Corporate Governance

A declaration, section 149(7). He must declare that he meets those criteria at the first Board meeting he attends, at the first meeting of every financial year, and whenever the circumstances change.

A code, section 149(8) and Schedule IV. The company and the independent directors must abide by the Code for Independent Directors, which requires him to insist that unresolved concerns are recorded in the minutes, to satisfy himself on related party transactions, to ensure a functional vigil mechanism, and to meet once a financial year without management present to review the performance of the other directors and the Chairperson and the flow of information from management.

A fixed term, section 149(10) and (11). Five years, renewable once by special resolution, then three years out with no association in any capacity.

No stock options, section 149(9), because a personal stake in the share price is exactly the interest independence excludes.

A narrowed liability, section 149(12), without which nobody worth having would accept the office.

And the small shareholders' director, section 151, by which a listed company may have one director elected by holders of shares of nominal value not more than twenty thousand rupees.

The second device: committees

The Audit Committee, section 177. At least three directors with independent directors in a majority, and a majority including the Chairperson able to read and understand a financial statement. Its written terms of reference must include recommending the appointment and remuneration of auditors, monitoring their independence and the effectiveness of the audit, examining the financial statement and the auditors' report, approving related party transactions, scrutinising inter-corporate loans and investments, valuation, evaluating internal financial controls and risk management, and monitoring the end use of funds raised through public offers. It may investigate, take outside professional advice and demand full access to records; the auditors and key managerial personnel may be heard but not vote; and where the Board does not accept its recommendation, the Board's report must say so with reasons.

The vigil mechanism, section 177(9) and (10). Every listed company and prescribed classes must give directors and employees a channel to report genuine concerns, with safeguards against victimisation and direct access to the Audit Committee's chairperson.

The Nomination and Remuneration Committee, section 178(1) to (4). Three or more non-executive directors, not less than half independent, the company's chairperson able to be a member but not to chair. It identifies who should be a director or in senior management, specifies the manner of performance evaluation of the Board, its committees and individual directors, and recommends a remuneration policy balancing fixed and incentive pay against performance benchmarks.

The Stakeholders Relationship Committee, section 178(5) and (6), where there are more than one thousand security holders, to consider and resolve their grievances.

And the Corporate Social Responsibility Committee, section 135, for companies above the thresholds, unless the amount to be spent is not more than fifty lakh rupees, when the Board itself does the work.

The third device: the Board's report

Section 134(3) requires the Board's report attached to the financial statements to include, among other things:

• (a) the web address where the annual return under section 92(3) has been placed;
• (b) the number of meetings of the Board;
• (c) the Directors' Responsibility Statement;
• (ca) details of frauds reported by auditors under section 143(12) other than those reportable to the Central Government;
• (d) a statement on the declaration of independence given by independent directors;
• (e) for a company covered by section 178(1), the policy on directors' appointment and remuneration, including the criteria for qualifications, positive attributes and independence;
• (f) explanations or comments by the Board on every qualification, reservation, adverse remark or disclaimer made by the auditor and by the company secretary in practice in his secretarial audit report;
• (g) particulars of loans, guarantees or investments under section 186;
• (h) particulars of related party contracts under section 188;
• (i) to (l) the state of the company's affairs, amounts carried to reserves, the dividend recommended, and material changes and commitments affecting the financial position between the end of the financial year and the date of the report;
• (m) conservation of energy, technology absorption, and foreign exchange earnings and outgo;
• (n) the development and implementation of a risk management policy, identifying elements of risk which in the Board's opinion may threaten the existence of the company;
• (o) the corporate social responsibility policy and the initiatives taken;
• (p) for a listed company and prescribed public companies, the manner of the formal annual evaluation of the performance of the Board, its committees and individual directors; and
• (q) such other matters as may be prescribed.

Two provisos ease the burden. Disclosures already in the financial statements are referred to rather than repeated; and where the policy under clause (e) or (o) is on the website, it is enough to give the salient features and the web address.

Section 134(3A) allows the Central Government to prescribe an abridged Board's report for a One Person Company or a small company, and section 134(4) reduces the report of a One Person Company to the explanations on the auditor's qualifications.

The Directors' Responsibility Statement: section 134(5)

The Directors' Responsibility Statement shall state that:

• (a) in preparing the annual accounts, the applicable accounting standards had been followed with proper explanation of material departures;
• (b) the directors had selected accounting policies and applied them consistently, and made judgments and estimates that are reasonable and prudent, so as to give a true and fair view of the state of affairs at the end of the financial year and of the profit and loss for the period;
• (c) the directors had taken proper and sufficient care for the maintenance of adequate accounting records in accordance with the Act, for safeguarding the assets and for preventing and detecting fraud and other irregularities;
• (d) the directors had prepared the annual accounts on a going concern basis;
• (e) in the case of a listed company, the directors had laid down internal financial controls and that they are adequate and were operating effectively; and
• (f) the directors had devised proper systems to ensure compliance with all applicable laws and that those systems were adequate and operating effectively.

The Explanation defines internal financial controls as the policies and procedures for the orderly and efficient conduct of the business, including adherence to the company's policies, safeguarding of assets, prevention and detection of frauds and errors, accuracy and completeness of accounting records, and timely preparation of reliable financial information.

Learn clause (f) as well as the others. Compliance with all applicable laws, not merely the Companies Act, is something the directors state in their own names.

The fourth device: independent verification

The statutory audit, section 143. The auditor reports to the members on the accounts, and under section 197(16) he must also state whether the remuneration paid to the directors is in accordance with section 197 and whether any director's remuneration exceeds the limit. Under section 143(12) he must report frauds, and those not reportable to the Central Government come into the Board's report under section 134(3)(ca).

The secretarial audit, section 204. Every listed company and prescribed classes must annex to the Board's report a secretarial audit report by a company secretary in practice; the company must give all assistance and facilities; and the Board must explain in full any qualification, observation or other remarks.

And the audit committee's oversight of both, under section 177(4)(i) and (ii).

Controlling what management is paid: section 197

The ceilings. Eleven per cent of net profits to all directors and the manager; five per cent to any one managing or whole-time director or manager; ten per cent to all of them together; one per cent to the other directors where there is such an executive and three per cent where there is not.

Who decides. The members, by resolution or special resolution as the case requires; and since 12 September 2018 the Central Government has no part in it. Where the company has defaulted to a bank, public financial institution, debenture holders or other secured creditor, that creditor's prior approval comes first.

Transparency. A listed company must disclose in the Board's report the ratio of each director's remuneration to the median employee's remuneration: section 197(12).

And recovery. Excess drawn must be refunded within two years and is held in trust meanwhile (section 197(9)); and on a restatement of accounts due to fraud or non-compliance, the company shall recover the excess, including stock options, from past or present managerial personnel (section 199).

A worked example

Kopar Khairane Pharma Limited is a listed public company with a Board of twelve, four of them independent, and three thousand shareholders.

Composition. One third of twelve is four, so four independent directors satisfy section 149(4). Each gives the declaration under section 149(7) at the first Board meeting of the financial year. The company may, being listed, also have a small shareholders' director under section 151.

Committees. It constitutes an Audit Committee of three independent directors and one whole-time director, an independent chartered accountant chairing it, satisfying both the independent majority and the financial literacy requirements; a Nomination and Remuneration Committee of four non-executive directors, two of them independent, chaired by an independent director though the company's non-executive chairperson is a member; and, having more than one thousand security holders, a Stakeholders Relationship Committee with a non-executive chairperson.

The vigil mechanism. A junior quality officer reports, through the mechanism, that batch records were altered. He has direct access to the chairperson of the Audit Committee and safeguards against victimisation: section 177(10).

Investigation. The Audit Committee investigates, takes outside professional advice and demands full access to the records: section 177(6). It recommends that the head of quality be suspended and that the matter be reported. The Board disagrees. It may do so, but the Board's report must disclose that the recommendation was not accepted, with reasons: section 177(8).

The auditors. The statutory auditor qualifies his report on the valuation of inventory, and the company secretary in practice qualifies his secretarial audit report on the late filing of two returns. Under section 134(3)(f) and section 204(3) the Board must explain both in full in its report. The auditor also reports a fraud under section 143(12) which is not reportable to the Central Government, and the details go into the report under clause (ca).

The report. It states the web address of the annual return, the number of Board meetings, the Directors' Responsibility Statement, the independent directors' declaration, the remuneration policy with the criteria for qualifications, positive attributes and independence, the section 186 loans and investments, the section 188 related party contracts, the state of affairs, reserves and recommended dividend, material changes since the year end, energy, technology and foreign exchange, the risk management policy and the risks that may threaten the company's existence, the corporate social responsibility policy and initiatives, and the manner of the annual evaluation of the Board, its committees and individual directors.

The Responsibility Statement. The directors state that the accounting standards were followed with explanation of material departures, that policies were applied consistently and estimates were reasonable and prudent so as to give a true and fair view, that proper and sufficient care was taken for adequate accounting records, safeguarding assets and preventing and detecting fraud, that the accounts were on a going concern basis, that, the company being listed, internal financial controls were laid down and are adequate and operating effectively, and that systems to ensure compliance with all applicable laws were devised and are adequate and operating effectively: section 134(5).

Remuneration. The managing director's pay is six per cent of net profits, which crosses the five per cent inner limit, so a special resolution is required. The company has defaulted on a term loan, so the bank's prior approval must be obtained before the members' approval: third proviso to section 197(1). The Board's report gives the ratio of each director's remuneration to the median employee's remuneration: section 197(12).

A restatement. Two years later the accounts for this year are re-stated because of the fraud. The company shall recover from the managing director, past or present, the remuneration including any stock option in excess of what the restated figures would have supported: section 199.

The evaluation. The Nomination and Remuneration Committee specifies the manner in which the performance of the Board, its committees and individual directors is evaluated, and the independent directors meet once in the financial year without management to review the performance of the non-independent directors, the Board as a whole and the Chairperson, and the flow of information from management: section 178(2) and Schedule IV paragraph VII.

Distinctions that carry marks

What this does NOT mean

It does not mean corporate governance is one section. There is none; it is the combined working of sections 134, 149, 151, 166, 177, 178, 135, 143, 197, 199 and 204 and Schedule IV.

It does not mean the Board must accept its committees' advice. It may refuse, but the Board's report must disclose the refusal with reasons.

It does not mean the Responsibility Statement is about accounts alone. Clause (f) covers compliance with all applicable laws, and clause (e) internal financial controls in a listed company.

It does not mean disclosure must be repeated. Where a disclosure is already in the financial statements it is referred to, and a policy on the website may be given by its salient features and web address.

It does not mean an audit protects the directors. Section 205(2) preserves the duties of the Board, the chairperson, the managing director and any whole-time director notwithstanding the secretarial audit.

Quick revision

• Composition: one third independent directors in a listed public company, fractions rounded up; independence defined objectively in section 149(6); annual declarations under 149(7); Schedule IV code, including the separate meeting and the right to have concerns recorded in the minutes; five year terms, twice, then three years out; no stock options; narrowed liability under 149(12); and a small shareholders' director under section 151.
• Committees: Audit Committee with an independent majority and financial literacy including the Chairperson, eight terms of reference, powers to investigate, take outside advice and access all records, the auditors and KMP heard but not voting, and disclosure of any recommendation not accepted with reasons; the vigil mechanism with safeguards against victimisation and direct access to its chairperson; the Nomination and Remuneration Committee of non-executive directors, half independent, fixing the evaluation manner and the remuneration policy; the Stakeholders Relationship Committee above one thousand security holders; and the CSR Committee under section 135.
• Disclosure: section 134(3), seventeen matters including the annual return's web address, number of Board meetings, the Directors' Responsibility Statement, frauds reported under section 143(12), the independence declarations, the remuneration policy, explanations of every qualification by the auditor and the secretarial auditor, section 186 loans and section 188 related party contracts, the state of affairs, reserves, dividend and material changes, energy, technology and foreign exchange, the risk management policy, the CSR policy and initiatives, and the annual performance evaluation; with cross-reference instead of repetition and website plus salient features for policies.
• Section 134(5): accounting standards with explanation of material departures; consistent policies and prudent estimates giving a true and fair view; proper and sufficient care for records, safeguarding assets and preventing and detecting fraud; a going concern basis; for a listed company, adequate and effective internal financial controls; and systems for compliance with all applicable laws.
• Verification and restraint: section 143 statutory audit and the auditor's statement under section 197(16); section 204 secretarial audit by a company secretary in practice with the Board explaining qualifications in full; section 197 ceilings of eleven, five, ten, one and three per cent, the members deciding and a defaulting company's lender approving first; section 197(12) the pay ratio; section 197(9) refund of excess held in trust; and section 199 mandatory recovery on a restatement due to fraud or non-compliance.

Test yourself

1. What does the Directors' Responsibility Statement contain? That the applicable accounting standards were followed with proper explanation of material departures; that the directors selected accounting policies and applied them consistently and made reasonable and prudent judgments and estimates so as to give a true and fair view; that they took proper and sufficient care for the maintenance of adequate accounting records, for safeguarding the assets and for preventing and detecting fraud and other irregularities; that the accounts were prepared on a going concern basis; that, in a listed company, internal financial controls were laid down and are adequate and operating effectively; and that proper systems to ensure compliance with all applicable laws were devised and are adequate and operating effectively: section 134(5).

2. Name five matters the Board's report must contain. Any five of: the web address of the annual return; the number of Board meetings; the Directors' Responsibility Statement; details of frauds reported by auditors; the independent directors' declaration; the remuneration policy; explanations of every qualification by the auditor and the secretarial auditor; section 186 loans, guarantees and investments; section 188 related party contracts; the state of affairs, reserves and dividend; material changes since the year end; energy, technology and foreign exchange; the risk management policy; the corporate social responsibility policy; and the manner of the annual performance evaluation: section 134(3).

3. How does the Act make independent directors effective rather than ornamental? By an objective test of independence in section 149(6), an annual declaration under section 149(7), a statutory code in Schedule IV giving the right to have unresolved concerns recorded in the minutes and requiring a separate meeting once a financial year without management, a fixed term of five years renewable once, a bar on stock options, a narrowed liability under section 149(12), and a majority on the Audit Committee.

4. What happens when the Board rejects a recommendation of the Audit Committee? The Board's report must disclose that the recommendation was not accepted, together with the reasons: section 177(8).

5. How is managerial remuneration controlled? By the ceilings in section 197(1), eleven per cent overall and five, ten, one and three per cent within it; by requiring the members' approval, and a special resolution to cross the inner limits, with the prior approval of a lender to whom the company has defaulted; by the pay ratio disclosure for a listed company under section 197(12); by the duty to refund excess within two years, holding it in trust meanwhile, under section 197(9); and by the mandatory recovery on a restatement of accounts under section 199.

6. Which two audits does the Act require, and what must the Board do about their qualifications? The statutory audit of the accounts under section 143, and the secretarial audit of compliance by a company secretary in practice under section 204. The Board must explain in full every qualification, reservation, adverse remark or disclaimer by the auditor and by the secretarial auditor: sections 134(3)(f) and 204(3).