This chapter attempts at defining Corporate Governance and stressing its importance for adoption by corporate bodies in India to meet adequately the challenges faced by them in the new economy.

1. It is almost a truism that the adequacy and the quality of corporate governance shape the growth and the future of any capital market and economy.. Focus on corporate governance and related issues is an inevitable outcome of a process, which leads firms to increasingly shift to financial markets as the pre-eminent source for capital. In the process, more and more people are recognizing that corporate governance is indispensable to effective market discipline. This growing consensus is both an enlightened and a realistic view. In an age where capital flows worldwide, just as quickly as information, a company that does not promote a culture of strong, independent oversight, risks its very stability and future health. As a result, the link between a company's management, directors and its financial reporting system has never been more crucial. As the Boards provide stewardship of companies, they play a significant role in their efficient functioning.

2. Studies of firms in India and abroad have shown that markets and investors take notice of well-managed companies, respond positively to them, and reward such companies. A common feature of such companies is that they have systems in place, which allow sufficient freedom to the boards to take decisions towards the progress of their companies, to innovate, while remaining within a framework of effective accountability. In other words they have system of good corporate governance.

3. Strong corporate governance is thus indispensable to resilient and vibrant capital markets and is an important instrument of investor protection. It is the blood that fills the veins of transparent corporate disclosure and high-quality accounting practices. It is the muscle that moves a viable and accessible financial reporting structure. Without financial reporting premised on sound, honest numbers, capital markets will collapse upon themselves.

4. Another important aspect of corporate governance relates to issues of insider trading. It is important that insiders, which include corporate insiders also, do not use their position of knowledge and access to inside information, to take unfair advantage over the uninformed stockholders and other investors transacting in the stock of the company. To achieve this, the corporates are expected to disseminate the material price sensitive information in a timely and proper manner and also ensure that till such information is made public, insiders abstain from transacting in the securities of the company. The principle should be 'disclose or desist'. This calls for companies to devise an internal procedure for adequate and timely disclosures, reporting requirements, confidentiality norms and code of conduct for its directors and employees with regard to their dealings in securities.

However, the need for such procedures, rules and guidelines also goes beyond corporates to other entities in the financial markets such as Stock Exchanges, Intermediaries, Financial institutions, Mutual Funds and other professionals who may have access to inside information. This also needs to be dealt with in a comprehensive manner.

5. The Committee's recommendations look at corporate governance from the point of view of the stakeholders and in particular that of the shareholders, because they are the raison de etre for corporate governance and also the prime constituency of SEBI. The control and reporting functions of boards, the roles of the various committees of the board, the role of management, all assume special significance when viewed from this perspective. The other way of looking at corporate governance is from the contribution of corporate governance to the efficiency of a business enterprise, to the creation of wealth and to the country's economy. In a sense both these points of view are related and during the discussions at the meetings of the Committee, there was a clear convergence of both the points of view.

6. At the heart of the Committee's report is the set of recommendations which distinguishes the responsibilities and obligations of the boards and the management in instituting the systems for good corporate governance and restates the rights of shareholders in demanding corporate governance. A large part of the recommendations are mandatory and are intended to be enforced on the listed companies for initial and continuing disclosures in a phased manner within specified dates. The companies will be required to disclose separately in their annual reports, a report on corporate governance, delineating the steps they have taken to comply with the recommendations of the Committee. This will enable shareholders to know where the companies in which they have invested stand with respect to specific initiatives taken to ensure robust corporate governance. Companies above a particular size will be required to comply with the mandatory recommendations of the report by April 2000 and the remaining companies in the next year. For the non-mandatory recommendations the Committee felt that it would be desirable for companies to voluntarily follow these. It has been recommended that the SEBI may write to the appropriate regulatory bodies and governmental authorities to incorporate the recommendations in their respective regulatory or control framework.

7. The Committee agreed that India had in place a basic system of corporate governance and SEBI has already taken a number of initiatives towards raising the existing standards. The Committee also recognised that the Confederation of Indian Industries had published a Desirable Code of Corporate Governance and was encouraged to note that some of the forward looking companies have already reviewed or are in the process of reviewing their board structures and have also reported in their 1998-99 annual reports the extent to which they have complied with the Code. The Committee felt that under the Indian conditions a statutory rather than a voluntary code would be far more purposive and meaningful. The Committee however recognised that no system of control could eliminate the risk of fraud without so hamstringing the companies so as to impede their ability to compete in the market place. The Committee was convinced that the recommendations made in this report mark an important step forward and if accepted and followed by the industry, would raise the standards in corporate governance, strengthen the unitary board system, significantly increase its effectiveness and ultimately serve the objective of maximizing shareholder value

8. In the above mentioned context, the Committee on Corporate Governance was set up on May 7, 1999, by the Securities and Exchange Board of India (SEBI) under the Chairmanship of Shri Kumar Mangalam Birla, member SEBI Board, to promote and raise the standards of Corporate Governance. The committee's detailed terms of the reference are as follows:

   1. to suggest suitable amendments to the listing agreement 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;

   2. to draft a code of corporate best practices; and

   3. to suggest safeguards to be instituted within the companies to deal with insider information and insider trading

9. A number of reports and codes on the subject have already been published internationally - notable among them are the Report of the Cadbury Committee, the Report of the Greenbury Committee, the Combined Code, the OECD Code on Corporate Governance, The Blue Ribbon Committee on Corporate Governance in the US. In India, the CII has published a Code of Corporate Governance. While the Committee drew on these documents, to the extent appropriate in preparing this report, the primary objective of the committee has been to view corporate governance from the perspective of the investors and shareholders. The Committee also took note of the various steps already taken by SEBI for strengthening corporate governance, some of which are:

   • strengthening of disclosure norms for Initial Public Offers following the recommendations of the Committee set up by SEBI under the Chairmanship of Shri Y H Malegam;

   • providing information in director's report for utilisation of funds and variation between projected and actual use of funds according to the requirements of the Companies Act; inclusion of cash flow and funds flow statement in annual reports

   • declaration of quarterly results;

   • mandatory appointment of compliance officer for monitoring the share transfer process and ensuring compliance with various rules and regulations;

   • timely disclosure of material and price sensitive information including details of all material events having a bearing on the performance of the company;

   • despatch of one copy of complete balance sheet to every household and abridged balance sheet to all shareholders;

   • issue of regulations providing for a fair and transparent framework for takeovers and substantial acquisitions.

10. At the first meeting of the Committee the three key constituents of corporate governance were identified as the Shareholders, the Board of Directors and the Management. The board of directors is responsible for the governance of the company. They steward the company, set its strategic aim, the financial policy and oversee the implementation and the financial controls and report the activities and the progress of the company to the shareholders to whom they are accountable. The board's actions are subject to applicable laws, rules and regulations. The shareholders' role in governance is to appoint the directors and the auditors and to satisfy themselves that an appropriate governance structure is in place. The responsibilities of the management include ensuring that control systems are in place to achieve the objectives laid down by the board, and to help the board discharge its responsibilities to the shareholders.

11. The Committee felt that it would be necessary to identify and define the rights, roles, responsibilities and accountability of each of these constituents. Accordingly, three sub groups were formed to look more closely at each of these constituencies. Each of these sub groups was required to examine the existing situation, and the provisions of the existing laws, rules and regulations; define the desired situation; and make recommendations to the Committee to achieve the desired situation.

12. Another sub group was formed to deal with issues related to insider information and insider trading, which will give its report separately

13. Financial reporting and disclosure which are also related to the accounting policies of a company and the existing accounting standards and auditing practices, are corner stones of corporate governance. A separate Committee appointed by the SEBI under the Chairmanship of Shri Y H Malegam (who is also a member of this Committee) has been examining these issues in association with the Institute of Chartered Accountants of India. The Committee on Corporate Governance also considered the following critical issues having a bearing on the quality of financial reporting:

    • Consolidation of Accounts of subsidiaries

    • Segment reporting where a company has multiple lines of business

    • and treatment of related party transactions

    • Treatment of deferred taxation

The scope of the recommendations made by the Committee is discussed in Annexure-4