairs’ vision “to facilitate corporate growth with enlightened regulation”.

Among the new provisions,the one related to corporate social responsibility (CSR) is in the limelight. The bill requires large and profitable companies to spend 2 per cent of their average net profits from the previous three years in CSR-related activities. According to the bill,a company should ideally undertake CSR activities in its area of operation. A list of approved CSR activities outlined in the bill includes those aimed at building relationships and social capital,developing skills through vocational training,ensuring environmental sustainability and social business projects. This suggests lawmakers do not consider CSR to be purely philanthropic.

Interestingly,the law has only established a benchmark for CSR expenditure. A company may decide not to spend or spend less than 2 per cent of its profits on CSR activities. No penalty will be imposed on that company unless it fails to explain the reasons for its inability to spend 2 per cent of its net profits on CSR. This is a shift in the regulatory approach. It is for independent directors and investors to evaluate whether a “fail and explain” approach will expose the business to reputational and other risks. This experiment is likely to succeed,with an increase in institutional investment in companies and the emergence of proxy advisory firms. However,success will not come overnight.

The provisions on independent directors seem to look ahead. So far,independent directors,on average,have not done anything remarkable to improve corporate governance. The system has inherent weaknesses. However,research shows that the presence of independent directors on boards improves corporate governance to some extent. In the absence of a better alternative,independent directors occupy a central position in corporate governance. The bill aims to strengthen this institution. One provision mandates a separate meeting of independent directors to review the performance of non-independent directors and the chairman and the board,as well as to evaluate the effectiveness of the board process. It is unlikely that this requirement will yield results in the near future as the concept is new,and independent directors often fail to protect their independence from subtle pressures,particularly in companies with concentrated ownership. However,in the long run,the strengthening of this institution should yield the desired result.

The bill has capped the tenure of independent directors to protect their independence and to ensure that new blood is periodically injected. This will yield results only after a decade,because the existing independent directors can continue to hold office for the next five years,and with the approval of two-thirds of the shareholders,they can continue for another five years. The bill empowers the government to prescribe the appointment of at least one woman director in certain classes of companies. This is in line with contemporary ideas of corporate governance.

The bill aims to improve audit quality. Perhaps the most controversial provision is one that stipulates that auditors should be rotated. Many believe that such a measure could not be included in US corporate law due to pressure from the big four audit firms,although regulators and investors realise the benefits. An audit firm shall not hold office for more than 10 consecutive years and an individual auditor shall not hold office for more than five years in listed companies. They will be eligible for re-appointment after a cooling off period of five years. A National Financial Reporting Authority will be set up to oversee audit quality and take disciplinary action against erring auditors. This will go a long way in improving audit quality.

The bill gives extensive powers to the government to frame rules under various provisions. It will help bring necessary changes within the overall structure of the bill to keep the law contemporary and incorporate global best practices as they emerge. It will also help revise rules,based on the experience of implementing the bill. Still,there is a concern that this rule-making power might be abused.

By itself,the bill will improve neither corporate regulation nor governance. The mindset of regulators and those in charge of the governance of companies has to change to achieve the desired result. All stakeholders must work towards reducing the trust deficit between investors and promoters,companies and external stakeholders,regulators and companies. It is a long and difficult process,but achievable.

The writer is professor and head,School of Corporate Finance and Policy,Indian Institute of Corporate Affairs express@expressindia.com

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