Corporate Governance Reform in India: Gauging Impact on Investors
Approval of all material related-party transactions by independent shareholders (i.e., related parties have to abstain from voting) is standard in many markets around the world and considered a best practice. Now, listed companies in India will abide by this rule beginning in October 2014 as part of a slew of corporate governance reforms announced recently by the Securities and Exchange Board of India (SEBI). Will these new measures bring much-needed relief to minority shareholders, or is it just old wine in a new bottle?
SEBI consulted industry participants in January 2013 to revise and overhaul Clause 49 of the Equity Listing Agreement that deals with the corporate governance norms for listed companies in India. CFA Institute, in conjunction with the Indian Association of Investment Professionals (IAIP), officially responded to the consultation by highlighting our policies and global best practices. The recently revised SEBI norms are expected to enhance the corporate governance framework to reflect global best practices. The requirements in certain areas, including independent directors and related-party transactions, are more stringent than the new Companies Act 2013.
Some of the significant changes are discussed below.
Aligning Listing Agreement with the Companies Act 2013
Companies Act requirements on issuing a formal letter of appointment, performance evaluation, and conducting at least one separate meeting of the independent directors each year and providing suitable training to them are now included in the revised norms of SEBI. Independent directors are not entitled to any stock option, and companies must establish a whistle-blower mechanism and disclose them on their websites.
Restricting Number of Independent Directorships
Per Clause 49, the maximum number of boards a person can serve as independent director is seven, and three in case of individuals also serving as a full-time director in any listed company. The Companies Act sets the maximum number of directorships at 20, of which not more than 10 can be public companies. There are no specific limits prescribed for independent directors in the Companies Act.
Although SEBI reforms seem to be moving in the right direction, these limits may initially pose challenges in sourcing qualified independent directors for listed companies.
Maximum Tenure of Independent Directors
Based on the Companies Act as well as the new Equity Listing Agreement, an independent director can serve a maximum of two consecutive terms of five years each (aggregate tenure of 10 years). These directors are eligible for reappointment after a cooling-off period of three years.
Can a director who has served two five-year terms be considered independent after a cooling period of three years? CFA Institute recommends that board members limit their length of service on a specific company board to no more than 15 years to ensure new board members with fresh insights and ideas are elected.
Board-Mix Criteria Redefined
Per Clause 49 of the Equity Listing Agreement, 50% of the board should be made up of independent directors if the board chair is an executive director. Otherwise, one-third of the board should consist of independent directors. Additionally, the board of directors of a listed company should have at least one female director.
While it is a welcome change that SEBI mandates a female director, will it make a huge difference to the effectiveness of boards?
CFA advocates that diversity should be embraced from all angles, such as diversity of backgrounds, expertise, and perspectives, including an increased investor focus to improve the likelihood that the board will act independently and in the best interest of shareholders.
Role of Audit Committee Enhanced
The SEBI reforms call for two-thirds of the members of audit committee to be independent directors, with an independent director serving as the committee’s chairman. While the Companies Act requires the audit committee to be formed with a majority of independent directors, SEBI has gone a step further to improve the independence of the audit committee.
The role of the audit committee also has evolved to incorporate additional themes from the Companies Act, such as reviewing and monitoring auditor independence, approval of related-party transactions (RPTs), scrutiny of inter-corporate loans, valuations, and evaluations of internal financial controls and risk management systems.
More Stringent Rules for Related-Party Transactions
The scope of the definition of RPTs has been broadened to include elements of the Companies Act and accounting standards:
- All RPTs require prior approval of the audit committee.
- All material RPTs must require shareholder approval through special resolution, with related parties abstaining from voting.
- The threshold for determining materiality has been defined as any transaction with a related party that exceeds 5% of the annual turnover or 20% of the net worth of the company based on the last audited financial statement of the company, whichever is higher.
Since SEBI Clause 49 requires shareholder approval for all material RPTs, with no exception for transactions in ordinary course of business or at arms-length, companies feel that this will result in practical difficulties (i.e., compliances costs and delays), particularly for those that regularly transact business with subsidiaries.
The ultimate effectiveness of such legislation will depend upon the degree and quality of enforcement, or the monitoring capabilities of the regulator.
Improved Disclosure Norms
In certain areas, SEBI resorts to disclosure as an enforcement tool. Listed companies are now required to disclose in their annual report granular details on director compensation (including stock options), directors’ performance evaluation metrics, and directors’ training. Independent directors’ formal letter of appointment / resignation, with their detailed profiles and the code of conduct of all board members, must now be disclosed on companies’ websites and to stock exchanges.
E-voting Mandatory for All Listed Companies
Until now, resolutions at shareholder meetings in listed Indian companies were usually passed by a show of hands (except for those that required postal ballot). This means votes were counted based on the physical presence of shareholders. SEBI also has changed Clause 35B of its Equity Listing Agreement to provide e-voting facility for all shareholder resolutions.
We think this is a pertinent change as it will allow minority shareholders to express their voices at shareholder meetings without having a physical presence. CFA Institute has advocated for company rules that ensure each share has one vote.
SEBI is setting up the infrastructure to assess compliance with Clause 49 to ensure effective enforcement. Companies need to buckle up and assess the impact of these reforms and step up compliance.
I asked Navneet Munot, CFA, CIO of SBI Mutual Fund and advocacy director for IAIP, to gauge industry reactions. Mr. Munot was optimistic about SEBI boosting investor confidence through these sweeping changes, especially the potential to empower minority shareholders through e-voting, enhanced disclosures on remuneration that is aligned with global best practices, and by requiring independent shareowner approval for related-party transactions. Given India’s humongous need for risk capital, regulatory reforms and better enforcement are critical for market integrity and building investor trust, he said.
CFA Institute, along with the IAIP, is currently working on an investor’s guide to shareholder meetings in India to help retail and institutional investors understand the rights, role, and responsibilities of shareholders. Stay tuned.
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Photo credit: iStockphoto.com/Shikhar Bhattarai