Chapter 15. Landmarks in the Emergence of Corporate Governance – Business Ethics and Corporate Governance

CHAPTER 15

Landmarks in the Emergence of Corporate Governance

INTRODUCTION

The emergence of corporate governance as a fair and transparent mechanism to run and administer corporations in a manner that would result in long term shareholder value and benefits to the entire society has been fairly a recent phenomenon. There has been a perceptible change in people’s minds as to the objective of a corporation—from one which was intended to benefit exclusively the shareholders to one which is expected to benefit all its stakeholders. Besides, the corporate scams and frauds that came to light have brought about a change in the thinking of advocates of free enterprise that the system was not self-regulatory and needed substantial external regulations. These regulations should penalize the wrongdoers while those who abide by the rules of the game are to be amply rewarded by the market forces. The society’s response to these frauds reflected in the legislative and regulatory changes brought out by governments, shareholder activism, insistence of mutual funds and large institutional investors, that corporates they invested in adopt better governance practices, and in the formation of several committees to study the issues in depth and make recommendations, codes and guidelines on corporate governance that are to be put in practice. All these measures have brought about a metamorphosis in corporates that realised that the society, especially the investing public are pretty serious about corporate governance and started internalizing these values and later adopting them albeit selectively and sporadically.

DEVELOPMENTS IN THE US

Corporate governance gained importance with the occurrence of the Watergate scandal in the United States. Thereafter, as a result of subsequent investigations, US regulatory and legislative bodies were able to highlight control failures that had allowed several major corporations to make illegal political contributions and to bribe government officials. This led to the development of the Foreign and Corrupt Practices Act of 1977 that contained specific provisions regarding the establishment, maintenance and review of systems of internal control. This was followed in 1979 by the Securities and Exchange Commission’s proposals for mandatory reporting on internal financial controls. In 1985, following a series of high profile business failures in the US, the most notable one of which being the savings and loan collapse, the Treadway Commission was formed to identify the main causes of misrepresentation in financial reports and to recommend ways of reducing incidence thereof. The Treadway Report published in 1987 highlighted the need for a proper control environment, independent audit committees and an objective internal audit function and called for published reports on the effectiveness of internal control. The Commission also requested the sponsoring organizations to develop an integrated set of internal control criteria to enable companies to improve their controls.

DEVELOPMENTS IN THE UK

In England, the seeds of modern corporate governance were probably sown by the Bank of Credit and Commerce International (BCCI) scandal. The BCCI was a global bank, made up of multiplying layers of entities, related to one another through an impenetrable series of holding companies, affiliates, subsidiaries, banks-within-banks, insider dealings and shareholder (nominee) relationships. With this corporate structure of BCCI and shoddy record keeping, regulatory review and audits, the complex BCCI family of entities was able to evade ordinary legal restrictions on the movement of capital and goods as a matter of daily practice and routine. Since BCCI was a vehicle fundamentally free of government control, it was an ideal mechanism for facilitating illicit activity by others, including such activity by officials of many of the governments whose laws BCCI was breaking.

Another landmark that heightened people’s awareness and sensitivity on the issue and the resolve that something ought to be done to stem the rot of corporate misdeeds, was the failure of Barings Bank. Barings was Britain’s oldest merchant bank. It had financed the Napoleonic wars, the Louisiana Purchase, and the Erie Canal. Barings was the Queen’s bank. What really grabbed the world’s attention was the fact that its failure was caused by the actions of a single trader based at a small office in Singapore, Nick Leeson. He was posted as a trader in Singapore on behalf of Barings Bank. The cardinal principle in trading is to separate the front office from the back office. But Nick Leeson was posted in charge of the back office operations of Barings Bank as well. He started trading on behalf of the Bank, whereas he was supposed to trade only on behalf of the customers. Eventually when his strategy failed because of an earthquake in Japan, Barings Bank had already lost $1.4 billion and it had to shut office.

These are just a couple of examples of corporate failure due to absence of a proper structure and objectives in the top management. Corporate governance assumed more importance in the light of these corporate failures, which was affecting the shareholders and other interested parties.

As a result of these failures and lack of regulatory measures from authorities as an adequate response to check them in future, the Committee of Sponsoring Organisations (COSO) was born. The report produced by it in 1992 suggested a control framework, and was endorsed and refined in the four subsequent UK reports: Cadbury, Ruthman, Hampel and Turnbull. While developments in the United States stimulated debate in the UK, a spate of scandals and collapses in that country in the late 1980s and early 1990s led shareholders and banks to worry about their investments. These also led the government in the UK to recognize that the then existing legislation and self-regulation were not working. Companies such as Polly Peck, British & Commonwealth and Robert Maxwell’s Mirror Group News International were all victims of the boom-to-bust decade of the 1980s. Several companies, which saw explosive growth in earnings, ended the decade in a memorably disastrous manner. Such spectacular corporate failures arose primarily out of poorly managed business practices.

The publication of a series of reports consolidated into the Combined Code on Corporate Governance (The Hampel Report) in 1998 resulted in major changes in the area of corporate governance in the United Kingdom. The corporate governance committees of the last decade have analysed the problems and crises besetting the corporate sector and the markets and have sought to provide guidelines for corporate management. Studying the subject matter of the corporate codes and the reports produced by various committees highlight the key practical issues and concerns driving the development of corporate governance over the last decade.

CORPORATE GOVERNANCE COMMITTEES

The main committees to study and discuss issues of corporate governance and known by the names of the individuals who chaired them, are discussed as follows.

CADBURY COMMITTEE ON CORPORATE GOVERNANCE, 1992

The stated objective of the Cadbury Committee was ‘to help raise the standards of corporate governance and the level of confidence in financial reporting and auditing by setting out clearly what it sees as the respective responsibilities of those involved and what it believes is expected of them’.1

The Committee investigated the accountability of the board of directors to shareholders and to the society. It submitted its report and associated ‘Code of Best Practices’ in December 1992 wherein it spelt out the methods of governance needed to achieve a balance between the essential powers of the board of directors and its proper accountability.

The resulting report and associated ‘Code of Best Practices’ was generally well received. While the recommendations themselves were not mandatory, the companies listed on the London Stock Exchange were required to clearly state in their statement of accounts whether or not the code had been followed. The companies, which did not comply, were required to explain the reasons for the lapse.

The Cadbury Code of Best Practices had 19 recommendations. The recommendations are in the nature of guidelines relating to the board of directors, non-executive directors, executive directors and those on reporting and control.

Relating to the board of directors, the recommendations were as follows:

  • The board should meet regularly, retain full and effective control over the company and monitor the executive management.
  • There should be a clearly accepted division of responsibilities at the head of a company, which will ensure balance of power and authority, such that no individual has unfettered powers of decision making. In companies where the chairman is also the chief executive, it is essential that there should be a strong and independent director on the board, who is a recognized senior member.
  • The board should include non-executive directors of sufficient calibre and number, for their views to carry significant weight in the board’s decisions.
  • The board should have a formal schedule of matters specifically reserved to it for decisions to ensure that the direction and control of the company is firmly in its hands.
  • There should be an agreed procedure for directors in the furtherance of their duties to take independent professional advice, if necessary, at the company’s expense.
  • All directors should have access to the advice and services of the company secretary, who is responsible to the board for ensuring that board procedures are followed and that applicable rules and regulations are complied with. Any question of the removal of company secretary should be a matter for the board as a whole.

Relating to the non-executive directors, the recommendations were:

  • Non-executive directors should bring an independent judgment to bear on issues of strategy, performance, resources, including key appointments and standards of conduct.
  • The majority should be independent of the management and free from any business or other relationship, which could materially interfere with the exercise of their independent judgment, apart from their fees and shareholding. Their fees should reflect the time, which they commit to the work of the company.
  • Non-executive directors should be appointed for specified terms and reappointment should not be automatic.
  • Non-executive directors should be selected through a formal process—this process and their appointment—should be a matter for the Board as a whole.

For the executive directors, the rcommendations in the Cadbury Code of Best Practices were as given below:

  • Directors’ service contracts should not exceed 3 years without shareholders’ approval.
  • There should be full and clear disclosure of their total emoluments and those of the chairman, including pension contributions and stock options. Separate figures should be given for salary and performance related elements and the basis on which performance is measured should be explained.
  • Executive directors’ pay should be subject to the recommendations of a remuneration committee made up wholly or mainly of non-executive directors.

On reporting and controls, the Cadbury Code of Best Practices stipulated the following:

  • It is the board’s duty to present a balanced and understandable assessment of the company’s position.
  • The board should ensure that an objective and professional relationship is maintained with the auditors.
  • The board should establish an audit committee of at least three non-executive directors with written terms of reference, which deal clearly with its authority and duties.
  • The directors should explain their responsibility for preparing the accounts next to a statement by the auditors about their reporting responsibilities.
  • The directors should report on the effectiveness of the company’s system of internal control.
  • The directors should report that the business is a going concern, with supporting assumptions or qualifications, as necessary.

The stress in the Cadbury Report is on the crucial role of the board and the need for it to observe the Code of Best Practices. Its important recommendations include the setting up of an audit committee with independent members. The Cadbury model is one of self-regulation. It was recognized that in the event British companies failed to comply with the voluntary code, legislation and external regulation would follow.

It would be interesting to note how the corporate world reacted to the Cadbury Report. The report infact shocked many by its boldness, particularly by the Code of Best Practices recommended by it. The most controversial and revolutionary requirement and the one that had the potential of significantly impacting the internal auditing, was the requirement that the directors should report on the effectiveness of a company’s system of internal control. It was the extension of control beyond the financial matters that caused the controversy.

THE PAUL RUTHMAN COMMITTEE

This committee was constituted later to deal with the said controversial point of Cadbury Report. It watered down the proposal on the grounds of practicality. It restricted the reporting requirement to internal financial controls only as against ‘the effectiveness of the company’s system of internal control’ as stipulated by the Code of Best Practices contained in the Cadbury Report.

The final report submitted by the committee chaired by Ron Hampel had some important and progressive elements notably the extension of directors’ responsibilities to ‘all relevant control objectives including business risk assessment and minimizing the risk of fraud…’.

THE GREENBURY COMMITTEE, 1995

This committee was set up in January 1995 to identify good practices by the Confederation of British Industry (CBI) in determining directors’ remuneration and to prepare a code of such practices for use by public limited companies of the United Kingdom.2

The committee

  • aimed to provide an answer to the general concerns about the accountability and level of directors’ pay;
  • argued against statutory control and for strengthening accountability by the proper allocation of responsibility for determining directors’ remuneration, the proper reporting to shareholders and greater transparency in the process; and
  • produced the Greenbury Code of Best Practice which was divided into the following four sections:
    1. Remuneration committee
    2. Disclosures
    3. Remuneration policy
    4. Service contracts and compensation.

The Greenbury Committee recommended that the UK companies should implement the code as set out to the fullest extent practicable, that they should make annual compliance statements, and that investor institutions should use their power to ensure that the best practice is followed.

THE HAMPEL COMMITTEE, 1995

The Hampel Committee was set up in November 1995 to promote high standards of corporate governance both to protect investors and preserve and enhance the standing of companies listed on the London Stock Exchange.3

The committee

  • developed further the Cadbury Report.
  • recommended that
    1. the auditors should report on internal control privately to the directors;
    2. the directors maintain and review all (and not just financial) controls;
    3. companies that do not already have an internal audit function, should from time to time, review their need for one; and
  • Introduced the Combined Code that consolidated the recommendations of earlier corporate governance reports (Cadbury and Greenbury).
THE COMBINED CODE, 1998

The Combined Code 4 was subsequently derived from Ron Hampel Committee’s Final Report, Cadbury Report and the Greenbury Report. (Greenbury Report, which was submitted in 1995, addressed the issue of directors’ remuneration.) The Combined Code is appended to the listing rules of the London Stock Exchange. As such, compliance of the code is mandatory for all listed companies in the United Kingdom.

The stipulations contained in the Combined Code require, among other things, that the boards should maintain a sound system of internal control to safeguard shareholders’ investment and the company’s assets. The directors should, at least annually, conduct a review of the effectiveness of the group’s system of internal control covering all controls, including financial, operational, and compliance and risk management, and report to shareholders that they have done so.

It was observed that the one common denominator behind the past failures in the corporate world was the lack of effective risk management. As a result, risk management subsequently grew in importance and is now seen as highly crucial to the achievement of business objectives by the corporates.

It was clear, therefore, that the boards of directors were not only responsible but also needed guidance in not just reviewing the effectiveness of internal controls but also for providing assurance that all the significant risks had been reviewed. Furthermore, assurance was also required that the risks had been managed and an embedded risk management process was in place. In many companies, this challenge was being passed on to the internal audit function.

THE TURNBULL COMMITTEE, 1999

The Turnbull Committee was set up by the Institute of Chartered Accountants in England and Wales (ICAEW) in 1999 to provide guidance to assist companies in implementing the requirements of the Combined Code relating to internal control.

The committee

  • provided guidance to assist companies in implementing the requirements of the Combined Code relating to internal control;
  • recommended that where companies do not have an internal audit function, the board should consider the need for carrying out an internal audit annually; and
  • recommended that the boards of directors confirm the existence of procedures for evaluating and managing key risks.

Corporate governance is constantly evolving to reflect the current corporate, economic and legal environment. To be effective, corporate governance practices need to be tailored to the particular needs, objectives and risk management structure of an organization. Corporate governance is not a static concept, in fact it is dynamic, and thus needs to be altered with the changes that occur in the business environment.

WORLD BANK ON CORPORATE GOvERNANCE

The World Bank, both as an international development bank and as an institution, interested and involved in equitable and sustainable economic development worldwide, was one of the earliest international organizations to study the issue of corporate governance and suggest certain guidelines.

The World Bank Report on corporate governance recognizes the complexity of the very concept of corporate governance and focusses on the principles on which it is based. These principles such as transparency, accountability, fairness and responsibility are universal in their applications. The way they are put into practice has to be determined by those with the responsibility for implementing them. What is needed is a combination of statutory and self-regulation; the mix will vary around the world, but nowhere can statutory regulation alone promote effective governance. The stronger the partnership between the public and private sectors, the more soundly based will be their governance structures. Equally, as the report emphasizes, governance initiatives win most support when driven from the bottom up rather than from the top down.

It could be argued that international investors and capital markets are bringing about a degree of convergence over governance practices worldwide. But the standards that they are setting apply primarily to those corporations in which they invest or to which they lend. These standards set the target but it is one which, at present, is out of reach for the majority of enterprises across the world. In the past, these standards might have become diffused by a gradual process of economic osmosis. However, the pace of change today is such that to leave the raising of governance standards to natural forces might put parts of the world, where funds could be put to best use, at a competitive disadvantage in attracting them. Adoption of the report’s proposals offers enterprises everywhere the chance to gain their share of the potentially available funds for investment.

Corporate governance is concerned with holding the balance between economic and social goals and between individual and communal goals. The governance framework is there to encourage the efficient use of resources and equally to require accountability for the stewardship of those resources. The aim is to align as nearly as possible the interests of individuals, corporations and society. The incentive to corporations and to those who own and manage them to adopt internationally accepted governance standards is that they will help them to achieve their corporate aims and to attract investment. The incentive for their adoption by states is that they will strengthen their economies and discourage fraud and mismanagement. The foundation of any structure of corporate governance is disclosure. Openness is the basis of public confidence in the corporate system and funds will flow to those centres of economic activity, which inspire trust. This report points the way to the establishment of trust and the encouragement of enterprise. It marks an important milestone in the development of corporate governance.

OECD PRINCIPLES

The Organisation for Economic Co-operation and Development (OECD) was one of the earliest non-governmental organizations to work on and spell out principles and practices that should govern corporates in their goal to attain long-term shareholder value.5 The OECD Principles were oft-quoted and have won universal acclaim, especially of the authorities on the subject of corporate governance. Because of the ubiquitous approval, the OECD Principles are as much trend-setters as the Codes of Best Practices associated to the Cadbury Report. A useful first step in creating or reforming the corporate governance system is to look at the principles laid out by the OECD and adopted by its member governments. In summary, they include the following elements:

  1. The rights of shareholders: The rights of shareholders include a set of rights to secure ownership of their shares, the right to full disclosure of information, voting rights, participation in decisions on sale or modification of corporate assets, mergers and new share issues. The guidelines go on to specify a host of other issues connected to the basic concern of protecting the value of the corporation.
  2. Equitable treatment of shareholders: The OECD is concerned with protecting minority shareholders’ rights by setting up systems that keep insiders, including managers and directors, from taking advantage of their roles. Insider trading, for example, is explicitly prohibited and directors should disclose any material interest regarding transactions.
  3. The role of stakeholders in corporate governance: The OECD recognizes that there are other stakeholders in companies in addition to shareholders. Banks, bondholders and workers, for example, are important stakeholders in the way in which companies perform and make decisions. The OECD guidelines lay out several general provisions for protecting stakeholder’s interests.
  4. Disclosure and transparency: The OECD lays down a number of provisions for the disclosure and communication of key facts about the company ranging from financial details to governance structures including the board of directors and their remuneration. The guidelines also specify that independent auditors in accordance with high quality standards should perform annual audits.
  5. The responsibilities of the board: The OECD guidelines provide a great deal of details about the functions of the board in protecting the company and its shareholders. These include concerns about corporate strategy, risk management, executive compensation and performance as well as accounting and reporting systems.

The OECD guidelines are somewhat general and both the Anglo—American system and the Continental European (or German) system would be quite consistent with them. However, there is a growing pressure to put more enforcement mechanisms into those guidelines. The challenge will be to do this in a way consistent with market-oriented systems by creating self-enforcing procedures that do not impose large new costs on firms. The following are some ways to introduce more explicit standards:

  • Countries should be required to establish independent share registries. All too often, newly privatized or partially privatized firms dilute stock or simply fail to register shares purchased through foreign direct investment.
  • Standards for transparency and reporting of the sales of underlying assets need to be spelled out along with enforcement mechanisms and procedures by which investors can seek to recover damages.
  • The discussion of stakeholder participation in the OECD guidelines needs to be balanced by discussion of conflict of interest and insider trading issues. Standards or guidelines are needed in both areas.
  • Property rights and their protection.
  • Internationally accepted accounting standards should be explicitly required and national standards should be brought into alignment with international standards.
  • Internal company audit functions and the inclusion of outside directors on audit committees need to be made explicit. The best practice would be to require that only outside, independent directors be allowed to serve on audit committees.

These standards seem to be too heavily influenced by the Anglo—American tradition and may really be necessary in most countries. A study by the Center for European Policy Studies noted that the wider the distribution of shareholding the greater is the role of the market in the exercise of corporate control. Hence there is a greater need for corporate governance procedures in this type of economy than in one where shareholding is relatively concentrated. The report went on to note, however, that financial market liberalization increased privatization and the growing use of funded system to support pension rules driving European countries toward more explicit and more comprehensive rules on corporate governance. In short, globalization is forcing convergence of different systems into an open and internationally accepted set of standards.

The reason why it is important to take note of the trends toward convergence is that many people have cited the European experience as proof that corporate governance issues only apply to countries that follow an Anglo-American tradition, such as India, for instance. Recent history would seem to show that without sound corporate governance procedures, including the larger institutional features mentioned earlier, economic crises in developing countries are likely to become more frequent. Many developing countries face rather stark choices: either create the type of governance procedures needed to participate in and take advantage of globalization, run risk of severe (and frequent) economic crises or seek to build defensive walls around the economy. It should be noted that the last option usually entails the risk of keeping out investors and new technologies, and lower growth rates dramatically.

Another consideration in the debate over corporate governance system is the risk that individual firms face. Unless a company is able to build the kind of governance mechanisms that attract capital and technology, they run the risk of simply becoming suppliers and vendors to the multinationals.

McKINSEY SURVEY ON CORPORATE GOVERNANCE

There has been a continuing debate among those who hold divergent positions on corporate governance practices whether there is any quantifiable connection between good corporate governance and the market valuation of the company. In this regard, McKinsey, the international management consultant organization conducted a survey with a sample size of 188 companies from 6 emerging markets (India, Malaysia, Mexico, South Korea, Taiwan and Turkey), to determine the correlation between good corporate governance and the market valuation of the company. The results of the survey pointed out to a positive correlation between the two. In short, good corporate governance increases market valuation in the following ways:

  • Increasing financial performance.
  • Transparency of dealing, thereby reducing the risk that boards will serve their own self-interest.
  • Increasing investor confidence.

McKinsey rated the performance on corporate governance of each company based on the following parameters:

  • Accountability: transparent ownership, board size, board accountability, ownership neutrality.
  • Disclosure and transparency of the board: timely and accurate disclosure, independent directors.
  • Shareholder equality: one share-one vote.

Through the survey, McKinsey found that companies with good corporate governance practices have high price-to-book values indicating that investors are willing to pay a premium for the shares of a well-managed and governed company. Additionally, the survey revealed that investors are willing to pay a premium of as much as 28 per cent for shares of such a corporate governance based company.

Companies in emerging markets often claim that Western corporate governance standards do not apply to them. However, the survey revealed that studies of the six emerging markets show that investors the world over look for high standards of good governance. Additionally, they are willing to pay a high premium for shares in companies that meet their requirements of good corporate governance.

SARBANES—OXLEY ACT, 2002

‘Corporate America has been blotted with many scandals in the recent times. Despite the fact that there have been differences between the recent scandals and the earlier ones, there is a common thread running in between them. The common thread is that governance matters, that is, good governance promotes good corporate decision-making. The recent Sarbanes—Oxley Act is a step in this direction, which codifies certain standards of good governance as specific requirements. The Act calls for protection to those who have the courage to bring frauds to the attention of those who have to handle frauds. But it ensures that such things are not left to the individuals who may or may not choose to reveal them, it is better for the corporations to appoint an officer with the responsibility to oversee compliance and ethical issues. Unless corporate governance is integrated with strategic planning and shareholders are really willing to bear the additional expenses that may be required, effective corporate governance cannot be achieved.’

The Sarbanes—Oxley Act (SOX Act), 2002 is a sincere attempt to address all the issues associated with corporate failures to achieve quality governance and to restore investor’s confidence. The Act was formulated to protect investors by improving the accuracy and reliability of corporate disclosures, made precious to the securities laws and for other purposes. The Act contains a number of provisions that dramatically change the reporting and corporate director’s governance obligations of public companies, the directors and officers.

Important provisions contained in SOX Act are briefly given below:

  • Establishment of Public Company Accounting Oversight Board (PCAOB): The SOX Act creates a new board consisting of five members of whom two will be certified public accountants. All accounting firms will have to register themselves with this Board and submit among other details, particulars of fees received from public company clients for audit and non-audit services, financial information about the firm, list of firms’ staff who participate in audits, quality control policies, information on civil, criminal and disciplinary proceedings against the firm or any of the staff. The Board will conduct annual inspections of firms, which audit more than 100 public companies, and once in three years in other cases. The board will establish rules governing audit quality control, ethics, independence and other standards. It can conduct investigations and disciplinary proceedings and can impose sanctions on auditors.

    The Board reports to the SEC. The Board is required to send its report to the SEC annually, which will then be forwarded by the SEC to the Congress. The new board replaces the old one, which was funded by fees collected from public companies based on their market capitalization.

  • Audit committee: The SOX Act provides for a ‘new improved’ audit committee. The members of the committee are drawn from among the directors of the board of the company but all are independent directors as defined in the Act.

    The audit committee is responsible for appointment, fixing fees and oversight of the work of independent auditors. The committee is also responsible for establishing and reviewing the procedures for the receipt, treatment of accounts, internal control and audit complaints received by the company from the interested or affected parties.

    The SOX Act requires that registered public accounting firms should report directly to the audit committee on all critical accounting policies and practices and other related matters.

  • Conflict of interest: Public accounting firms should not perform any audit service for a publicly traded company if the CEO, CFO, CAO, controller, or any person serving in an equivalent position was employed by such firm and participated in any capacity in the audit of that company during the one year period preceding the date of initiation of the audit.
  • Audit partner rotation: The SOX Act provides for mandatory rotation of the lead auditor, co-ordinating partner and the partner reviewing audit once every five years.
  • Improper influence on conduct of audits: It will be unlawful for any executive or director of the firm to take any action to fraudulently influence, coerce, manipulate or mislead any auditor engaged in the performance of an audit with the view to rendering the financial statements materially misleading.
  • Prohibition of non-audit services: Under the SOX Act, auditors are prohibited from providing non-audit services concurrently with audit financial review services. Non-audit services include: (i) bookkeeping or other services related to the accounting records or financial statements of the client; (ii) financial information system, design and implementation; (iii) appraisal or valuation services, fair opinions; (iv) acturial services; (v) internal audit outsourcing services; (vi) management functions or human resources; (vii) broker or dealer, investment adviser or investment banking services; (viii) legal services or expert services unrelated to the audit; and (ix) any other service that the board determines, by regulation, is impermissible. However, the board has the power to grant exemptions. The Act also allows an accounting firm to ‘engage in any non-audit service including tax services’, if it has been pre-approved by the audit committee of the firm concerned.
  • CEOs and CFOs required to affirm financials: Chief executive officers and chief finance officers are required to certify the reports filed with the Securities and Exchange Commission. If the financials are required to be restated due to material non-compliance ‘as a result of misconduct’ of the CEO or CFO, then such CEO or CFO will have to return bonus and any other incentives received by him back to the company. This applies to equity-based compensation received during the first 12 months after initial public offering. False and/or improper certification can attract fine ranging from $1 million to $5 million or imprisonment upto 10 years or both.
  • Loans to directors: The SOX Act prohibits US and foreign companies with securities traded within the US from making or arranging from third parties any type of personal loan to directors. It appears that the existing loans are not affected but material modifications or renewal of loans and arrangements of existing loans are banned.
  • Attorneys: The attorneys dealing with the publicly traded companies are required to report evidence of material violation of securities law or breach of fiduciary duty or similar violations by the company or any agent of the company to the Chief Counsel or CEO and if the Counsel or CEO does not appropriately respond to the evidence, the attorney must report the evidence to the audit committee or the Board of Directors.
  • Securities analysts: The SOX Act has a provision under which brokers and dealers of securities should not retaliate or threaten to retaliate an analyst employed by the broker or dealer for any adverse, negative or unfavourable research report on a public company. The Act further provides for disclosure of conflict of interest by the securities analysts and brokers or dealers whether
    1. the analyst has investments or debt in the company he is reporting on;
    2. any compensation received by the broker dealer or analyst is ‘appropriate in the public interest and consistent with the protection of investors’;
    3. the company (issuer) has been a client of the broker or dealer; and
    4. the analyst received compensation with respect to a research report based on investment banking revenues.
  • Penalties: The penalties prescribed under SOX Act for any wrongdoing are very stiff. Penalties for wilful violations are even stiffer. Any CEO or CFO providing a certificate knowing that it does not meet with the criteria stated may be fined upto $ 1 million and/or imprisonment upto 10 years. However, those who ‘wilfully’ provide certification knowing that it does not meet the required criteria can be punished with a fine of $5 million and/or with prison term upto 20 years. These heavy penalties are bound to be a deterrent for wrongdoers.

    Very importantly, the SOX Act provides for studies to be conducted by the Securities and Exchange Commission or the Government Accounting Office in the following areas:

    1. Auditor’s rotation.
    2. Off-balance sheet transactions.
    3. Consolidation of accounting firms and its impact on the accounting industry.
    4. Role of Credit Rating Agencies.
    5. Study of violators and violations during the years 1998–2001.
    6. SEC enforcement actions over the past 5 years.
    7. Role of investment banks and financial advisers.
    8. ‘Principle-based’ accounting.

The SOX Act would certainly enhance accountability levels for directors, officers, auditors, security analysts and legal counsel involved in the financial markets. It would have far reaching implications worldwide particularly in areas of audit. The Act targets specifically publicly traded companies and does not distinguish between the US and non-US companies. It applies to all companies with a listing in the US

But the most important aspect of the SOX Act is that it makes it clear that a company’s senior officers are responsible for the corporate culture they create, and must be faithful to the same rules they set out for other employees. The CEO, for example, must be ultimately responsible for the company’s disclosure, controls and financial reporting.

INDIAN COMMITTEES AND GUIDELINES

The corporate world in India could not remain indifferent to the developments that were taking place in the UK. In fact, the developments in the UK had tremendous influence in India too. They triggered the thinking process in the country, which finally led to the government and regulators laying down the ground rules on corporate governance. As a result of the interest generated in the corporate sector by the Cadbury Committee’s report, the issue of corporate governance was studied in depth and dealt with by the Confederation of Indian Industry (CII), the Associated Chambers of Commerce and the Securities and Exchange Board of India (SEBI). Though some of the studies did touch upon shareholders’ right to ‘vote by ballot’ and a few other issues of general nature, none can claim to be wider than the Cadbury report.

Working Group on the Companies Act, 1996

Over the years, it has been felt necessary to re-write completely the Companies Act in the light of the modern-day requirements of the corporate sector, the aspirations of investors, globalization of the economy, liberalization etc. The government accordingly set up a Working Group in August 1996 for this purpose.

The Working Group on the Companies Act has recommended a number of changes and also prepared a working draft of the Companies Bill 1997. The Bill was introduced in the Rajya Sabha on 14 August 1997, containing the following recommendations:

Financial disclosures recommended by the Working Group on the Companies Act were as follows:

  • A tabular form containing details of each director’s remuneration and commission should form a part of the directors’ report in addition to the usual practice of having it as a note to the profit and loss account.
  • Costs incurred in using the services of a group resource company must be clearly and separately disclosed in the financial statement of the user company.
  • A listed company must give certain key information on its divisions or business segments as a part of the directors’ report in the annual report. This should comprise: (i) the share in total turnover, (ii) a review of operations during the year in question, (iii) market conditions and (iv) future prospects. For the present, the cut-off may be 10 per cent of the total turnover.
  • Where a company has raised funds from the public by issuing shares, debentures or other securities, it would have to give a separate statement showing the end-use of such funds, namely: how it was utilized in the project up to the end of the financial year; and where are the residual funds, if any, invested and in what form. This disclosure would be in the balance sheet of the company as a separate note forming a part of accounts.
  • The disclosure on debt exposure of the company should be strengthened.
  • In addition to the existing level of disclosure on foreign exchange earning and outflow, there should also be a note containing separate data on foreign currency transactions that are germane in the present context: (i) foreign holding in the share capital of the company and (ii) loans, debentures or other securities raised by the company in foreign exchange.
  • The difference between financial statements pertaining to fixed assets and long term liabilities (including share capital and liabilities which are not to be liquidated within a year) as at the end of the financial year and the date on which the board approves the balance sheet and profit and loss account should be disclosed.
  • If any fixed asset acquired through or given out on lease is not reported under appropriate subheads, then full disclosure would need to be made as a note to the balance sheet. This should give details of the type of asset, its total value and the future obligations of the company under the lease agreement.
  • Any inappropriate treatment of an item in the balance sheet or profit and loss account should not be allowed to be explained away either through disclosure of accounting policies or through notes forming a part of accounts but should be dealt with in the directors’ report.

All other things being equal, greater the quality of disclosure, the more loyal are a company’s shareholders. Non-financial disclosures recommended by the Working Group on Companies Act were the following:

  • A comprehensive report on the relatives of directors—either as employees or board members—to be an integral part of the directors’ report of all listed companies.
  • Companies have to maintain a register, which discloses interests of directors in any contract or arrangement of the company. The existence of such a register and the fact that it is open for inspection by any shareholder of the company should be explicitly stated in the notice of the AGM of all listed companies.
  • Likewise, the existence of the directors’ shareholding register and the fact that members in any AGM can inspect it should be explicitly stated in the notice of the AGM of all listed companies.
  • Details of loans to directors should be disclosed as an annex to the directors’ report in addition to being a part of schedules of the financial statements. Such loans should be limited to only three categories— housing, medical assistance and education for family members—and be available only to full-time directors. The detailed terms of loan would need shareholders’ approval in a general meeting.
  • Appointment of sole selling agents for India will require prior approval of a special resolution in a general meeting of shareholders. The board may approve the appointment of sole selling agents in foreign markets, but the information must be divulged to shareholders as a part of the directors’ report accompanying the annual audited accounts. In either case, if the sole selling agent is related to any director or director having interest, this fact has not only to be stated in the special resolution but also divulged as a separate item in the directors’ report.
  • Subject to certain exceptions there should be a Secretarial Compliance Certificate forming a part of the annual returns that is filed with the Registrar of Companies.
  • The Compliance Certificate should certify in prescribed format that the secretarial requirements under the Companies Act have all been adhered to.

Deficiencies of the Companies’ 1956 Act

The Companies Act, 1956 was rooted in an environment of License and Permit Raj. Though the Act has been amended on more than two dozen times to take cognizance of the changing and liberalized environment, it has been felt by many authorities on the subject that the Act has long outlived its usefulness. The relevance of a large number of provisions to private companies, which are often not more than mere family enterprises has been justifiably questioned. Though the Indian Companies Act 1956 provides the formal structure of corporate governance, it does not address adequately the governance problems. Some of the main deficiencies found in the provisions of the Act with regard to the basic issues of corporate governance are given below:

  • Though non-executive directors can play a significant role in providing independent and objective opinion in discussions on many strategic areas in board deliberations, the Act does not assign them any formal role between executive and non-executive directors, so far as their roles and responsibilities are concerned, the effective control in practice is in the hands of executive, whole time and managing directors.
  • In actual practice, non-executive directors have only ornamental value. They also lack a sense of commitment as the Act allows them to be on the boards of as many as 20 companies.
  • With regard to financial reporting, the provisions of the Act make it more rule-based and ritualistic, rather than being transparent.
  • The Act does not prescribe any formal qualification for a director of a company, with the result even an incompetent and mediocre person can become a member of the board.
  • Though the Act formally provide for the appointment of auditors by shareholders, in practice they work more closely with the company management. Shareholders hardly have a chance to interact with the auditors. Corporate malpractices are often the result of the collusion between management and auditors.
  • A large number of companies hardly provide any service to investors, particularly with regard to redres-sal of grievances, delay in share transfers, dispatch of dividend warrants and share certificates.
THE CONFEDERATION OF INDIAN INDUSTRY’s INITIATIVE

In 1996, the Confederation of Indian Industry (CII) took a special initiative on corporate governance, the first ever institutional initiative in Indian industry. This initiative by the CII flowed from public concerns regarding the protection of investors’ interest, especially of the small investor; the promotion of transparency within business and industry; the need to move towards international standards in terms of disclosure of information by the corporate sector and, through all of this, to develop a high level of public confidence in business and industry. The objective of the effort was to develop and promote a code of corporate governance to be adopted and followed by Indian companies, be they in the private sector or in the public sector, banks or financial institutions, all of which are mostly corporate entities.

A National Task Force that was set up with Rahul Bajaj (past President of the CII) as the chairman, and had members drawn from industry, the legal profession, media and academia, presented the draft guidelines and the Code of Corporate Governance in April 1997 at the National Conference and Annual Session of CII. This draft was then publicly debated in workshops and seminars and a number of suggestions were received for the consideration of the Task Force. The Task Force finalized the Code for Desirable Corporate Governance, subsequently.7

The Task Force opined that although the concept of corporate governance still remained an ambiguous and misunderstood phrase, two aspects were becoming evident:

  1. As India gets integrated in the world market, Indian as well as international investors will demand greater disclosure, more transparent explanation for major decisions and better shareholder value. Indian companies, banks and financial institutions (FIs) can no longer afford to ignore better corporate practices.
  2. The governance features such as quantity, quality and frequency of financial and managerial disclosure, the extent to which the board of directors exercise their fiduciary responsibilities towards shareholders, the quality of information that managements share with their boards and the commitment to run transparent companies that maximize long term shareholder value, cannot be legislated at any level of detail.

To survive international competition, Indian companies have to attract low cost capital from across the globe. For this, Indian companies have to gear themselves to meet the increasingly demanding standards of international disclosures and corporate governance.

The CII has pioneered the concept of corporate governance in India and has been internationally recognized as one of the best in the world. Corporate India has started recognizing the pivotal role that disclosures play in creating corporate value in the increasingly market oriented environment.

When the CII adopted the Code of Corporate Governance from the recommendations of the Task Force, there was very little difference between the recommendations of the Task Force and the final outcome. These are as follows.

Recommendations of the CII’S Code of Corporate Governance

  1. A single board, if it performs well, can maximize long-term shareholder value. The board should meet at least six times a year, preferably at intervals of 2 months.
  2. A listed company with a turnover of INR100 crores and above should have professionally competent and recognized independent non-executive directors who should constitute
    • at least 30 per cent of the board, if the chairman of the company is a non-executive director; and
    • at least 50 per cent of the board, if the chairman and managing director is the same person.
  3. A person should not hold directorships in more than 10 listed companies.
  4. For non-executive directors to play a significant role in corporate decision making and maximizing long term shareholder value, they need to
    • become active participants in boards and not just passive advisors;
    • have clearly defined responsibilities within the board such as the audit committee; and
    • know how to read a balance sheet, profit and loss account, cash flow statements and financial ratios and have some knowledge of various company laws. This, of course, excludes those who are invited to join boards as experts in other fields such as science and technology.
  5. To secure better effort from non-executive directors, companies should
    • pay a commission over and above the sitting fees for the use of the professional inputs.

      Commissions are rewards on current profits; and

    • consider offering stock options, so as to relate rewards to performance. Stock options are rewards contingent upon future appreciation of corporate value.
  6. While re-appointing members of the board, companies should give the attendance record of the concerned directors. If a director has not been present (absent with or without leave) for 50 per cent or more meetings, then this should be explicitly stated in the resolution that is put to vote. One should not re-appoint any director who has not had the time to attend even 50 per cent of the meetings.
  7. Key information that must be reported to, and placed before the board, must contain the following:
    • Annual operating plans and budgets, together with up-dated long term plans.
    • Capital budgets, manpower and overhead budgets.
    • Internal audit reports including cases of theft and dishonesty of a material nature.
    • Fatal or serious accidents, dangerous occurrence, and any effluent or pollution problems.
    • Default in payment of interest or non-payment of the principal on any public deposit and/or to any secured creditor or financial institution.
    • Defaults such as non-payments of the principal on any company or materially substantial non-pay ments for goods sold by the company.
    • Details of any joint venture or collaboration agreement.
    • Transactions that involve substantial payment towards goodwill, brand equity or intellectual property.
    • Recruitment and remuneration of senior officers just below the board level, including appointment or removal of the chief financial officer and the company secretary.
    • Labour problems and their proposed solutions.
    • Quarterly details of foreign exchange exposure and the steps taken by management to limit the risks of adverse exchange rate movement.
  8. For all companies with paid-up capital of INR 20 crores or more, the quality and quantity of disclosure that accompanies a GDR issue should be the norm for any domestic issue.
  9. Under ‘Additional Shareholder’s Information’, listed companies should give data on the following:
    • High and low monthly averages of share prices in a major stock exchange where the company is listed for the reporting year.
    • Greater detail on business segments up to 10 per cent of turnover, giving share in sales revenue, review of operations, analysis of markets and future prospects.
  10. Companies that default on fixed deposits should not be permitted to accept further deposits and make inter-corporate loans or investments or declare dividends until the default is made good.
  11. Major Indian stock exchanges should insist upon a compliance certificate, signed by the CEO and the CFO which should clearly state the following:
    • The company will continue in business in the course of the following year.
    • The accounting policies and principles conform to the standard practice.
    • The management is responsible for the preparation, integrity and fair presentation of financial state ments and other information contained in the annual report.
    • The board has overseen the company’s system of internal accounting and administrative controls either directly or through its audit committee.
SEBI’S INITIATIVES

The Securities and Exchange Board of India appointed a committee on corporate governance on 7 May 1999, with 18 members under the chairmanship of Kumar Mangalam Birla with a view to promoting and raising the standards of corporate governance. The committee’s terms of reference were: (i) to suggest suitable amendments to the listing agreement (LA) executed by the stock exchanges with the companies and any other measures to improve the standards of corporate governance in the listed companies in areas such as continuous disclosure of material information, both financial and non-financial, manner and frequency of such disclosures, responsibilities of independent and outside directors; (ii) to draft a code of corporate best practices; and (iii) to suggest safeguards to be instituted within the companies to deal with insider information and insider trading.

The committee submitted its famous and oft-quoted report to SEBI in March 2000 after several sittings of debates and deliberations.8 The Kumar Mangalam Birla Committee’s Report is indeed a veritable landmark in the evolution of corporate governance in India.

KUMAR MANGALAM BIRLA COMMITTEE, 1999

The Birla Committee’s recommendations consist of both mandatory recommendations and non-mandatory recommendations.

Mandatory Recommendations

  1. Applicability: These are applicable to all listed companies with paid-up share capital of INR 3 crore and above.
  2. Board of directors: The board of directors of a company must have an optimum combination of executive and non-eutive directors. The number of independent directors should be at least one-third in case the company has a non-executive chairman and at least half of the board in case the company has an executive chairman.

    Kumar Mangalam Birla Committee defines independent directors as directors who apart from receiving directors’ remuneration do not have any material pecuniary relationship or transactions with the company, its promoters, its management or its subsidiaries, which in the judgment of the board, may affect independent judgment of the directors.

  3. Audit committee: A qualified and independent audit committee should be set up to enhance the credibility of the financial disclosures and to promote transparency.

    The audit committee should have a minimum of three members, all being non-executive directors with a majority being independent and at least one director having financial and accounting knowledge. In addition to this, the following stipulations will have to be met:

    • The company will continue business in the course of the following year.
    • The accounting policies and principles conform to standard practice.
    • The management is responsible for the preparation, integrity and fair presentation of financial statements and other information contained in the annual report. Besides, the chairman should be an independent director and must be present at the annual general meeting to answer shareholders’ queries.

    The audit committee should invite such executives as it considers appropriate (and particularly the head of the finance function) in addition to the head of internal audit when required and a representative of the external auditor should be present as an invitee for the meetings of the committee.

    The audit committee should meet at least thrice a year with a gap of not more than six months with one meeting necessarily before the finalization of annual accounts. The quorum should be either two members or one-third whichever is higher with a minimum of two independent directors.

    The audit committee specifically should function as the bridge between the board, the statutory auditors and internal auditors.

  4. Remuneration committee of the board: The board of directors should decide the remuneration of nonexecutive directors.

    Full disclosure of the remuneration package of all the directors covering salary benefits, bonuses, stock options, pension-fixed component, performance-linked incentives along with the performance criteria, service contracts, notice period, severance fees etc., is to be made in the section on corporate governance of the annual report.

  5. Board procedures: The board meeting should be held at least four times a year with a maximum time gap of four months between any two meetings. Minimum information on annual operating plans and capital budgets, quarterly results, minutes of meetings of audit committee and other committees, information on recruitment and remuneration of senior officers, significant labour problems, material default in financial obligations, statutory compliance etc. should be placed before the board.

    In order to ensure total commitment to the board meetings, a director should not be a member in more than 10 committees and act as chairman of more than five committees across all companies in which he is a director.

  6. Management: Management discussions and analysts’ report covering industry structure, opportunities and threats, segment-wise or product-wise performance outlook, risks, internal control systems etc. are to form a part of directors’ report or as an addition thereto.

    Besides, the management must make disclosure to the board relating to all material, financial and commercial transactions where they have personal interest that may have a potential conflict with the interest of the company.

  7. Shareholders: In case of appointment of a new director or re-appointment of existing director, information containing a brief resume, nature of expertise in specific functional areas and companies in which the person holds directorship and committee membership, must be provided to the benefit of the shareholders.

    There is also a specific recommendation of sharing information of quarterly results presentation made by the company to analysts, through company’s website.

    In addition, a board committee under the chairmanship of a non-executive director is to be formed to specifically look into the redressing of shareholder complaints of declared dividends etc. In order to expedite the process of share transfers, the board should delegate the power of share transfer to an officer or a committee or to the registrar and share transfer agents with a direction to the delegated authority to attend to share transfer formalities at least once in a fortnight.

  8. Manner of implementations: A separate section on corporate governance in the annual reports is to be introduced covering a brief statement on company’s philosophy on code of governance, board of directors, audit committee, remuneration committee, shareholders’ committee, general body meeting, disclosures etc. Non-compliance of any of the mandatory recommendations with reasons thereof and the extent of adoption of non-mandatory recommendations should be highlighted to enable the shareholders and securities market to assess for themselves the standards of corporate governance followed by the company.
NON-MANDATORY RECOMMENDATIONs
  1. Chairman of the board: The chairman’s role should in principle be different from that of the chief executive, though the same executive can perform both the roles.

    In view of the importance of the chairman’s role, the committee recommended that a non-executive chairman should be entitled to maintain a chairman’s office at the company’s expense and also allowed reimbursement of expenses incurred in the performance of his duties, to enable him to discharge his responsibilities effectively.

  2. Remuneration committee: A company must have a credible and transparent policy in determining and accounting for the remuneration of the directors. The remuneration package should be good enough to attract, retain and motivate the executive directors of the quality required.

    The board of directors should set up a remuneration committee to determine on their behalf and on behalf of the shareholders with agreed terms of reference, the company’s policy on specific remuneration packages for executive directors including pension rights and any other compensation payment. The committee should comprise at least three directors all of whom should be non-executive directors, the chairman being an independent director. All the members must be present at the meeting for the purpose of quorum as it is not necessary for the meeting to be held very often. The chairman should be present at the annual general meeting to answer the shareholders’ queries.

  3. Shareholders’ rights: Half-yearly declaration of financial performance including summary of the significant events in six months should be sent to each of the shareholders.
  4. Postal ballot: Although the formality of holding the general meeting is gone through in actual practice, only a small fraction of the shareholders of a company do or can really participate therein. This virtually makes the concept of corporate democracy illusory. It is imperative that this situation, which has lasted too long, needs an early correction. In this context, for shareholders who are unable to attend the meeting, there should be a requirement, which will enable them to vote by postal ballot on key issues. Some of the critical matters, which should be decided by postal ballot, are the following:
    • Matters relating to alteration in the Memorandum of Association of the company such as changes in name, objects, address of registered office, etc.
    • Sale of whole or substantially the whole of the undertaking.
    • Sale of investments in the companies, where the shareholding or the voting rights of the company exceeds 25 per cent.
    • Making a further issue of shares through preferential allotment or private placement basis.
    • Corporate restructuring.
    • Entering a new business area not germane to the existing business of the company.
    • Variation in rights attached to class of securities.
    • Matters relating to change in management.

There are many corporate governance structures available in the developed world, but all of them have their merits as well as demerits. There is no ‘One Size Fits All’ structure for corporate governance. The committee’s recommendations, therefore, are not based on any one model, but are designed for the Indian environment. The Birla Committee believed that its recommendations would go a long way in raising the standards of corporate governance in Indian firms and make them attractive destinations for local and global investments. These recommendations could also form the base for further evolution of the structure of corporate governance in consonance with the rapidly changing economic and industrial environment of the country.

SEBI’S RESPONSE

SEBI considered and adopted in its meeting held on 25 January 2000, the recommendations of the committee on corporate governance appointed by it under the chairmanship of Kumar Mangalam Birla.

In accordance with the guidelines provided by the SEBI, the stock exchanges in India have modified the listing requirements by incorporating in them a new clause (Clause 49), so that proper disclosure for ensuring corporate governance is made by the companies in the following areas:

  • Board of directors
  • Audit committee
  • Remuneration of directors
  • Board procedure
  • Management
  • Shareholders
  • Report on corporate governance
  • Compliance certificate from auditors.

The above amendments to the listing agreement were to be implemented in a time-bound manner and to be completed by all entities seeking listing for the first time at the time of listing.

SEBI’s Code of Corporate Governance requires that the following information be placed by a company before the board of directors periodically:

  • Annual operating plans and budgets and any updates thereon.
  • Capital budgets and any updates thereon.
  • Quarterly results for the company and its operating divisions or business segments.
  • Minutes of audit committee meetings.
  • Information on recruitment and remuneration of senior officers just below the board level.
  • Material communications from government bodies.
  • Fatal or serious accidents, dangerous occurrences, or any material effluent pollution problems.
  • Details of any joint venture or collaboration agreement.
  • Labour relations.
  • Material transactions which are not in the ordinary course of business.
  • Disclosures by the management on material transactions, if any, with potential for conflict of interest.
  • Quarterly details of foreign exchange exposures and risk management strategies.
  • Compliance with all regulatory and statutory requirements.

A separate section on corporate governance in the annual reports should be introduced covering a brief statement on company philosophy on code of governance, board of directors, audit committee, remuneration committee, shareholders’ committee, general body meeting, disclosures, means of communication and general shareholders information. In addition, companies have been asked to adopt non-mandatory requirements relating to the chairman of the board, remuneration committee, shareholders’ rights and postal ballot.

Non-compliance of any of the mandatory recommendations, which is part of the listing agreement with reasons thereof, and the extent to which the non-mandatory requirements have been adopted, are to be specifically highlighted.

NAREsH CHANDRA COMMITTEE REPORT, 2002

While SEBI was making efforts to introduce corporate governance standards among Indian corporates, the Department of Company Affairs took another initiative in this direction.

The Naresh Chandra Committee was appointed as a high level committee to examine various corporate governance issues by the Department of Company Affairs on 21 August, 2002. The committee’s recommendations mainly concerned issues such as these: (i) the auditor-company relationship; (ii) disqualifications for audit assignments; (iii) list of prohibited non-audit services; (iv) independence standards for consulting; (v) compulsory audit partner rotation; (vi) auditor’s disclosure of contingent liabilities; (vii) auditor’s disclosure of qualifications and consequent action; (viii) managements’ certification in the event of auditor’s replacement; (ix) auditor’s annual certification of independence; (x) appointment of auditors; (xi) certification of annual audited accounts by CEO and CFO; (xii) auditing the auditors; (xiii) setting up of the independent quality review board; (xiv) proposed disciplinary mechanism for auditors; (xv) independent directors; (xvi) audit committee charter; (xvii) exempting non-executive directors from certain liabilities; (xvii) training of independent directors; (xix) establishment of corporate serious fraud office; and (xx) SEBI and subordinate legislation. Naresh Chandra Committee report on ‘Corporate Audit & Governance’ has taken forward the recommendations of the Kumar Mangalam Birla Committee on corporate governance which was set up by the Securities and Exchange Board of India (SEBI) on the following two counts:

  • Representation of independent directors on a company’s board.
  • The composition of the audit committee.

The Naresh Chandra Committee has made no distinction between a board with an executive chairman and that with a non-executive chairman. It has recommended that all boards need to have at least half of its members as independent directors. As regards the audit committee, the Kumar Mangalam Birla Committee had said that it should have non-executive directors as its members with at least two independent directors, but the Naresh Chandra Committee has recommended that all audit committee members should be independent directors.

The Naresh Chandra Committee has laid down stringent guidelines defining the relationship between auditors and their clients. In a move that could impact small audit firms, the committee has recommended that along with its subsidiary, associates or affiliated entities, an audit firm should not derive more than 25 per cent of its business from a single corporate client. This committee opined that it would improve the independence of audit firms. While turning down the proposal for a compulsory rotation of audit firms, the committee stressed that the partners and at least 50 per cent of the audit team working on the accounts of a company, need to be rotated by the audit firm once every five years.

While the committee has said that it has no objection to an audit firm having subsidiaries or associate companies engaged in consulting or other specialized businesses, it has drawn up a list of prohibited non-audit services. It has said that nominees of institutions (FIs) cannot be counted as independent directors.

The Committee has further recommended the following:

  1. The auditors should be asked to make an array of disclosures.
  2. Calling upon CEOs and CFOs of all listed companies to certify their companies’ annual accounts, besides suggesting.
  3. Setting up of quality review boards by the Institute of Chartered Accountants of India (ICAI), Institute of Company Secretaries of India and the Institute of Cost and Works Accountants of India, instead of a Public Oversight Board similar to the one in the United States.

At a time when people are shy of accepting the post of an independent director in a company because of the liabilities that might follow, the Naresh Chandra Committee has come up with recommendations that will help remove their fears. To attract quality independent directors on the board of directors of a company, the committee has recommended that these directors should be exempt from criminal and civil liabilities under the Companies Act, the Negotiable Instruments Act, the Provident Fund Act, ESIS Act, the Factories Act, the Industrial Disputes Act and the Electricity Supply Act. However, unlisted public companies that do not have more than 50 shareholders and carry no debt from the public, banks or financial institutions and unlisted subsidiaries of listed companies have been exempted from these recommendations.

SEBI’S FOLLOW-UP ON BIRLA COMMITTEE REPORT

In the wake of SEBI’s instruction to the companies that they should comply with Birla Committee’s recommendations in the manner dictated by the market regulator, compliance reports on corporate governance received in respect of 1,026 and 595 listed companies, for the Mumbai and National Stock Exchanges respectively, showed some progress in that direction. On the basis of the analysis from the data submitted by them, SEBI observed that the compliance with the requirements in Clause 49 of the Listing Agreement is by and large satisfactory. However, an analysis of the financial statements of companies and the reports on corporate governance disclosed that their quality was not uniform. SEBI also observed that there was a considerable variance in the extent and quality of disclosures made by companies in their annual reports.

RATIONALE FOR A REVIEW OF THE BIRLA CODE

In the perception of SEBI, there was a need to appoint a committee as a follow-up of the Birla Committee’s report and the experience gained from the analysis of compliance reports. SEBI then believed that there should be on-going efforts to build up on the corporate governance structure already put in place. This is because governance standards are themselves evolving in keeping with market dynamics. Recent developments worldwide, especially in the US, have renewed the emphasis on corporate governance. These developments have highlighted once again the need for ethical governance and management and for looking beyond mere systems and procedures. Further attempts were called for in the perception of SEBI, to ensure compliance with corporate governance codes both in the letter and spirit. Another loophole in the existing governance standards was the lack of investor’s protection. SEBI wanted to strengthen the means through which the individual investor could be protected.

SEBI, therefore, set out to form another committee with the twin perspectives: to evaluate the adequacy of the existing practices, and to further improve them. This committee on corporate governance was constituted under the chairmanship of N.R. Narayana Murthy, chairman and chief mentor of Infosys Technologies Ltd., and comprised representatives from stock exchanges, chambers of commerce, investors’ associations and professional bodies.

NARAYANA MURTHY COMMITTEE REPORT, 2003

The committee on corporate governance set up by SEBI under the chairmanship of N.R. Narayana Murthy which submitted its report in February 2003 was yet another committee on the subject signifying the regulator’s anxiety to expeditiously promote corporate governance practices in Indian companies.

The committee’s terms of reference were the following:

  • To review the performance of corporate governance.
  • To determine the role of companies in responding to rumour and other price sensitive information circulating in the market in order to enhance the transparency and integrity of the market.

The committee’s report expresses its total concurrence with the recommendations contained in the Naresh Chandra Committee’s report on the following counts:

  1. Disclosure of contingent liabilities
  2. Certification by CEO’s and CFO’s
  3. Definition of independent directors
  4. Independence of audit committees

The committee came out with two sets of recommendations namely, mandatory recommendations and non-mandatory recomendations. The mandatory recommendations focus on strengthening the responsibilities of audit committees, improving the quality of financial disclosures including those pertaining to related party transactions and proceeds from initial public offerings, requiring corporate executive boards to assess and disclose business risks in the annual reports of companies, calling upon the boards to adopt formal codes of conduct; the position of nominee directors and improved disclosures relating to compensation to non-executive directors and shareholders.

MANDATORY RECOMMENDATIONS

Audit Committee

An audit committee is the bedrock of quality governance. An effective audit committee is a pre-requisite for achieving high standard of governance. The committee recommended a bigger role for the audit committee. The committee suggested that the audit committee of publicly listed companies should be required to review the following information mandatorily:

  1. Financial statements and draft audit reports including quarterly and half yearly information.
  2. Management discussion and analysis of financial condition and the results of operations.
  3. Report relating to compliance with laws and risk management.
  4. Management letters of internal control weaknesses issued by statutory internal auditors.
  5. Records of related party transactions.

In the present dispensations, audit committee, set up as per Clause 49 of the Listing Agreement, is empowered to recommend the appointment and removal of statutory auditors, fixation of audit fee and also approval for payment for any other services in addition to the powers of review etc. If the above powers are added as per the committee’s recommendations, the audit committee of the listed companies in India will become one of the most empowered committees in a corporate set up.

The Narayana Murthy committee has not taken a view on rotation of auditors.

Related Party Transactions

A statement of all transactions with related parties including their bases should be placed before the audit committee for formal approval/ratification and that if any transaction is not on an arm’s length basis, management should provide explanation to the audit committee justifying the same.

The existing requirement as per Clause 49 of the Listing Agreement has been reiterated.

Proceeds from Initial Public Offerings

Companies raising money through initial public offering should disclose to the audit committee the uses and application of funds under major heads on a quarterly basis.

Each year, the company shall prepare a statement of funds utilized for purposes other than those stated in offer document/prospectus. This statement shall be certified by the independent auditors of the company. The audit committee should make appropriate recommendations to the board to take steps in the matter.

This suggestion was welcomed by many as it enlarges the existing requirement in this regard and is a response to manipulations perpetrated by some corporates in this area.

Risk Management

The committee has deemed it necessary for the boards of companies to be fully aware of the risks involved in the business and that it is also important for shareholders to know about the process by which companies manage their business risks. The mandatory recommendations in this regard are the following:

Procedures should be in place to inform board members about the risk assessment and minimization procedures. These procedures should be periodically reviewed to ensure that executive management controls risks through means of a properly defined framework.

Management should place a report before the entire board of directors every quarter documenting the business risks faced by the company, measures to address and minimize such risks and any limitation to the risk-taking capacity of the corporations. The board should formally approve this document.

At present, in Clause 49 of the Listing Agreement, there is a stipulation that the management discussion and analysis report forming part of the board’s annual report should include discussion on ‘risks and concerns’. The suggestion contained in the report is more elaborate and this would encourage a meaningful discussion at the board level periodically and the company will have the benefit of advice from board members who are in charge of day to day management.

Code of Conduct

The committee has recommended that it should be obligatory for the board of a company to lay down a code of conduct for all board members and senior management of the company. This code should be posted on the company’s website and all board members and senior management personnel shall affirm compliance with the code on an annual basis. The annual report of the company shall contain a declaration to this effect signed off by the CEO and COO.

This suggestion which is long overdue in the Indian context is in line with the best practices adopted by corporates in developed economies. In fact, such matters are included in the charters of companies, sending a clear message to the company’s personnel, how serious the company is about ensuring that the code is followed both in the letter and spirit. It is found that in most of the cases the misdemeanours reported were caused by breach of the code of conduct.

Nominee Directors

The committee recommended doing away with nominee directors. If a corporation wishes to appoint a director on the board, such appointment should be made by the shareholders. The committee insisted that an institutional director, if appointed, shall have the same responsibilities and shall be subject to the same liabilities as any other director. Nominees of the government on public sector companies shall be similarly elected and shall be subject to the same responsibilities and liabilities as other directors.

This suggestion has become an issue of hot debate in corporate circles and outside. However, in the present context where one finds a nominee director in the board of a company very often working or voting against matters perceived to be in interest to the company, and hence there is ample justification for this suggestion to be implemented. The board of a company is expected to be a cohesive team, characterized by mutual consultations and collective wisdom. There is no place for a person who does not fall in line. The inherent conflict would seriously harm the interests of the company.

Other mandatory recommendations of the committee are the following:

  • Compensation to non-executive directors (to be approved by the shareholders in general meeting, restrictions placed on grant of stock option, requirement of proper disclosures of details of compensation).
  • Whistle blower policy to be in place in a company.

All these suggestions are well merited and deserve implementation. Some objections raised in certain quarters about the recommendation of the committee with regard to whistle blowing can be met by suitable provisions to avoid frivolous and vexatious complaints.

The non-mandatory recommendations pertain to moving to a regime providing for unqualified corporate financial statements, training of board members and evaluation of non-executive director’s performance by a peer group comprising the entire board of directors, excluding the director being evaluated.

DR J.J. IRANI COMMITTEE REPORT ON COMPANY LAW, 2005

The Government of India constituted an expert committee on company law on 2 December 2004 under the chairmanship of Dr J.J. Irani to make recommendations on (i) responses received from various stakeholders on the concept paper; (ii) issues arising from the revision of the Companies Act, 1956; (iii) bringing about compactness by reducing the size of the Act and removing redundant provisions; (iv) enabling easy and unambiguous interpretation by recasting the provisions of the law; (v) providing greater flexibility in rule making to enable timely response to ever-evolving business models; (vi) protecting the interests of the stakeholders and investors, including small investors; and (vii) any other issue related, or incidental, to the above.

Set up to structurally evaluate the views of several stakeholders in the development of company law in India in respect of the concept paper promulgated by the Union Ministry of Company Affairs, the J.J. Irani Committee has come out with suggestions that will go far in laying sound base for corporate growth in the coming years.10 There has been a movement for some years now in many countries to create better frameworks of corporate governance. This has happened along with a trend towards global alignment of laws governing companies. Drawing from developments in countries such as the UK, Australia, New Zealand and Canada, the Irani Committee report has made suggestions to reform and update the basic corporate legal framework essential for sustainable economic reform.

The expert committee comprised experts drawn from trade and industry associations, professional bodies and institutes, chambers of commerce, leading senior advocates and auditors. Representatives of government departments, regulatory bodies and other organizations were included as special invitees. The committee deliberated on various issues on company law requiring a review on the basis of comments and suggestions received in response to the concept paper, opinions expressed by experts, professional bodies etc. The committee submitted its report to the Government of India on 31 May 2004.

The committee’s report is a balanced and well-rounded document and attempts to equate the pulls and pressures of modern business and those of shareholder democracy. It is a step toward providing a growth-oriented modern company law, with the thrust on stakeholder democracy and self-regulation. The report has taken a pragmatic approach keeping in view the ground realities, and has sought to address the concerns of all the stakeholders to enable the adoption of internationally accepted best practices.

INDEPENDENT DIRECTORs IN LISTED COMPANIES

SEBI had in the revised Clause 49 of the Listing Agreement mandated that at least 50 per cent of the board of a listed company comprise independent directors. The capital market regulator has made it clear that the corporate India should comply with revised Clause 49 by 31 December 2005.

Taking a position that is at variance with that of the Securities and Exchange Board of India, the J.J. Irani Committee has recommended that one-third of the board of a listed company should comprise independent directors.

PYRAMIDAL STRUCTURES

The committee has also suggested that corporates should be allowed to maintain pyramidal corporate structures, that is, a company which is a subsidiary of a holding company could itself be a holding company. ‘We suggest that pyramidal structures should be allowed because it is in the interest of corporate sector, especially when many companies are making acquisitions abroad. Although the committee started its deliberations under the presumption that only one layer should be allowed, we later decided against it,’ J.J. Irani commented.

POWER TO SHAREHOLDERS

The main thrust of the committee’s recommendations were to give full liberty to the shareholders and owners of the company to operate in a transparent manner. The committee calls for a significant shift from a government approval regime to a ‘shareholder approval and disclosures’ regime. The report thus gives more power to shareholders, allowing them rather than the company law administration to decide on certain crucial matters. Mergers between willing companies will be quicker. They will not be subject to the vagaries of the legal system any more. Ratification by shareholders will be enough. To protect the rights of minority shareholders and also to ensure investor protection, the committee has aptly suggested that the new company law should recognize principles such as ‘class actions’ and ‘derivative action’.

The capital market got plenty of attention from the committee. There are proposals to devise an exit option for shareholders who have stayed with a company and not participated in a buy back scheme implemented earlier.

SINGLE PERSON COMPANY

The committee has also mooted the concept of single-person company. Introducing the concept of One Person Company (OPC) as against the current stipulation of at least two persons to form a company, the committee has pitched for entrepreneurship in individuals. ‘The whole idea is that if there is an entrepreneur who wants to form his own company, he should not be bound down by company law to find other partners,’ according to Irani.

SELF-REGULATION

One distinctive approach of the committee was to allow corporates to self-regulate their affairs. This is a much-needed orientation for corporate growth in an overall policy regime being provided by the government.

STRINGENT PENALTIES

In order to strengthen the deterrent provisions in the present framework, the report has mandated publication of information relating to convictions for criminal breaches of the Companies Act on the part of the company or its officers in the annual report. The suggestions to provide stringent penalties will certainly help the regulator to curb fraudulent behaviour of companies.

ACCOUNTS AND AUDITS

According to the committee, ‘Proper and accurate compilation of financial information of a corporate and its disclosure in a manner that is standardized and understood by stakeholders is central to the credibility of the corporates and soundness of investment decisions by the investors. The preparation of financial information and its audit, therefore, needs to be regulated through law with stringent penalties for non-observance’. The committee took note of the contributions made by the Institute of Chartered Accountants of India and the National Advisory Committee on Accounting Standards and favoured the continuance of the existing institutional mechanism for formulating and notifying Accounting Standards.

GOVERNANCE STANDARDS

Those who believed that the Irani Committee would make corporate law and governance standards less stringent point to its advocacy of a smaller number of independent directors (just one-third of a company’s board) compared to the much higher proportion (one half specified by the Securities and Exchange Board of India) under Clause 49 of the listing agreement.

There are other points of differences too between the committee and SEBI. But it is not correct to look at an expert committee’s report purely from the points of its departure from current developments in those areas. It is too early to interpret the Irani committee, but its thrust is reminiscent of attempts in the US and elsewhere to tone down the rigours of the emerging law. At the same time, it is hoped that the committee’s report would give a new thrust and fresh perspective to the government on company law.

The foregoing analysis of the emergence of corporate governance traces the chequered history through which governance issues have been highlighted, shaped and refined, and the long road it has to traverse to acquire some degree of perfection. The worldwide movement for better corporate governance practices progressed between 1985 and 1997. The harbinger of the initiatives in this direction was the oft-quoted Cadbury Committee Report in the United Kingdom in 1992. Such initiatives being few and far between, most companies, be they global or Indian, knew little of what the phrase ‘corporate governance’ meant and cared even less for its implications. More recently, the first major stimulus for corporate governance reforms came after the Southeast Asian crisis of 1997–98 followed by the Enron debacle of 2001, which brought home the necessity of ensuring better corporate governance practices, culminating in the enactment of the hard-hitting Sarbanes—Oxley Act of 2002 in the United States.

Although India has been fortunate in not having to go through the massive corporate failures such as Enron and Worldcom, it has not been wanting in its resolve to incorporate better governance practices in the country’s corporates emulating stringent international standards. Surprisingly, the initial drive for better corporate governance and disclosure—perhaps as a result of the 1992 stock market scam and the fast emerging international competition consequent on the liberalization of the economy that began in 1991—came from the Confederation of Indian Industry and the Department of Corporate Affairs. Various committees were constituted that recommended stringent guidelines for corporate governance, most of which have been accepted by the government and the market regulator. However, as the Naresh Chandra Committee on corporate audit and governance pointed out: ‘There is scope for improvement. For one, while India may have excellent rules and regulations, regulatory authorities are inadequately staffed and lack sufficient number of skilled people. This has led to less than credible enforcement. Delays in courts compound the problem. For another, India has had its fair share of corporate scams and stock market scandals that has shaken investor confidence. Much can be done to improve the situation.’

KEY WORDS
  • World Bank
  • Guidelines
  • Mandatory recommentions
  • OECD
  • Public company
  • Rationale for a dations
  • McKinsey
  • Non-mandatory recommenda-review
  • SEBI’s initiatives
DISCUSSION QUESTIONS
  1. Why is it considered that the Cadbury Committee’s Report is the landmark in the evolution of corporate governance both as a concept and practice?
  2. What was the objective behind the setting up of the Cadbury Committee? Explain briefly The Cadbury Code of Best Practices.
  3. Explain in detail the OECD Principles of Corporate Governance.
  4. Discuss critically The Sarbanes—Oxley Act of 2002. Did it have the desired impact on the management of the corporate bodies both in the USA and elsewhere?
  5. Outline briefly the Indian Companies Act 1956. What were the pitfalls of the said Act and how were these sought to be remedied subsequently?
  6. Discuss critically the recommendations of Kumar Mangalam Birla Committee 1999.
FURTHER READINGS

Balasubramanian, S. (ed. 1988), “Corporate Boards and Governance”, N. Delhi: Sterling.

Paril, R.H. (Apr. – Sep. 1997), “Some Ground Realities”, Corporate Governance in India: Management Review, Vol 9., No. 2–3.

Rajiv Gandhi Institute for Contemporary Studies (1998), “Corporate Governance and Ethics”, N. Delhi: RGICS.

Sundarajan, S. (Jul.–Sept. 1996), “Improving Accounting Practices”, Corporate Governance: Management Review.

Vittal, N. (1998), “Corporate Governance: Principles and Objectives”, Vision, July—December.

Vittal, N. (Jul. – Dec. 1998), “Principles and Objectives”, Corporate Governance.

(This case is based on reports in the print and electronic media. The case is meant for academic purpose only. The writer has no intention to sully the reputations of the corporate or the executives discussed.)

COMPANY PROFILE

ITC is one of India’s foremost private sector companies with a market capitalization of over US$10 billion and a turnover of US$3 billion. Forbes magazine has rated it amongst world’s leading companies. Among India’s private sector corporations, ITC ranks third in pre-tax profits. ITC has evolved over the years from a single-product company to a multi-business corporation. Its businesses are spread over a wide spectrum. ITC has a diversified presence in cigarettes, hotels, paperboards and specialty papers, packaging, agri-business, branded apparel, packaged foods and confectionery, greeting cards and other FMCG products. ITC is rapidly gaining market share even in its new businesses of branded ready-made garments, greeting cards, packaged foods and confectionery, while it is an outstanding market leader in its traditional businesses of cigarettes, hotels, paperboards, packaging and agri-exports. ITC is considered to be nationalistic to the core as one of India’s most valuable and respected corporations, which contributes substantially to the country’s revenues, employment, exports, and socio-economic development. ITC’s strength emanates from its corporate strategy that aims at creating multiple drivers of growth anchored on its time-tested core competencies: large distribution reach, superior brand-building capabilities, effective supply chain management and acknowledged service skills in hotel business. In the not too distant future, ITC’s strategic forays into new businesses are likely to get it a significant share of these emerging high-growth Indian markets. For instance, ITC which has 3.5 lakh tonnes capacity in paper and paperboard in its four production units including 1 lakh tonnes of Elemental Chlorine-Free (ECF) paper for food packaging, has announced in August 2005 its plan to invest INR 2,500 crores during the next to three years to enhance its production of ECF by 2,000 lakh tonnes, which will increase the company’s total capacity to 5.5 lakh tonnes in this segment.1 Likewise, the company, encouraged by the tremendous response to its new food products such as ‘Ashirwad’ brand atta and ‘Sunfeast’ brand biscuits, hopes to achieve more than 100 per cent growth in turnover in this fast-growing segment in 2005. Against the present turnover of less than INR 400 crore, ITC Foods hopes to increase the turnover to more than INR 800 crore by the end of the financial year 2005.2

ITC continuously endeavours to enhance its wealth generating capabilities in a globalizing environment to consistently reward its 1.50 lakhs shareholders, fulfill the aspirations of its stakeholders and meet societal expectations. ITC employs over 20,000 people at more than 60 locations across India. The ‘Business Today-Stern Stewart’ study ranked the company among the top five sustained value creators in India.

ITC’S MISSION AND VISION

The vision of the company is very well captured in its corporate positioning statement: ‘Enduring Value for the Shareholder for the Nation.’ Vision: Sustain ITC’s position as one of India’s most valuable corporations growing value for the Indian economy and the company’s shareholders. Mission: To enhance the wealth generating capability of the enterprise in a globalizing environment delivering superior and sustainable stakeholder value.

CORE VALUES

ITC has adopted certain core values that would enable the company to be a customer-focussed, highs-performance organization which creates value for all its stakeholders:

  • Trusteeship: To redeem the Trust of all its stakeholders by adding value all the time.
  • Customer focus: To deliver to the customer his/her needs in terms of value, quality and satisfaction.
  • Respect for people: To give respect and value people in all respects.
  • Excellence: To do what is right, do it well and win.
  • Innovation: For better processes, products, services and management practices.
  • Ethical corporate citizenship: To pursue exemplary standards of ethical behaviour.
CORPORATE GOVERNANCE AT ITC

ITC has grown to its present status of one of India’s premier companies with a multi-product portfolio from a single product. ITC’s businesses are as vast as they are different, from tobacco to hotels, from paper to international commodities trading. These businesses differ in their very nature, the manner of their evolution and the methods of their operations. All these diverse factors have influenced in one way or the other the form of governance at ITC. ‘The challenge of governance for ITC, therefore, lies in fashioning a model that addresses the uniqueness of each of its businesses and yet strengthens the unity of purpose of the company as a whole.’

ITC, like any other Indian corporate, has been highly influenced by economic liberalization, globalization and the wide challenges and opportunities they have thrown open. To adapt themselves to a market situation replete with risks and to attract larger investments, companies have to be more open, transparent and adopt international governance practices. ITC’s governance policy recognizes the challenge of this new business reality in India.

ITC defines corporate governance ‘as a systemic process by which companies are directed and controlled to enhance their wealth generating capacity. Since large corporations employ vast quantum of societal resources, we believe that the governance process should ensure that these companies are managed in a manner that meets stakeholders’ aspirations and societal expectations.’

Core principles: ITC’s corporate governance initiative is based on two core principles. namely: (i) management must have the executive freedom to drive the enterprise forward without undue restraints and (ii) this freedom of management should be exercised within a framework of effective accountability.

ITC believes that any meaningful policy on corporate governance must provide empowerment to the executive management of the Company, and simultaneously create a mechanism of checks and balances, which ensures that the decision making powers vested in the executive management is not only not abused, but is used with care and responsibility to meet stakeholder aspirations and societal expectations.

THE GOVERNANCE STRUCTURE

Flowing from its vision and mission and amplified by its core principles, corporate governance in ITC is achieved at three interlinked levels:

  • Strategic supervision by the board of directors.
  • Strategic management by the Corporate Management Committee
  • Executive management by the Divisional Chief Executive assisted by the Divisional Management Committee.

It is ITC’s belief that the right balance between freedom of management and accountability to shareholders can be achieved by segregating strategic supervision from strategic and executive management. The board of directors as trustees of the shareholders will exercise supervision through strategic direction and control, and seek accountability for effective management from the Corporate Management Committee (CMC). The CMC will have the freedom, within board approved direction and framework, to focus its attention and energies on the strategic management of the Company. The divisional chief executive, assisted by the divisional management committee, will have the freedom to focus on the executive management of the divisional business.

The three-tier governance structure thus ensures the following:

  1. Strategic supervision (on behalf of the shareholders) being free from involvement in the task of strategic management of the company, can be conducted by the board with objectivity, thereby sharpening accountability of management.
  2. Strategic management of the company, uncluttered by the day-to-day tasks of executive management, remains focussed and energized.
  3. Executive management of the divisional business, free from collective strategic responsibilities for ITC as a whole, gets focussed on enhancing the quality, efficiency and effectiveness of its business.
BOARD OF DIRECTORS

The crucial role of the board of directors in leading ITC to adopt and follow corporate governance standards are as follows: As envisaged by internationally accepted corporate governance practices the primary role of the board of directors is that of trusteeship to protect and enhance shareholder value through strategic supervision of ITC and its wholly owned subsidiaries. As trustees they will ensure that the company has clear goals relating to shareholder value and its growth. They should set strategic goals and seek accountability for their fulfilment. They will provide direction, and exercise appropriate control to ensure that the company is managed in a manner that fulfills stakeholder aspirations and societal expectations. The board will periodically review its own functioning to ensure that it is fulfilling its role.

ITC BOARD STRUCTURE

The ITC board is a balanced board, consisting of executive and non-executive directors, the latter including independent professionals, as envisaged by the codes of corporate governance. Executive directors, including the executive chairman, do not generally exceed one-third of the total strength of the board. The non-executive directors comprise eminent professionals, drawn from amongst persons with experience in business, finance, law and public enterprises. Directors are appointed, re-appointed for a period of three to five years, and in the case of executive directors up to the date of their retirement, whichever is earlier. The board determines from time to time the retirement age for both executive and non-executive directors. The board specifies the maximum number of company directorships which can be held by members of the ITC board. Non-executive directors are expected to play a crucial role in imparting balance to the board processes by bringing an independent judgement to bear on issues of strategy, performance, resources, standards of company conduct etc.

The board meets at least six times a year and as far as possible meetings are held once in two months. The annual calendar of meetings is agreed upon at the beginning of each year. As laid down in the Articles of Association of the Company, the quorum for meetings shall be one third of members and decisions shall be taken by simple majority, unless statutorily required otherwise. Meetings are governed by a structured agenda. All major issues included in the agenda are backed by comprehensive background information to enable the board to take informed decisions. Agenda papers, as far as practicable, are circulated at least three working days prior to the meeting. Normally items for the board Agenda, except those emanating from board Committees, would have been examined by the CMC. Minutes are circulated within 15 working days of the meeting and confirmed at the next meeting. Board decisions record the related logic as far as practicable.

COMMITTEEs OF THE ITC BOARD

The board has the following committees whose terms of reference are determined by the board from time to time:

Audit committee: To provide assurance to the board on the adequacy of internal control systems and financial disclosures. The head of internal audit will act as coordinator to the audit committee, but will be administratively under the control of the director accountable to the board for the finance function.

Compensation committee: To recommend to the board compensation terms for executive directors and the senior most level of management below the executive directors.

Nominations committee: To recommend to the board nominations for membership of the CMC and the board, and oversee succession for the senior most level of management below the executive directors.

Investor services committee: To look into redressal of shareholder and investors grievances, approval of transmissions, sub-division of shares, issue of duplicate shares etc.

Composition of these committees along with their objectives, role, responsibilities will be as on the next page.

Corporate Management Committee (CMC): The primary role of the CMC is strategic management of the Company’s businesses within board approved direction/framework. The CMC will operate under the superintendence and control of the board. The composition of the CMC will be determined by the board (based on the recommendation of the nominations committee), and will consist of all the executive directors and three or four key senior members of management. Membership of the CMC shall be reviewed by the Nominations Committee annually. The CMC shall be convened and chaired by the executive chairman of the company. The company secretary shall be the secretary of the CMC.

 

Committee Members Chairman
Audit committee Directors of the company, as may be decided by the board, with not less than three members, all being non-executive directors with majority of them being independent, and with at least one director having financing and accounting knowledge. The director accountable to the board for the finance function, head of internal audit and representative of external auditors shall be the permanent invitees with the company secretary to act as the secretary. One of the independent directors, to be determined the board.
Compensation committee Non-executive directors, as may be decided by the board, with the director accountable to the board for the HR function as the Secretary. One of the independent directors, to be determined the board.
Nominations committee The executive chairman and all the non-executive directors. Executive chairman,
Investor services committee Directors of the company, as may be decided by the board, with the company secretary as the Secretary, One of the non-executive directors, to be determined by the board.

Executive Chairman of ITC: The executive chairman of ITC shall operate as the chief executive for ITC as a whole. He shall be the chairman of the board and the CMC. His primary role is to provide leadership to the board and CMC for realizing company goals in accordance with the charter approved by the board. He shall be responsible for the working of the board, for its balance of membership (subject to board and shareholder approvals), for ensuring that all relevant issues are on the agenda, for ensuring that all directors are enabled and encouraged to play a full part in the activities of the board. He shall keep the board informed on all matters of importance.

All these bodies and governance norms with regard to the board of directors, board committees and their structures faithfully follow the recommendations of national and international committees on corporate governance.

FACE-TO-FACE INTERACTION WITH SHAREHOLDERS

A general meeting of the shareholders of the company is held at least once a year to consider and approve the report of the directors, the annual financial statements with the notes and schedules thereto, declaration of dividends, any other returns or resources intended for distribution, the appointment of directors, appointment of auditors and other important matters requiring shareholder approval. The annual general meeting is the principal forum for face-to-face interaction with shareholders, where the entire board is present. The chairman addresses the shareholders on issues of relevance to the company and provides clarifications to shareholders on behalf of the board. The board encourages open dialogue with all its shareholders—be it individuals, corporates or foreign investors.

Cornerstones of ITC’s corporate governance: ITC—s governance philosophy rests on the following cornerstones: trusteeship, transparency, empowerment and accountability, control and ethical corporate citizeship. ITC believes that the practice of each of these leads to the creation of the right corporate culture in which the company is managed in a manner that fulfils the purpose of corporate governance.

Trusteeship: Large corporations like ITC have both a social and economic objective. Inherent in the concept of trustee-ship is the responsibility to ensure equity, namely, that the rights of all shareholders, large or small, are protected.

Moreover, corporate governance in large corporations represents a coalition of interests, namely, those of the shareholders, creditors and bankers, business associates and employees. This belief, therefore, casts a responsibility of trusteeship on the company’s board of directors, who are expected to act as trustees to protect and enhance shareholder value, as well as to ensure that the company fulfils its obligations and responsibilities to its other stakeholders.

Transparency: Transparency implies explaining a company’s policies, decisions and actions to those to whom it has responsibilities. Such transparency should lead to maximum appropriate disclosures without jeopardizing the company’s strategic interests. Internally, transparency means openness in company’s relationship with its employees, as well as the conduct of its business in a manner that will bear scrutiny. Obviously, transparency enhances accountability.

Empowerment and accountability: Empowerment is an essential concomitant of an organization’s core principle of governance that management must have the freedom to drive the enterprise forward. Empowerment is a process of actualizing the potential of its employees. Empowerment unleashes creativity and innovation throughout the organization by truly vesting decision-making powers at the most appropriate levels in the organizational hierarchy.

In such a scheme of things, the board of directors are accountable to the shareholders, and the management is accountable to the board of directors. Empowerment, combined with accountability, provides an impetus to superior performance and improves effectiveness, thereby enhancing shareholder value.

Control: Control is a necessary concomitant of its second core principle of governance namely, the freedom of management should be exercised within a framework of appropriate checks and balances. Control should prevent misuse of power, facilitate timely management response to change, and ensure that business risks are pre-emptively and effectively managed.

Ethical corporate citizenship: Corporations like ITC have a responsibility to set exemplary standards of ethical behaviour, both internally within the organization, as well as in their external relationships. Unethical behaviour corrupts organizational culture and undermines stakeholder value.

MORE ON CORPORATE CITIZENsHIP

The governance processes in ITC continuously reinforce and help realize the Company’s belief in ethical corporate citizenship. According to ITC Chairman, Y.C. Deveshwar, ITC endeavours to pursue the Triple Bottom Line, which is centred on the company’s ‘Commitment as a Corporate Citizen to contribute to the nation’s economic, social and ecological capital’.3

ITC: A COMMITMENT BEYOND THE MARKET

ITC believes that its aspiration to create enduring value for the nation provides it the motive force to sustain growing shareholder value. During 1996–2005, for instance, Total Shareholder Returns, measured in terms of increase in market capitalization and dividends, grew at a compound rate of more than 23 per cent per annum. This performance has placed ITC among the foremost companies in the country in terms of efficiency of servicing financial capital. In a testimony to ITCs ability to generate shareholder wealth, the company’s market capitalization recently touched the milestone and symbolic landmark of US$ 10 billion—an extraordinary performance indeed!

INDIA’S SALVATION LIES IN THE UPLIFTMENT OF THE RURAL POOR

It is imperative for the Indian economy to not only sustain high rates of growth over many years but also ensure that such growth is inclusive so as to free millions of our disadvantaged citizens from the indignity of poverty. The requisite high rates of inclusive growth can only be achieved by putting in place an effective growth strategy for rural India, which is home to 62 per cent of the Indian population and 70 per cent of its poor. The competitiveness of the Indian farmer has to be significantly enhanced and he has to be effectively linked to remunerative opportunities in world markets.

ITC’s multiple businesses have created diverse farmer partnerships: some of these associations are almost a century old. The interdependence between ITC’s agri-based businesses and the farm sector has provided the company a sustainable platform to make a sizeable contribution to rural India.

India’s rural transformation cannot be brought about by the government alone. Nor can the efforts of only a few enterprises make a decisive difference. What is required is a revolution inspired by public—private partnership that will transform lives and landscapes. ITC’s efforts in this direction have proved that it is possible to create and sustain a model that can harmonize the need for shareholder value creation while making a substantial contribution to society. It would be mission fulfilled for ITC if its example succeeds in inspiring others.

TRANSFORMING LIVES AND LANDSCAPES

ITC’s diversified business portfolio has enabled the Company to create and nurture numerous farmer partnerships in many value chains. These cover multiple crops and locations. Leveraging these partnerships, ITC has created a number of unique community development programmes by synergizing its social sector initiatives with its business plans.

ITC’S E-CHOUPAL MOVEMENT

The immense potential of Indian agriculture is waiting to be unleashed. The endemic constraints that shackle this sector are well known. These are, inter alia excessive dependence on the monsoon, fragmented farms, weak infrastructure, unorganized markets, too many blood-sucking intermediaries, variations between different agro-climatic zones etc. These pose their own challenges to improving productivity of land and quality of crops. The unfortunate result is inconsistent quality and uncompetitive prices, making it difficult for the farmer to sell his produce in world market.

ITC’s proactive solutions to these problems is the e-Choupal initiative; the single largest information technology-based intervention by a corporate entity in rural India. Transforming the Indian farmer into a progressive knowledge-seeking netizen. Enriching the farmer with knowledge; elevating him to a new order of empowerment.

Enduring value for the shareholder

(INR in Crores)
Particulars 1995–96 2004–05
Gross income 5188 13585
Market capitalization 5571 33433
Profit after tax (before exceptional items) 261 1837
Profit after tax (after exceptional items) 261 2191
EPS—basic (INR) (before exceptional items) 10.64 73.74
EPS—basic (INR) (after exceptional items) 10.64 87.97
Net worth 1121 7896
Book value per share (INR) 45.69 316.54
Capital employed 1886 8517
WHAT IS THE E-CHOUPAL MODEL?

Under this model, ITC has created and maintains its own IT network in rural India to identify and train local farmer to manage the e-Choupal. The computer, typically housed in the farmer’s house, is linked to the Internet via phone lines or, increasingly, by a VSAT connection, and serves an average of 600 farmers in 10 surrounding villages within about a 5 km radius.

Five years ago, ITC leveraged the power of the internet to empower the small and marginal farmer with a host of services related to know-how, best practices, timely and relevant weather information, and transparent discovery of prices. Such customized knowledge is intended to progressively raise farm productivity and incomes by linking the Indian farmer with markets, both domestic and international. The ITC e-Choupal also acts as an alternative marketing channel, creating enhanced competition among buyers, to the benefit of the farmers.

The ITC e-Choupal can serve as a powerful and effective delivery channel for a host of goods and services for the rural economy, including those related to insurance, credit, education and health. In effect, the e-Choupal is potentially an efficient delivery channel for rural development and an instrument for converting village populations into vibrant economic organizations.

Implementing such a model poses many difficulties not the least of which is the low level of literacy. Despite challenges of implementation, this initiative now comprises about 5,200 installations covering nearly 31,000 villages and serving over 3 million farmers. Over the next 7–10 years it is ITC’s vision to create a network of 20,000 e-Choupals and over 700 Choupal Sagars entailing investments of nearly INR 5,000 crores, thereby extending coverage to 1,00,000 villages—representing one-sixth of rural India. This networked rural delivery infrastructure comprising digital, human and physical assets would complement the initiatives embodied in ‘Bharat Nirman’ and create a front-running example of public-private partnership for rural transformation. The realization of such a vision, of course, is dependent on the progress of reforms.

As ITC’s Chairman Y.C. Deveshwar summed it up in a recent interview with Economic Times: ITC wants to create a high-quality, low-cost fulfillment channel for India. ‘The e-choupal was the first step in the last mile towards complete backward integration. It’s also the first mile on a new information highway around which multiple suppliers and buyers can coverage. It can make a huge impact on rural well-being,’ he said.

The farm-to-factory model operates on the principle of providing crop management inputs to farmers throughout the season. Post harvest, the hub operates as a price discovery mechanism for farmers, with ITC initially as the main buyer. Consequently, while ITC’s own supply chain has become more cost-effective, avoiding the mandis, farmers have access to timely information and good growing practices.

What is so special about ITC’s e-choupal? It is a virtual ‘e-business.’ All the basic rules help create a successful e-commerce model and being leveraged to chop costs and boost volumes, that in turn improve revenues. ‘There is no guarantee that ITC will achieve its ambitious goal of expanding the e-choupal network to 1,00,000 villages and 10 million farmers in 5 years. But, what it has achieved so far paints a tantalizing picture of the possibilities of e-business for rural India. And it offers valuable insights into using creativity and pragmatism to overcome barriers in implementing e-business solutions,’ says Professor Mahanbir Sawhney, McCormick Tribune University’s Kellogg School of Management, in a case study on the project. Professor David Upton of Harvard’s Business School agrees.4 ‘It provides an excellent example of combining social goals with profitability. It demonstrates how a deep understanding of social context, along with a powerful vision can result in a stellar implementation. And it shows how everyone can win when inefficiencies are removed from a supply chain,’ he told ET in a recent inverview. The e-Choupal initiative also creates a direct marketing channel, eliminating wasteful intermediation and multiple handling, thus reducing transaction costs and making logistics efficient.

DIGITAL TRANsFORMATION

ITC began the silent evolution of rural India with soya growers in the villages of Madhya Pradesh. For the first time, the stereotype image of the farmer on his bullock cart made way for the e-farmer, browsing the e-Choupal web site. Farmers now log on to the site through Internet kiosks in their villages to order high quality agri-inputs, get information on best farming practices, prevailing market prices for their crops at home and a broadband weather forecast—all in the local language. In the very first full season of e-Choupal operations in Madhya Pradesh, soya farmers sold nearly 50,000 tonnes of their produce through the soya-choupal Internet platform, which has doubled since then. The result marks the beginning of a transparent and cost-effective marketing channel and bringing prosperity to the farmers’ doorstep.

LINKING FARMERS TO REMUNERATIVE MARKETS

Farmers grow wheat across several agro-climatic zones, producing grains of varying grades. Though these grades had the potential to meet diverse consumer preferences, the benefit never trickled down to the farmers, because all varieties were aggregated as one average quality in the mandis. With ITC’s e-Choupal intervention, farmers have discovered now the best price for their quality at the village itself. The site also provides farmers with specialized knowledge for customizing their produce to the right consumer segments. The new storage and handling system preserves the identity of different varieties right through the ‘farm-gate to dinner-plate’ supply chain. It also encourages the farmers to raise their quality standards and attract higher prices.

SOCIAL AND FARM FORESTRY

ITC’s afforestation project is driven by the realization that India’s poor forest cover—a meagre 11 per cent of the geographical area of the country against a desirable 33 per cent—has serious implications for the rural poor. Forests and common property resources constitute as much as 20 per cent or more of the total income source of such households. ITC has effectively leveraged its need for wood fibre to provide significant opportunities to economically backward wasteland owners. The main plank of ITC’s forestry projects is the building of grassroots capacities to initiate a virtuous cycle of sustainable development.

ITC also makes available high-yielding, disease-resistant clonal planting stock developed through biotechnology-based research at its Bhadrachalam unit. The commercial viability of these clones is evident from the fact that farmers have brought 29,000 hectares under such plantations, wherein more than 100 million saplings have been planted. ITC intends to scale up the afforestation endeavour to cover over 1,00,000 hectares by planting more than 600 million saplings during the next 8–10 years, creating in the process over 40 million person days of employment among the dis-advantaged.

Another 10,000 hectares have been planted by the forest departments of Andhra Pradesh, Tamil Nadu, Karnataka, Maharashtra and West Bengal.

INTEGRATING WATERSHED DEVELOPMENT

Some dry and despairing facts stare India in the face. The present average soil loss in the country is about 16.35 tonnes per hectare per year, which is at least three to five times worse than what it ought to be. Nearly 67 per cent of the cultivated area in the country faces severe moisture stress for 5–10 months a year. Crop productivity in dry lands is low, unstable and highly vulnerable to seasonality.

ITC’s integrated watershed development initiative is a key intervention to reverse such moisture stress in some of the more acutely affected, drought-prone districts of the country. Currently, 550 small and large water harvesting structures with a storage capacity of 16 billion litres built by ITC provide critical irrigation to nearly 7,000 hectares of land in Andhra Pradesh and Karnataka. ITC has also embarked upon a comprehensive natural resource management initiative called ‘Sunehra Kal’ in the vicinity of choupal locations.

WOMEN’S EMPOWERMENT

The need of the hour is to diversify rural livelihoods. Towards this end, ITC has forged an empowering partnership with rural women—the most effective development workers. ITC’s intervention leverages micro-credit and skills training to generate alternate employment opportunities. Increased income in the hands of rural women means better nutrition, health care and education for their children.

Working with NGOs, ITC has organized village women into micro-credit groups. Group members make monthly contributions to create a savings corpus. The corpus is used to extend soft loans to group members, thereby eliminating the stranglehold of the moneylender. The system of mandatory contribution further strengthens the savings habit, leading to capital augmentation.

ITC provides training to group members to handle bank accounts and understand the nuances of government development programmes. Empowered groups function autonomously and take their own decisions, including sanction of loans to fellowmembers and collection of repayments. Well-managed micro-credit groups with no default records receive further support from ITC in the form of seed money for self-employment activities.

Venture funds provided by ITC have already spawned hundreds of women entrepreneurs. Their earnings, ranging from INR 70–50 per day, not only supplement household incomes but also significantly enhance their self-esteem. These programmes aim to provide the wherewithal for sustainable incomes for at least 200 additional women each year.

CONCENTRATION ON PRIMARY EDUCATION

ITC’s education support programmes are aimed at overcoming the lack of opportunities available to the poor. ITC believes that the extensive network of government-supported schools must be made more attractive to children. It provides critical support to state-run schools to maximize enrolment and minimize dropouts. So far, ITC’s rural education initiatives cover over 10,000 children through 94 supplementary leaving centres and support to government primary schools. ITC aims to cover at least 5,000 additional children each year. The company reserves one rupee out of every ‘class-mate’ note books sold towards rural development initiatives including primary education in villages.

Its initiatives include improving school buildings, constructing toilets, providing electricity connections and supplying fans and lights. ITC provides students with uniforms, satchels and books. So far, 20,000 children have benefited in four states.

ITC’S EHS PHILOSOPHY

ITC as one of India’s premier corporations attaches paramount importance to its responsibility to contribute to the preservation and enrichment of the physical environment. The company’s commitment finds expression in its Environment, Occupational Health and Safety (EHS) philosophy which recognizes the need to preserve and enrich the environment and provide a safe and healthy workplace for its employees, while constantly creating productive economic resources.

ITC’S EHS COMMITMENT
  1. To contribute to sustainable development through the establishment and practice of environmental standards that are scientifically tested and meet the requirements of relevant laws, regulations and codes of practice.
  2. To factor in environment, occupational health and safety in the planning and decision-making process.
  3. To disseminate information and provide appropriate training to enable all employees to accept individual responsibility for environment, health and safety, implement best practices and work collectively to create a culture of continuous improvement.
  4. To instill a sense of duty in every employee towards personal safety, as well as that of others who may be affected by the employee’s actions.
  5. To provide and maintain facilities, equipment, operations and working conditions which are safe for employees, visitors and others at the company’s premises.
  6. To ensure safe handling, storage, use and disposal of all substances and materials that are classified as hazardous to health and environment.
  7. To reduce waste, conserve energy and promote recycling of materials wherever possible.
  8. To institute and implement a system of regular EHS audit in order to assure compliance with laid down policy, benchmarked standards and requirements of laws, regulations and applicable codes of practice.
  9. To proactively share information with business partners towards inculcating world-class EHS standards across value chains of which ITC is a part.
GLOBAL HONOURS

ITC constantly endeavours to benchmark its products, services and processes to global standards. The company’s pursuit of excellence has earned it national and international acclamations. ITC is one of the eight Indian companies to figure in Forbes A-List for 2004, featuring 400 of ‘the world’s best big companies’. The ET 500 survey by The Economic Times, rating companies on the basis of market capitalization, ranks ITC 9th among 500 listed Indian companies. ITC has several firsts to its credit: It has won the inaugural ‘World Business Award’, the worldwide business award recognizing companies who have made significant efforts to create sustainable livelihood opportunities and enduring wealth in developing countries, instituted jointly by the United Nations Development Program (UNDP), International Chamber of Commerce (ICC) and the HRH Prince of Wales International Business Leader’s Forum (IBLF). ITC Infotech finds a place of pride among a select group of SEI CMM Level 5 companies in the world. The company is also the recipient of the Corporate Social Responsibility Award 2004 from The Energy and Resources Institute (TERI) for its e-Choupal initiative. The award provides impetus to sustainable development and encourages ongoing social responsibility processes within the corporate sector. ITC has won the ‘Golden Peacock Global Award for Corporate Social Responsibility (CSR) in Emerging Economies for 2005’. The company received this award for two of its unique initiatives that are impactfully transforming lives and landscapes in rural India—ITC’s e-Choupal and social and farm forestry. ITC is the only Indian FMCG company to have featured in the Forbes 2000 list. The Forbes 2000 is a comprehensive ranking of the world’s biggest companies, measured by a composite of sales, profits, assets and market value. The list spans 51 countries and 27 industries. According to an analysis based on data from the Centre for Monitoring Indian Economy (CMIE), the ITC Group is among the ‘Top 10 wealth creator groups’ in the private sector for the financial year 2003–04. This ranking was based on market capitalization of group entities. ITC has won the ‘Enterprise Business Transformation Award’ for Asia Pacific (Apac), instituted by Infosys Technologies and Wharton School of the University of Pennsylvania for its celebrated e-Choupal initiative. ITC has been ranked 29th among India’s Top 500 Companies in 2003 by Dun & Bradstreet (D&B). Dun & Bradstreet is the world’s leading provider of business information services, which are universally accepted as key measures of corporate performance.

Every discerning analyst will agree that ITC has won a bagful of honours—some of them very prestigious indeed, for its strict adherence to excellence in everyone of its operations and its social activism. Though most of its social initiatives are related to its industrial pursuits, it has gone much beyond to espouse the causes of the underprivileged and the rural poor. However, there had been certain acts of commission and omission within the organization which never came to the knowledge of ITC’s stakeholders until the BAT—ITC spat and the company’s FERA violations came to limelight.

THE BAT-ITC SPAT

History of BAT-ITC Relationship

ITC’s history dates back to 1905, when British American Tobacco (BAT) set up the Peninsular Tobacco Company (Peninsular) in India. Peninsular was involved in cigarette production, tobacco procurement and processing. It set up a full-fledged sales organization named the Imperial Tobacco Company of India Limited in 1910. BAT set up another cigarette manufacturing unit in Bangalore in 1912, to cope with the growing demand. A new company called Indian Leaf Tobacco Company (ILTC) was incorporated in July 1912, to handle the raw material (tobacco leaf) requirements, the poor quality of tobacco obtained from Bihar prompted ILTC to search for better alternatives, leading to the establishment of the South India Leaf Area (SILA) in Andhra Pradesh.

By 1919, BAT had transferred its holdings in Peninsular and ILTC to Imperial Tobacco Company. Following this, Imperial replaced Peninsular as BAT’s main subsidiary in India. Throughout the 1920s, Imperial Tobacco Company appointed distributors and agents in various parts of the country. As sales were growing faster in North India than in other regions of the country, Imperial set up its third factory at Saharanpur in UP in 1924. In 1925, Imperial set up a printing factory at Munger to cater to the printing and packaging needs of the Company. In 1928, Imperial’s head office in Calcutta was inaugurated.

THE UNFOLDING OF THE SPAT

All of a sudden in March 1995, a press release issued by the UK-based parent company of ITC, British American Tobacco (BAT) shocked the Indian corporate world. Expressing a lack of confidence in K.L. Chugh, the chairman of its Indian subsidiary. ITC, the press release demanded his resignation. The incident took place soon after Chugh had accused BAT of trying to forcibly increase its stake in ITC to gain majority and that BAT was not in favour of ITC’s diversification into the power generation business.

Though the ITC-BAT relationship had been strained for quite some time, the move took issueTC by surprise. The surprise element was BAT’s claim that it was not demanding Chugh’s resignation because of the shareholding issue, but because it had detected certain financial irregularities in the company. BAT said, ‘chugh should resign in the interests of the company, its employees and its shareholders.’

Soon after, Chugh called a press conference, at which he made it clear that be would not step down. ‘Just because one of the shareholders throws a tantrum does not mean the chairman goes.’ He reiterated his stand that BAT was trying to increase its stake and added that BAT only wanted to use ITC’s funds for its own benefits. Chugh also said that ITC did not need BAT.

Soon, the inside details of the ITC-BAT conflict became public knowledge as a series of allegations and counter-allegations from both the parties surfaced in media reports. Commenting on the showdown, a report said, ‘As skeletons come tumbling out, ITC’s carefully nurtured public image as a professionally managed enterprise has been tarnished.’

THE END—AN ANTI-CLIMAX

However, the entire episode ended in an anticlimax. BAT claimed that Chugh had departed from the standards of professional management and wanted him to resign on charges of financial irregularities. These charges were confirmed by an audit committee, which however, cleared Chugh of all charges. But, unexpectedly, at a press conference summoned by him Chugh announced his resignation stating the difference of opinion between him and BAT was not good for the growth of ITC and hence he had decided to put in his papers. Surprisingly, media reports revealed that BAT had agreed to drop all charges against Chugh, gave him a hefty severance package and offered him the exalted Chairman Emeritus position at ITC. It sounded obvious that this understanding between Chugh and BAT was meant to avoid washing dirty linen in public. Till date the investing public are not aware of the reasons for the sudden spat and the real terms of the hatch-up between BAT and Chugh.

ITC—FERA VIOLATION STORY

Notwithstanding the conferment of so many global honours on ITC for its adherence to corporate governance practices and its commitment to social responsibility, ITC got into serious trouble with the Customs and Revenue Intelligence Enforcement authorities of Government of India for FERA violations. There were allegations of dubious international deals by ITC and its partners, the Chitalias, for excise duty evasion and share price manipulations.

In October 1996, officers of the Enforcement Directorate, Customs and Department of Revenue Intelligence raided various ITC offices in Kolkata. The raid was due to the suspicion of officials that ITC had contravened FERA violations to the tune of $ 100 million. On 30 October 1996, ED officials arrested, after finding conclusive evidence of FERA violations during the raid, K.K. Kutty, Director and Head of the International Business Division (IBD), a subsidiary of ITC, G.K.P. Reddi, former IBD Director and Chairman, E. Ravindranath, former Vice President, Operations, IBD and M.B. Rao, former Export Manager, IBD. The arrests were made under section 35 of FERA, to conduct interrogations on FERA violations by ITC in international trading deals during 1991–95. All the arrested officials were remanded to judicial custody until 13 November 1996.

On 31 October 1996, former chairmen of ITC Ltd, J.N. Sapru and Krishen Lal Chugh were summoned to the ED’s office in Kolkata for interrogation. They were arrested the same day. On 5 November 1996, the ED interrogated ITC chairman, Y.C. Deveshwar, who promised to submit a complete report on alleged FERA violations. By mid November, the ED arrested a few more ITC executives taking the total number of arrested officials to 15.

By June 1997, ITC’s board of directors was facing prosecution on account of allegations of FERA contravention. An ED official said, ‘For the first time in Indian corporate history, the entire board of directors of a company has been held liable for irregularities.’ The case attracted extensive media attention, resulting in serious debates regarding the stringent FERA regulations and the need for efficient corporate governance practices in companies. The issue was discussed in both the Houses of Parliament, where MPs accused ITC of poor corporate governance practices and lack of transparency. The MPs wanted the Department of Company Affairs (DCA) to investigate into the matter, as they felt ITC had contravened various sections of the Companies Act and wilfully and deliberately misinterpreted information causing loss to the shareholders. Though ITC performed very well on the financial front for the fiscal 1996–97, charges of FERA violation, excise duty evasion and share price manipulation in the early 1990s seemed to have tarnished the company’s image beyond repair.

CONCLUSION

ITC, though basically a cigarette-manufacturing company, has earned several positive distinctions to fame. It is one of India’s foremost private sector companies having a market capitalization exceeding US $10 billion. In fact, the venerable Forbes magazine has placed ITC amongst the world’s leading companies. The company which was basically known as a cigarette-producing company has evolved over the years as a multipurpose corporation and now has a strong prcesence in hotels, paperboards, speciality papers, packaging, agri-business, branded apparel, packaged foods, confectionary and greeting cards. ITC has adopted several core values and tries to live by them. ITC is passionately engaged in transforming the lives of the rural poor, farmers and the marginalized sections of society through various innovative initiatives amongst which the e-choupal movement is the foremost. This movement combines social goals with profitability, apart from being a direct marketing initiative, eliminating wasteful intermediation and multiple handling, thus reducing transaction costs and making logistics more efficient. No wonder, the e-choupal movement has attracted worldwide attention both in academic and business circles.

DISCUSSION QUESTIONS
  1. Elaborate on the company profile of ITC Ltd. Relate ITC’s growth to the core values it follows.
  2. Explain the pursuit of corporate governance of ITC Limited. What are the diverse features of corporate governance of ITC Ltd?
  3. Discuss the salient features of the e-Choupal movement. How does it create connectivity between ITC’s activities and the company’s goal of rural rejuvenation?
  4. What is ITC’s EHS philosophy? How is this philosophy translated into the firm’s commitment to various social causes?
  5. Discuss the reasons for the conflict between BAT and ITC. How was the spat settled between them?
FURTHER READINGS

OECD principles

www.co-oDertaivebank.co.uk

www.iccwbo.ora

www.itcportal.com