Dear Reader,

This reading material consists of a total of 52 pages and is to the best of my knowledge
sufficient. Also the reference for the material is Taxman, the handouts, slides and other
typed material, Khan and Jain and my class notes. Please ask Ankita, Janhavi and Geetan
incase any doubt arises as regards Corporate Governance or Geetan incase you want to
know something in Financial Management. You may still want to refer to any other
material (I’m still a little unsure as to which one must be used). Happy Reading & Best of
Luck!

Regards,
Ankita, Janhavi and Geetan

CORPORATE GOVERNANCE AND FINANCE

Unit II- Corporate Governance- agency theory notebook

CORPORATE GOVERNANCE: AN INTRODUCTION

CONCEPT:
1. Refers to an economic, legal and institutional environment that allows companies
to diversify, grow, restructure and exit and do everything necessary to maximise
shareholder value
2. Governance deals with laws, procedures, practices and implicit rules that
determine a company’s ability to take informed managerial decisions.
3. Milton Friedman defines corporate governance as “the conduct of business in
accordance with shareholder’s desires, which generally is to make as much money
as possible while conforming to the basic rules of society embodied in law and
local customs”. This is CG in the narrowest sense.
4. Simplest and most common definition of CG is given by the Cadbury report is “
CG is the system by which businesses are directed and controlled”
5. OECD principles: “CG... Involves a set of relationships between a company’s
mgmt, its board, its shareholders and other stakeholders. CG also provides the
structure through which the objectives of the company are set, and the means of
attaining those objectives and monitoring performance are determined.”
6. CG represents the moral, ethical and value frameworks within which a company
takes decisions.

FEATURES:
1. There is no unique structure of CG in the developed world nor is one particular
type better than others.
2. Indian companies, banks and financial institutions can no longer afford to ignore
better corporate practices.
3. CG goes far beyond corporate law, many other aspects are also considered like
quality and frequency of financial and managerial disclosure, commitment to run
company with transparency etc
 4. CG deals with laws, procedures, practices and implicit rules that determine a
company’s ability to take managerial decisions.
5. CG code to have real meaning must first focus on listed companies. However,
unlisted and private companies also need to be brought under the realm of CG
6. There is a diversity of opinion regarding beneficiaries of CG. The Anglo-
American system tends to focus on shareholders and various classes of creditors
7. Irrespective of differences between various forms of CG, all recognise that good
CG practices must at the very least satisfy atleast two sets of claimants: creditors
and shareholders.
8. The key to good CG is a well functioning, informed Board of directors.
NEED:
1. A corporate is a congregation of various stakeholders, namely, customers,
employees, investors, vendor partners, govt and society. A corporate should be
fair and transparent to all its stakeholders.
2. CG is about ethical conduct of a business. Ethical leadership is good for business
as the organisation is seen to conduct their business in line with expectations of all
stakeholders.
3. CG is beyond the realm of law. It deals with conducting business affairs with all
fairness to all stakeholders and actions that benefit greatest number of
shareholders.
4. Corporate need to recognise that their growth requires that cooperation of all the
stakeholders and such cooperation is enhanced by the corporate adhering to the
best CG practices.
5. CG is a key element in improving the economic efficiency of a corporate. Good
CG also helps ensure that corporate take into account the interests of a wide range
of constituencies. Also ensures that their Board is accountable to the shareholders,
help operate for benefit of society
6. Failure to implement good CG can have a heavy cost beyond regulatory
problems.
7. Credibility offered by good CG also helps maintain the confidence of investors
and reduce cost of capital and induce more stable source of financing
8. Often increased attention on CG is due to huge financial crisis. For instance the
Asian financial crisis brought into subject the concept of CG in Asia.
9. CG is a concept, rather than an individual instrument. It includes debate on
appropriate management and control structures of the company.
10. The most common school of thought would have us believe that if mgmt is about
running businesses, governance is about ensuring that it is run properly. All
companies need governance as well as mgmt.
OBJECTIVES OF GOOD CG:
1. To promote a healthy environment for long term investment.
2. To create trust in the corporate and its abilities.
3. To promote business development.
4. To improve efficiency of the capital markets.
5. To enhance the effectiveness in the service of the real economy.
PRINCIPLES:
1. People are more important than processes
 2. Shareholder accountability
3. External audit must be independent and penetrating
4. Disclosure and transparency are crucial to market integrity
5. There must be an appropriate regulatory regime to back these obligations
OECD (organisation for economic co-operation and development):
1. Issued OECD principles of CG in 1999
2. Has become an international benchmark for policy makers, investors and other
stakeholders worldwide.
3. Advanced the CG agenda and provided specific guidance for legislative and
regulatory initiatives of both OECD and Non- OECD countries
4. Financial stability forum has designated the principles as one of the 12 key
standards for sound financial system.
5. Principles offer non-binding standards and good practices as well as guidance on
implementation
6. OECD PRINCIPLES:
i. Ensuring the basis for an effective CG framework
ii. The rights of shareholders and key ownership functions
iii. The equitable treatment of shareholders
iv. The role of stakeholders in CG
v. Disclosure and transparency
vi. The responsibilities of the board

IMPACT:
CG on performance, there are basically 2 models to be looked at:
• Stakeholder’s model
• Shareholder’s model
COMPONENTS:
1. It must include the framework of a strong performance orientation
2. It needs to be incorporate leadership and management imperatives that can lead to
strong financial and strategic performance
3. Financial disclosure is a critical component of effective CG
4. Human resource management is another key component
5. Board of directors is the pillar on which The CG system stands.
ADVANTAGES/ BENEFITS:
Good CG provides
1. A competitive edge in the global market
2. Enables companies to raise capital widely
3. Easily and economically
4. Improves employee morale
5. Generates higher productivity
6. Well governed companies last longer, stand the test of time and changing
environment
EFFECT OF NON-IMPLEMENTATION OF CG:
 1. A school of thought prevails on the cost-benefit analysis, whether the cost of good
governance reforms is too high
2. Failure to implement good governance procedure has a cost beyond mere
regulatory problems
3. Companies suffer a significant risk premium when competing for scarce capital in
today’s public markets

2.1 Introduction

1. Advantages of a company/incorporation are as follows-

(a) It can sue and can be sued in its own name.
(b) Limited liability
(c) Perpetual succession
(d) Common seal
(e) Corporate personality
(f) Large funds may be raised easily
(g) Sharing of risk
(h) Objectives of the Company have to be stated in the MoA and one can’t go beyond the
same. In order to do an act outside the purview of the MoA, the MoA needs to be
amended.
(i) Free transferability of shares.

2. A Company is different from a sole proprietorship and a partnership. Some major

differences are-
(a) A sole proprietorship is a kind of business in which there is a single owner of the
business. In a partnership, there is more than just one owner.
(b)In both these cases, there is no perpetual succession. The death of the sole proprietor
or of the partner leads to the end of the organisation.
(c)Also, these organisations don’t require compulsory registration.
(d) Further, incase of a partnership, the liability of a partner may not be the same as what
he has actually invested, except in case of a limited liability partnership.

3. A very important concept in corporate law is the ‘piercing of the corporate veil’. This
doctrine was established in the case of Solomon v. Solomon. Solomon had a boot
manufacturing business under a sole proprietorship. He later felt that it would be
advantageous to him to form a company and hence distributed a share each amongst his
family members keeping the bulk to himself, so as to satisfy the requirements of English
law which makes it mandatory to have a minimum number of shares to incorporate a
company. His sons and he became the directors of the company. The company had
several creditors, Solomon being one of them. Later the company started doing badly, so
he filed for bankruptcy. Being a secured creditor, Solomon asked for satisfaction of his
claims first. The other creditors instituted a suit for fraud against him. The House of
Lords on the contrary held that the shareholders (including Solomon) have a distinct
personality as compared to the company and thus Solomon was entitled to get his money
back. This case was highly criticized. Hence, incorporation leads to creation of a
corporate veil between the company and the shareholder. Courts need to pierce this veil
and hold persons in default accountable.

4. The different types of companies are as follows-

(a) Public Limited Company
(b) Private Limited Company
(c) S.25 Companies
(d) Joint Stock Companies
(e) Foreign Companies
(f) Companies Limited by shares
(g) Public and Private Companies
(h) Family based Companies
(i) Listed and Unlisted Companies
(j) PSU s

5. Differences between a public and private company-

(a) In a private company, there can be a minimum of 2 members and a maximum of 50
members. In a public company, there can be a minimum of 7 members and there is no
maximum limit as such.
(b) In a private company, there are restrictions on transferability of shares. In a public
company, there are no such restrictions.
(c) In a private company, there is no concept of public issue although investments may be
made by directors, their relatives, etc. In a public company instead, deposits can be
invited from the public.
(d) In a public company, an existing shareholder of the company doesn’t have the pre-
emptive right of purchasing shares of the company unless specified in the AoA. The
existing shareholders of a private company have a pre-emptive right to purchase shares of
the company. This is primarily so that the limit of 50 is not crossed.

6. As per S.111 of the Companies Act, the Directors of a Company have a right to refuse
registration of a person as shareholder/member. This is only in case of a private company
(Amendment of 2000 stated that this provision cannot apply to a public company) as in a
public company there are no restrictions on transferability of shares. This is generally
done as private companies are essentially closed concerns. Also, an increase in the
number of shareholders would lead to crossing the statutory limit of 50.
7. A company is very vaguely defined under the Companies Act. As per the Act, a
company is one which is registered under the Companies Act.
8. There is a difference between winding up and dissociation of a company. Winding up
leads to dissociation and is a long process by itself. Liquidators need to be appointed to
decide about the distribution of assets. Dissociation is when the company actually comes
to an end. Hence, it may take a very long time and this might lead to depreciation in value
of assets, development of new technology, etc.
9. A person can become the director of a maximum of 15 companies.
10. As per the Companies Act, 11% profits must go to the Company.
11. A company is formed in the following manner-
(a) Promoters come up with the idea of forming the company and float the same amongst
others and get consensus.
(b) Permission is sought from the Registrar of Companies.
(c) Once the registrar is satisfied that all requirements have been met, he gives permission
by way of a letter/certificate of incorporation. For public companies, even a letter of
commencement is required from the registrar.
(d) Now shares may be floated, funds may be raised and the company can be started. A
company needs to be compulsorily registered with a stock exchange before it floats its
shares.

12. The basic documents required by the registrar to give permission are the MoA and the
AoA. This is mainly to know about what projects the company would indulge in, sector
in which it is working, financial status, etc.
13. The MoA states the objects of the company and the framework within which it should
work. It must always comply with the Companies Act. An AoA on the other hand
prescribes the internal rules and regulations which govern the company and the conduct
of its members. The AoA must never contain what is not allowed under the MoA. Non-
adherence to the MoA and AoA will attract penalties. It may also lead to repudiation of
contract with the company. If the company doesn’t continuously follow its objective, it
may be wound up (loss of substratum).
14. The MoA must necessarily contain the following 5 clauses-
(a) Name clause- This must state the name of the Company. Such name must not be the
name of another registered company as it leads to ambiguity and may even lead to fraud.
A company cannot also register with a name which has ‘bharat’, ‘national’, ‘hindustan’,
etc. in it. The name of a partnership generally has the name of its partners.
(b) Liability clause- This clause shows the liability of the company which may be limited,
unlimited, guarantee liability (company where directors guarantee to pay more than what
they have put in-check), etc.
(c) Registered office clause- This specifies the name of the company’s registered office
where all the official communications would be sent. Further, the Companies Act
provides that AGM s must be held in a city where the registered office of the company is.
(d) Capital clause- The current financial status of the company need not be depicted as
the promoters and others wouldn’t have collected as many funds. What needs to be
shown is the authorized capital or the amount the company wishes to raise by way of
public issue in the future. For a private company, minimum authorized capital is 1 lakh
while for a public company it is 5 lakhs. The authorized capital is the maximum a
company can collect. It cannot go beyond this no matter how many times shares are
issued. But only a part of the authorized capital is issued to the public at a certain point of
time. This is the issued capital. The entire amount of authorized capital need not be
issued. Out of this, the public may either oversubscribe or undersubscribe shares. This is
the subscribed capital. A company cannot go for allotment of shares unless 90% of its
shares have been subscribed to. Generally, underwriters take up shares to fulfill this
requirement under an underwriters’ agreement. Next is the paid up capital or the amount
actually received by the company from shareholders. Generally the company goes for
calling on shares rather than floating shares when it is in need of funds. The shareholders
owe a debt to the company which needs to be paid back when asked for. If not paid back,
the company may forfeit shares of the shareholder and give it to someone else.
(e) Object clause- This final clause mentions the objects of the company and the
boundaries within which it must work.
14. The MoA is a public document. Once a company is registered, any person from the
general public may approach the registrar of companies to show the MoA on payment of
a certain fees.
15. The MoA is generally drafted flexibly so that it doesn’t require frequent amendments
later on.

2.1.1 Shareholder model and Stakeholders model

1. A share is the smallest indivisible unit of a company. A share may not be further
divided but there may be joint ownership of a share.
2. Generally, shareholders’ interest is given primacy in a company as they are regarded as
the owners and major stakeholders of the Company. The shareholder theory focuses just
on this.
3. On the other hand, there is a stakeholder theory which states that there are other
stakeholders as well to whom the company is responsible and these stakeholders are
equally important as shareholders. The stakeholders in a company include shareholders,
employees (including directors), creditors, suppliers, customers, investors, government,
society, etc.
4. The reasons why these stakeholders associate with the company may be illustrated
with the help of the following table-

Sl. Stakeholder Economic Return Duration Ownership Risk Hedging the

No. risk
1. Shareholder Dividend (only Depends on Intangible Value of Monitoring
when profit shareholder. property. shares might share
generated and Ownership diminish due market,
dividend declared), but no to economic investing in
Price on sale of regulation. recession, lack companies
shares Shareholder of buyers, whose
s give shares political state, health is
to directors etc. good, etc.
in trust.
2. Creditors Priority in payment Generally time Problem of Become a
when company is specified. lesser amounts secured
wound up, being paid creditor,
especially in case of back ascertain
secured creditors. (especially in whether or
Also, when time of limited not the
association with liability company is
company ends, companies) generating
creditors must be when more is profits,
 repaid. invested, charging
incase the higher rates
company goes of interest
bankrupt. and asking
for
periodical
payments.
3. Directors Paid remuneration. Depends on They have the They must
Also paid sitting whether the risk of act in the
fees for every board
person is a managing the interests of
of directors’ permanent affairs of the the
meeting. (maximum1/3 of company and company
board) or a are the first and its
rotational ones to be various
director held liable in stakeholders
(minimum 2/3 of case of any and not in
board).Rotational default. their own
directors change personal
every AGM interest.
unless
reappointed.
They can have a
maximum term
of 3 years. Incase
of independent
directors, one
term lasts for 3
years and they
have a maximum
of 3 terms.
4. Employees Salary/remuneration No fixed tenure Risk of being Depends on
paid. as such. Depends removed. the sort of
on one’s skills. relationship
Company may maintained
terminate with
employment by company,
giving a 3 employee
month’s notice. skills, etc.
5. Community Employment, Depends on how Environmental Exercise
consumer goods, long a company hazards effective
infrastructure, etc. exists. (Bhopal Gas check on
Tragedy), company by
exploitation of way of
labour (Nike), basic
etc. awareness,
litigation,
 etc. May
stop
purchasing
products.

5. As per the stakeholder theory, incase there is a conflict of interests, interests of certain
stakeholders including shareholders must be sacrificed or moderated to fulfill the basic
demands of other stakeholders.
6. However, the stakeholder theorists greatly underestimate the extent to which
shareholder interests may help in furthering interests of other stakeholders.
7. Milton Friedman once said that ‘social responsibility of business is to maximize
profits’. This is opposed to the stakeholder theory which states that a company owes
responsibility to all its stakeholders on whom it depends. There are several types of
stakeholder theories given, which are as follows-
(a) Ontological Stakeholder theory- This theory is about the fundamental nature and
purpose of a corporation. It says that the very purpose of a firm is to coordinate
stakeholder interests.
(b) Explanatory Stakeholder theory- This theory explains as to how corporations and their
managers actually work taking into consideration stakeholder interests.
(c) Strategic Stakeholder theory- This theory states as to how devoting resources and
attention towards stakeholder interests will lead to positive outcomes.
(d) Stakeholder theory of Branding and Corporate Culture- This theory states that how
paying extra attention to stakeholders improves a company’s branding and adds to its
corporate culture.
(e) Deontic Stakeholder theory- This theory states the legitimate interests and rights and
stakeholders vis-à-vis the duties of corporate management.
(f) Managerial Stakeholder theory- This involves incorporating theories such as human
resource management, leadership, operations research, etc. which helps leaders and
managers realize the benefits of deontic stakeholder theory.
(g) Stakeholder theory of Governance- This theory deals with how stakeholder groups
could control the management.
(h) Regulatory Stakeholder theory- This theory is about how the government must
regulate businesses to protect certain stakeholder rights and interests.
(i) Stakeholder theory of Corporate Law- It deals with how corporate law should be
restructured to reflect principles and practices under the Ontological and Deontic
theories.

8. The deontic theory is particularly related to Corporate Social Responsibility (CSR).

9. The stakeholder theorists firmly believe that all these theories need to be put in place
for a company to work efficiently to serve the interests of stakeholders. For example, if a
moral argument exists that it is the obligation of a company to serve interests of
stakeholders, there exists a responsibility on the government to regulate businesses in a
manner that they cater to such interests. Further, every company must act in a manner as
if there was actually a regulation.
10. Further, corporate law must be brought into the picture to regulate the entire process.
Corporate law is that which defines relationships between owners, the board and
managers. The most basic right of a shareholder in particular is to get information from
managers as regards buying and selling of shares, voting rights with respect to board
membership and basic corporate policies. The primary reason why stakeholder theorists
show an interest in corporate law is because of CSR.
11. However, there are certain implications of the same. Managers who pursue CSR as a
goal may be fired by current shareholders or even by future corporate raiders for not
furthering shareholder interests, the basic goal of every corporation. This is also because
CSR and other stakeholder friendly policies may actually end up depressing share prices
and may fail to maximize profits. Stakeholder friendly approaches may also lead to
several agency problems.
12. This brings us to the principal-agent theory. Here the shareholders are the principal
while the managers are their agents. The principal may use either moral persuasion or
incentives to make its agents work efficiently to further its interests. However, the
interests of the corporation may be profit of the enterprise as a whole but this may be
contrary to the individual interests of persons within the corporation. A clash of interests
between shareholders and managers often leads us to characterize them as being in a
principal-agent relationship.
13. A major problem arises when the agent/manager holds information which is material
to satisfaction of his interests. This leads to a moral hazard when an agent’s action based
on the information he has is only imperfectly visible to the principal. For e.g. managers
may waste resources to further their interests, etc. Another problem relates to a situation
when an agent has some private information prior to entering into relations with the
principal.
14. Such problems may be reduced by way of compensation schemes, removal or threat
of removal, hostile takeover, etc. However, this becomes very difficult to control owing
to the wide disparities in information available to shareholders and managers. Also,
shareholders do not have the time or resources to oversee the management.
15. The problem mainly lies with multitasking. Managers are expected not only to
maximize profits but also to cut costs, project a good corporate image, etc. Sometimes
tasks may be complimentary in the sense that investing efforts in one task would reduce
costs as regards the other tasks. But, this is only an ideal situation. The difficulty arises
incase of substitutes where doing one task would mean neglecting the other or increasing
the costs of the others. A system of ‘dull incentives’ has been suggested to combat the
same so that managers would want to divert atleast some of their energy performing
every task possible.
16. However, providing an incentive becomes difficult when the principal lacks
information necessary to determine how various tasks must be balanced against each
other. If the agent is given discretion with respect to the same, there will be no
accountability.
17. Further, the principals include not only the shareholders but other stakeholders as
well. All such persons would balance tasks in their own way and automatically it would
revert back to the system of dull incentives yet again.
18. There is also the triple bottom line principle which requires the management to
impose social and environmental bottomlines in addition to net income which will in turn
worsen the multitask incentive problem and the existence of multiple principals would
make the situation worse.
19. This is one of the major problems associated with CSR and implementation of the
same by managers. This can be seen from the example of State owned enterprises which
ended up being in heavy losses and debts due to special focus on interests of stakeholders
and CSR. These enterprises where handed over the broad responsibilities of
macroeconomic projects, pursuance of national interest, redistribution, acting as a model
employer and reduction of negative externalities.
20. Managers of such enterprises were not efficient primarily because of lack of proper
incentives. Also, there was no threat of a hostile takeover incase of continuous losses,
mismanagement, etc. There were also several agency problems.
21. Agency problems arise mainly when managers are given multiple tasks and then
asked to do ‘the best they can’. This brings in a sort of vagueness into the system. This
provides managers an opportunity to pursue their own interests. Incase of any losses, the
management can easily say that it is due to losses with respect to a particular task they
were handling and not due to inefficiency. They could easily say that costs increased with
respect to certain activities in order to meet certain other objects.
22. Such problems may be resolved not only by incentive and internal controls but also
by good faith and efforts on the part of the management. Further, the principal may also
specify to the management, the average balance he would like to see as regards the
various objectives. For that the principal must be aware of the profits generated and costs
incurred with respect to various activities.
23. Another problem which may arise is the multiprincipal problem which may lead to
provision of incentives from various principals. When there is a clash between these
incentives, it will lead to confusion in management as to which interest they must cater
to.
24. Managers may also try to play one group against the other strategically to avoid
accountability. The ability of management to leak out information which only they have
to certain stakeholder groups helps them do this.
25. The problem with major stakeholder groups other than trade unions is that they are
generally very poorly organised and hence can’t exercise direct control over the
management. A probable solution may be stakeholder representation on the board. On the
contrary, shareholders are in a better position to control the management.
26. Hence, considerable reforms are required with respect to corporate governance for
CSR in manner by which shareholders’ interests are not neglected as well.

2.1.2 Corporate and Social Responsibility-

1. This is mainly to serve the interests of the community as a stakeholder.

2. It is not a compulsion on the company.
3. This helps develop a positive attitude by people towards the company and it makes
them favour the company while purchasing products, applying for jobs, etc.
4. It also helps companies to get skilled labour from amongst the local population in the
future especially when then establish educational institutions, hospitals, etc.
5. Although, it provides only long term benefits, it instills a sort of confidence amongst
the public at large.
6. However, a company must necessarily incorporate CSR in its MoA. In Lakshman
Swami Mudaliar v. LIC, it was held that if the MoA doesn’t specifically talk about CSR,
the directors of the company would be made responsible for any spending done with
respect to the same.
7. CSR is very closely connected with human rights as can be seen from the case of Nike
who exploited the labour market in 3rd world countries due to lack of stringent labour and
environmental laws. Other examples are those of the carpet weaving business in India
wherein shipments were sent back as the industry employs child labour. Another such
example is that of the fireworks industry.
8. Recently, the Norms on responsibilities of Transnational Corporations and Other
Business Enterprises with regard to Human Rights were approved by the UN Sub-
Commission on Promotion and Protection of Human Rights. These have been submitted
to the UN Commission on Human Rights for approval.
9. Previous examples of human rights violations by companies include Krupp Industrial
firm’s using slave labour in Nazi Germany, IG Farben Industry in Germany using slave
labour for producing poison gas used in concentration camps, forced labour practices
followed by companies in Congo during the civil war, the Bhopal Gas Tragedy (read
handout), etc.
10. Such rights to be protected by companies have been impliedly realized by the UDHR,
ICCPR, International Convention on All Forms of Discrimination against Women,
International Convention on All Forms of Racial Discrimination, etc.
11. Other attempts are guidelines given by the OECD, UN Commission on Transnational
Corporations, ILO, the Global Compact initiated by Kofi Annan, etc.
12. Some of the major problems associated with such norms were non-enforceability, a
very broad view of human rights with respect to companies taken, problems as to whether
the norms should relate to TNC s or other businesses as well, etc.
13. Some NGO s and organisations like Amnesty International, Barclays have been trying
to create awareness and lay down norms with respect to CSR and Human Rights.

2.2 Corporations and need for Good Governance

2.2.1 Good Governance and ethics in Corporations

1. The three main aspects of good governance are transparency, accountability and
fairness.
2. It is generally the board of directors or the auditors who may be made accountable for
acts done.
3. Fairness involves protection against insider trading and protection provided to
investors. Insider trading involves exchange of inside information by employees and
others within the company with outsiders. Such information may then lead to unfair
advantage to outsiders who would deal with shares based on the information provided.
Another component of fairness is equal pay for equal work.
4. Corporate Governance came about somewhere in the late 70s and the 80s. It grew
majorly in the 90s. Every governance mechanism has seen to have developed after some
corporate scam. For e.g. SEBI made new rules after the Harshad Mehta scam.
5. Corporate Governance may have said to have started after the Watergate scandal
wherein there was a lot of political spying which on investigation revealed had been
funded by several corporates. President Nixon resigned after the incident and the Unfair
Trade Practices Act was brought into the picture. Thereafter, companies had to
compulsorily provide accounts about what they were doing with people’s money.
6. In UK as well in the 80s a number of companies went bankrupt and thus the London
Stock Exchange appointed the Cadbury Committee to make recommendations for the
same.
7. The main problem was that huge companies showing large profits collapsed. This
made the public question management practices in such companies. Hence, it affected
public confidence.
8. There are 3 stages in the downfall of a company, namely-
(a) Bad management- This is the first stage when profits start dipping, the confidence of
shareholders and creditors go down, etc. This is an early stage of detection and can be
managed with the help of internal controls. Further, shareholders might still want to stay
with the company.
(b) In the second stage, the profits dip further, shareholders start selling their shares and
moving out, creditors become more conscious and start charging higher rates of interest,
credit rating agencies which rate corporate performance also give bad reviews, there are
negative reviews by the media, etc. At this stage it becomes a little more difficult for the
company to bounce back. If the company still does nothing it goes into the 3rd stage.
(c) In this stage revival is difficult and the company may ask for external help from the
government and its agencies like the BIFR. This also comes under S.424 of the
Companies Act. This is the stage when the company goes in for revival and
rehabilitation. Generally there is a fund for the same wherein all companies contribute
about 1% of their profits.

9. Some important provisions under the Companies Act as regards good governance
include-
(a) S.425- Voluntary winding up of companies or winding up by tribunals. After the 2002
amendment, winding up by courts has been omitted. (check)
(b) S.292A- Audit Committees (new addition after 2002 amendment)
(c) S.192A- Postal Ballot system. It was suggested by the Kumarmangalam Birla
committee that this system be used for AGM s. There is as such no compulsion on
companies to go for the same. In 1997, a working committee was set up to look into this
system. It pointed out certain drawbacks like the problem of the mail reaching within a
certain time period, lesser scope for discussion, etc. Also, since the method of present and
voting is followed in AGM s, the problem is that if the votes don’t come in time, the
actual result may never be ascertained.
(d) S.10- National Company Law Tribunal to decide all disputes in place of the Company
law board. From this tribunal the case would go to the appellate company law tribunal
and finally to the Supreme Court. However, this tribunal has not been set up as its
validity was challenged in the President Bar Association’s case (2004) which is still
pending in the Madras High Court. Hence, the Company law board has been settling
disputes as of now.
(e) S.56- Prospectus which must give a true and fair picture of the company.
(f) S.5- meaning of officer in default.
(g) S.7-interpretation of persons according to whose instructions directors are supposed to
act.
(h) S.12- formation of an incorporated body
(i) S.13-requirements of MoA
(j) S.14- form of MoA
(k) S.15-Printing, signatures of subscribers of MoA. Subscribers automatically become
members of the company as well as directors.
(l) S.16-alteration of MoA
(m) Ss. 26-31-AoA
(n) S.41- member of a company
(o) S.51- service of documents on company. This has to be sent to the registered office
and service of documents on directors is regarded as knowledge of the company if done
during the course of employment.
(p) s.58-experts’ consent to issue prospectus
(q) S.69-allotment of shares
(r) S.71- effect of an irregular allotment. This gives one the right to avoid the contract.
(s) Ss. 165-197-meetings- Includes GM, AGM, BoD meetings, Shareholder meetings,
creditors’ meetings, etc.
S.166- AGM s. There must be atleast 1 AGM every year and the gap between 2
successive AGM s can’t be more than 15 months.
S.174- Quorum. This is required for a valid meeting.
S.171-Notices. The general notice period is 21 days but the same may be changed in the
AoA. Meetings are generally called by directors. But, they can also be called by
Shareholders in which case they must inform the board about the same. If one has 1/10th
of the paid up capital of a company, he may ask the directors to convene a meeting.
(s1) S.205-dividends and their payment
Ss. 209-234- Accounts and Audits-
(t) S.215- authentication done by directors
(u) S.217-Board’s report with respect to financial matters
(v) S.221- disclosures
(w) S.224-remuneration of auditors
S.226- qualifications and disqualifications of auditors
(x) S.227- powers and duties (check)
(y) S.397 and 398-oppression and mismanagement
(z) S.433- winding up by court

10. Generally Shareholders cannot monitor the Company due to reasons mentioned
earlier and also because they are too many in number.
11. Hence, there are provisions for independent directors, audit committees, etc. to
monitor directors and others. However this becomes very difficult especially in family
based companies wherein actually only one person is at the helm of affairs.
12. It has been stated that both control and encouragement with respect to directors is
required. When directors are held accountable it makes them take calculated risks
because of which the business becomes profitable.
13. Generally listed companies must follow corporate governance principles else they
would be delisted. As regards unlisted companies, they can choose what principles they
would want to follow.

2.2.2 Need for Governance in Various forms of Companies

Family Based Companies-

1. Among the most prominent corporations in the world are the ones controlled by large
business families. These firms are passed on to heirs and show signs of dynastic control.
2. A family firm at the apex controls publicly traded firms which then control other
publicly traded firms and so on. At each level of the pyramid, public shareholders
contribute a minority equity stake.
3. In these firms, the managers serve at the pleasure of the family and not the
shareholders.
4. Although the owner of the company at the apex pyramid controls companies in the
lower tiers of the pyramid, its actual investment in such companies is often very less.
Hence, these families can easily control a major part of the corporate sector as they
control assets worth a lot more than their actual wealth.
5. The situation is very different in the US and UK wherein the firms are widely held and
are mainly free standing entities. They are widely held as they have no dominant
shareholder and are free standing because they own stock in no other domestically listed
firm and no other domestically listed firm owns stock in them.
6. One advantage of such family based firms is that they are free from agency based
problems. This is mainly because large shareholders would rarely give a chance to
managers to neglect the firm and deal in mismanagement.
7. However, the major problem is that instead of the managers, it is the controlling family
which can actually end up spending a lot of public funds. This is mainly because such
firms hold shares of other firms in the pyramid as well which are publicly traded.
8. Another problem is that widely held firms are threatened by hostile takeovers which
are not possible when it comes to family based firms. Also, institutional investors cannot
force their representatives on the board where 50% of the votes are held by members of
the family.
9. Further, in such pyramids, there is generally a lot of transfer of funds from firms to the
controlling body. This is done by way of tunneling. (Read handout for exact meaning and
example)
10. However, this effect is weaker in countries where there is better legal protection for
public shareholders and in pyramid firms for outside shareholders. Both law and large
independent shareholders help reduce tunneling.
11. Hence, the contention that family based firms reduced agency problems may be
rebutted as agency problems still exist in firms at the lower levels of the pyramid. Also,
the controlling firm cannot be easily ousted and also due to tunneling.
12. An argument in favour of such firms is that the controlling family is able to monitor
the activities of the firm more efficiently as compared to public shareholders. However it
has also been observed that such concerns avoided risks and curtailed expansion.
13. Another argument presented in favour of these companies is that due to family
relationships, the directors are closer and hence there is smooth functioning of the
company’s activities. This however has been contradicted by the fact that most family
based companies have a lot of in-fighting going on as in case of Reliance.
14. It has been seen that in economies where there is poverty, illiteracy, corruption, etc.
such firms work the best. It has been said that in such systems pyramid group firms
provide capital and labour to each other. They also buy and sell goods amongst
themselves.
15. However a problem associated with this is that physical capital is often over used and
more productive applications outside the organisation are neglected. The more the capital
is efficiently allocated within the firm, the more misallocation of capital is there in the
economy.
16. Also, firms like these exist in corrupt nations as they have close connections with
politicians and are more likely to return political favours by using the public’s money.
17. Such families do not like the entry of professional managers who they feel cannot be
trusted and only work to further their self interest. They are generally allowed into the
firm through marriages.
18. Generally a well developed legal and regulatory system would want the families to
sell out or allow outsiders into the firm so that greater control may be exercised.
19. A reason why in some countries control pyramids do not exist may be their taxation
system as in case of the US wherein a tax is imposed at every level of the pyramid
thereby discouraging such organisations. Also, in the US, the Public Utilities Holding
Companies Act banned pyramiding outright among public utility firms.
20. Another way is by levying an inheritance tax as has been done in Canada in the
1970s.
21. It has also been pointed out that in economies where there are control pyramids, the
politics is mainly socio-democratic. While in countries where firms are widely held,
liberal politics thrives.
22. Another way in which such firms may be controlled is by introducing competition by
way of liberalisation and globalisation.
23. Inspite of the existence of such firms in countries like Hong Kong, controls have been
exercised and the economic crisis of the 90s was combated because of a strong banking
system and equity markets.

CORPORATE GOVERNANCE IN UNLISTED COMPANIES

CG CODE FOR UNLISTED COS
1. Unlisted companies are a significant part of the corporate world in India.
2. A number of Indian groups have deliberately moved into the unlisted sector,
attracted by less onerous reporting and other requirements and presumably not
deterred by potentially lower access to capital.
3. While a strong corporate governance framework is in place for listed companies,
there is a need for enhancing the focus on unlisted companies to strengthen the
overall system.
4. Accordingly, it is recommended that a separate corporate governance code for
unlisted companies may be brought out under the Companies Act by the Ministry
of Corporate Affairs, which takes into account the interests of stakeholders in
such companies.
5. Unlisted companies can voluntarily evolve and adopt a code of corporate
governance.
6. Trade and industry associations such as the CII, FICCI and ASSOCHAM can
play an important role in this regard. The Ministry can also consider mandating,
in respect of unlisted companies above a particular size, compliance with
applicable provisions of Clause 49 of the Listing Agreement.
7. The role and responsibilities of the Ministry of Corporate Affairs may be
crystallised in the Companies Act itself, especially in the case of mergers and
amalgamations.
8. The committee pointed that the quality of corporate governance in Indian
companies would be a key determinant in affecting their ability to attract capital,
business, global partners and quality manpower.

NEED FOR CORPORATE GOVENANCE IN UNLISTED COMPANIES:

1. Therefore the need to consider the relevance of OECD principles of
Corporate Governance in where non listed and often family / founder owned
companies play a pivotal economic & social role.
2. When unlisted companies go in search of external capital like venture capital
they face many challenges. Banks and financial institutions should consider
improving their monitoring of CG in non listed companies.
3. the controlling shareholder may use his position to deprive the non
controlling shareholder of influence over major decision and / or
significant distribution of business earnings. In the absence of the above
external mechanism an alternate framework is needed to improve the
performance of unlisted companies.
4. The composition & role of management on Boards of unlisted
companies is of significance. Corporate Governance problems could be
minimised by appointment of competent rather than independent
professional outside Directors.
5. There is need to build up know how on Corporate Governance in the courts.
6. Giving non-controlling shareholders full and timely access to
information enhances the governance of both listed and unlisted companies.
7. The controlling shareholders close levels of monitoring and cheaper
intervention in the event of management failure, seem to entail better
performance in non listed companies.
8. The financing structure of non listed companies can bring benefits
9. Protecting non minority interest(like non controlling shareholders) from
exploitation by controlling shareholders
10. A proper legal framework can induce desired manager and shareholder
 behaviour.
DEVELOPMENTS IN INDIA:
The Indian Govt plans new guidelines to bring unlisted PSUs under corporate governance
ambit:
1. New Delhi, Oct 24: Underlining the need to bring in more accountability and
professionalism into public sector enterprises (PSEs), the government is set to
chalk out new guidelines for corporate governance for unlisted PSUs.
2. At present, only listed PSUs are mandated to adhere to Securities and Exchange
Board of India’s (Sebi) corporate governance guidelines. The final guidelines are
likely to be ready in the next few months.
3. The Department of Public Enterprises (DPE) is working out guidelines in
consultation with the Standing Committee of Public Enterprises (SCOPE).
4. The present DPE guidelines for unlisted companies state that at least one-third of
the directors on a PSU board should be ‘independent directors’. According to
official sources, most of these posts lie vacant in a large number of PSUs.
5. Increasing the number of independent directors on PSE boards will facilitate more
competence and transparency in their functioning.
6. According to sources, out of a total of 242 PSEs functional in 2004-05, about 200
are unlisted, implying that a majority of the PSUs are out of the ambit of Sebi’s
guidelines for corporate governance, which stipulate that at least 50% of members
on the board of a listed company should be independent ones.
FICCI IN NEWS
1. Panel calls for constant review of code, March 31, 2009
2. The Committee on Financial Sector Assessment, which released its report on
Monday, suggested several measures to strengthen the corporate governance
practices in the country. The committee was jointly set up by the Government and
the Reserve Bank of India.
3. According to the committee, certain requirements of Clause 49 of the Listing
Agreement were non-mandatory. Given the fact that listed companies are required
to disclose the extent to which the non-mandatory requirements have been
adopted, the listed companies may be required to also disclose the reasons for
non-compliance of non-mandatory requirements.
4. There is a need to strengthen the existing framework with regard to risk
management in listed companies.
5. Need felt for:
i. Transparency
ii. Enforcement mechanism

2.3 International Perspective on Corporate Governance

2.3.1 Corporate Governance Committees in UK

(A) Cadbury Committee Report-

1. This was the first corporate governance committee which defined the term as a system
of policies and principles which control the company.
2. It gave a code of good practices with 19 provisions dealing with board of directors,
independent directors, committees, structure of committees, remuneration of directors,
etc.
3. It was constituted by the London Stock Exchange.
4. It was mainly a ‘comply or explain’ code. Whenever the company filed for annual
returns, they had to submit these forms.
5. The key recommendations include-
(a) The BoD should include atleast 3 outside directors.
(b) Position of chairman and CEO to be held by 2 different individuals.
(c) Full disclosure of payment of chairman and highest paid director.
(d) Shareholders’ approval of executive directors’ contract exceeding 3 years.
(e) Directors should establish a sub-committee of the main board mainly comprised of
outside directors to report on the effectiveness of the company’s system of internal
control including mechanism for risk assessment and management.

Important Info-
THE BOARD OF DIRECTORS
1. The board should meet regularly, retain full and effective control over the
company and monitor the executive management.
2. There should be a clearly accepted division of responsibilities at the head
of a company, which will ensure a balance of power and authority, such that no
one individual has unfettered powers of decision. Where the chairman is also the
chief executive, it is essential that
3. There should be a strong and independent element on the board, with a
recognised senior member.
4. The board should include non-executive directors of sufficient calibre
and number for their views to carry significant weight in the board’s decisions.
5. The board should have a formal schedule of matters specifically reserved
to it for decision to ensure that the direction and control of the company is firmly
in its hands.
6. 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.
7. 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
8. Applicable rules and regulations are complied with. Any question of the
removal of the company secretary should be a matter for the board as a whole. ‘_
NON-EXECUTIVE DIRECTORS
1. Non-executive directors should bring an independent judgement 10 bear
on issues of strategy, performance, resources, including key appointments, and
standards of conduct.
2. The majority should be independent of management and free from any
business or other relationship which could materially interfere with the exercise
 of their independent judgement. apart from their fees and shareholding. Their
fees should reflect the time which they commit to the company.
THE CODE OF BEST PRACTICE
I. Non-executive directors should be appointed for specified terms and
reappointment should not be automatic.
II. Non-executive directors should be selected through a formal process and
both this process and their appointment should be a matter for the board as a
whole.
EXECUTIVE DIRECTORS
i) Directors’ service contracts should not exceed three years without
shareholders’ approval.
ii) There should be full and clear disclosure of directors’ total emoluments
and those of the chairman and highest-paid UK director, including pension
contributions and stock
iii) options.
iv) Separate figures should be given for salary and performance-related
elements and the basis on which performance is measured should be explained.
v) Executive directors’ pay should be subject to the recommendations of a
remuneration committee made up wholly or mainly of non-executive directors.
REPORTING AND CONTROLS
a. It is the board’s duty to present a balanced and understandable
assessment of the company’s position.
b. The board should ensure that an objective and professional relationship is
maintained with the auditors.
c. 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.
d. The directors should explain their responsibility for preparing the
accounts next to a statement by the auditors about their reporting responsibilities.
e. 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.

(B) Greenbury Committee (1995)-

1. This committee looked into the problem related with senior executives getting a major
part of profits as remuneration. This was a matter of concern for investors.
2. Some of the main issues dealt by this committee were-
(a) Role of remuneration committee in setting remuneration packages of CEO s and other
directors.
(b) Required level of disclosure needed by shareholders with respect to remuneration of
directors and whether there is a need to obtain shareholder approval.
(c) Specific guidelines for determining remuneration policy for directors.
(d) Service contracts requiring payment of remuneration to directors in case of removal
for unsatisfactory performance.
3. This committee also recommended the constitution of a remuneration committee
composed of non-executive directors.
4. However, it didn’t gain much acceptance as it didn’t lay down any new policies to be
followed and merely reiterated the Cadbury Committee Report.

(C) Hampel Report (1998)-

1. It focused on increasing the long term value of shareholders.

2. It also focused on preventing abuse of discretionary powers by the Board.
3. It favoured greater involvement of shareholders with the Company.
4. It looked into areas of accountability and audits to be conducted.
5. The board was regarded as an internal control mechanism and hence had to look after
the interests of shareholders.
6. The board was to also look into mismanagement.
7. It didn’t look into aspects of remuneration as it didn’t think that shareholders were
connected with it.

(D) Combined Code (1998)-

1. It mainly focused on consolidating the best provisions under the previous reports.
Another code came out in 2003.
2. It looked into shareholders’ interests as well as the way in which the board must
function.

(E) Myners’ Report-

1. It was given by Paul Myner who was commissioned by the government to look into
factors affecting investment decision making of institutions.
2. It was observed that various problems were created due to unrealistic demands of
pension funds thereby burdening investment consultants.
3. Questions on objectives of fund managers came up.
4. Recommendations were given on decision making and the flexibility with which they
perform their functions.

2.3.2 Corporate Governance Committees in the US

2.3.3 Enron and Post Enron

1. The collapse of Enron happens to be one of the biggest corporate scams in the business
world. It has been said that the auditing firm Andersen couldn’t detect mismanagement
by Enron due to an unconscious bias, organizational flaws and emphasis on marketing
non-audit services to clients for profits. Sherron Smith Watkins had tried to
unsuccessfully blow the whistle on Enron’s aggressive accounting policies.
2. The prime job of an auditor is to compare financial statements of a company with other
notes about the firm’s assets and liabilities during a given period so as to assess whether
the company has presented a fair picture of its financial condition as per accepted
accounting principles. However, this only provides reasonable assurance about the
veracity of the financial statements.
3. It has been observed that even in the most organised audit, fraud may not be as easily
detected as compared to unintentional errors. Thus, investors expect auditors to be a lot
more careful as regards frauds in financial statements and disclosures.
4. A jury convicted Andersen on the charge of obstructing justice. Andersen stated that its
audits failed to require Enron to mention about 2 special purpose entities (SPE) in its
financial statements. At that time, it was required that unrelated parties must own an
investment upto atleast 3% of the fair value of an SPE’s asset in order to avoid
consolidation. Originally, Andersen’s audit team declared that the unrelated parties held
more than 3% of the subsidiary’s residual equity and thereby fulfilling the required
criteria. However, later on Andersen claimed that it had reached such judgment in error
and asked Enron to correct the error. Immediately after Andersen’s conviction, the Wall
Street Journal in an article highlighted inadequate disclosures, questionable transactions
with other SPE s, premature recognition of revenue, etc.
5. The reasons for such an unconscious bias on the part of Andersen were said to be due
to the following reasons-
(a) Ambiguity- Accounting is an art and depends on the degree of skill and
professionalism exercised by the auditor. Also, auditing gives a company numerous
options to choose from.
(b) Attachment- The auditor may give a clean chit to the firm due to present or future
business interests with the firm.
(c) Approval- An audit essentially endorses or rejects the accounting choices that the
client’s management has made.
(d) Familiarity- People are often less willing to harm individuals they know and such
relationships grow with time.
(e) Discounting- This is the human tendency to place more emphasis on the short term
effects of decisions rather than long term effects.
(f) Escalation- Unconscious biases may also make auditors escalate only the minor
mistakes in the client’s financial statements. Atleast on 4 occasions Andersen allowed
Enron to hide debt and inflate earnings.

6. When fees for non-audit services amount to a large part of earnings from the firm, the
audit firms tends to have bias towards the firm in order to save its business.
7. The Sarbanes-Oxley Act which came up subsequently after this scam consists of the
following provisions to solve such problems-
(a) S.301- Required SEC to prescribe rules asking securities’ exchanges and securities’
associations to prohibit listing of companies which don’t have an audit committee
consisting primarily of independent directors in place. Such a committee has the power of
hiring, firing and compensating the company’s auditors. This committee has been
instituted in most publicly traded companies.
(b) S. 201- It lists several services as ‘prohibited services’ and out of the scope of audit
firms such as bookkeeping services, financial information systems design, management
or human resource services, etc. The auditor may however render tax services to the
client.
(c) S.202- This section requires the audit committee to review all audit and non-audit
services.
(d) S.203- Most accounting firms cannot perform audit services for a publicly traded
company, if the lead audit partner or reviewing audit partner has performed audit services
for the company in its last 5 fiscal years.
(e) S.206- It prohibits an audit firm from auditing accounts of a firm which has employed
such a person to a high level position who had served in the audit team in the past year.
Thus, a year of ‘cooling-off’ has been suggested by the SEC.
(f) The rules also require the rotation of the lead and concurring partners on an audit team
every 5 years.
(g) The Act also creates the Public Company Accounting Oversight Board (PCAOB) to
register, regulate and inspect public accounting firms that audit publicly traded
companies. S.102 requires such companies to register with the PCAOB and each
application must contain a statement of the firm’s quality control policies for its
accounting and auditing practices. The PCAOB may also conduct investigation or
disciplinary proceedings when required.
(h) S.207- It directs the Comptroller General to study the effects arising from the limits
on an audit firm’s association with a company and submit such reports to Congressional
committees within a year from the commencement of the Act.
(i) This Act doesn’t apply to closely held firms or non-profit organisations.

2.4 Corporate Governance in India

2.4.1 Various codes and Corporate Governance Committee reports in India

(A) Kumarmangalam Birla Committee Report-

1. The BoD must consist of atleast 50% non-executive directors. If the chairman is a non-
executive director, the board must consist of atleast 1/3rd independent directors but if the
chairman is an executive director, the board must consist of atleast 1/2 independent
directors.
2. An independent audit committee must be set up by the board.
3. The board should set up a remuneration committee to determine the company’s policy
on specific remuneration packages for executive directors.
4. The board should set up a committee under the chairmanship of a non-executive or
independent director to look into shareholders’ issues.
5. The board should delegate share transfer responsibilities to an officer or committee or
to the registrar and share transfer agents who must look into the same atleast once every
fortnight.
6. The Corporate Governance section of the Annual Report should contain details of
every form of remuneration paid to the directors including salary, incentives, etc.
7. Board meetings must be held atleast 4 times a year with a maximum gap of 4 months
between 2 successive meetings. All information recommended by the SEBI committee
must be placed before the board.
8. The Directors’ Report, Management Discussion and Analysis Report must all form
part of the annual report to shareholders.
9. All company related information like quarterly results and presentations made by the
company to analysts must be put on the official website.
10. A special section must be dedicated to Corporate Governance in the Annual report
with details of the level of compliance achieved by the Company. This must highlight
non-compliance with any mandatory requirements and extent upto which non-mandatory
requirements have been adopted.
11. The non-executive chairman must be allowed to keep an office at the company’s
expense and be reimbursed for expenses incurred in performing his duties.
12. No director should be a member of more than 10 committees and chairman of more
than 5 committees across all companies of which he is a director. All directors must
disclose to a company about their membership of committees of other companies.
13. Disclosures to be made by the management to the Board as regards all material,
financial and commercial transactions which includes dealing in company shares,
commercial dealings with bodies that have shareholders, etc.
14. The half yearly declaration of financial performance shall be sent to each shareholder.
15. Financial institutions as such must not influence the decision of the board or nominate
any members to the board. However, this is allowed in case of term lending associations
in order to protect the interests of creditors.
16. A certificate from auditors on compliance should form part of the Annual report and
Annual return. A copy of the same must be sent to the Stock Exchanges.
17. This committee was set up under SEBI.

Extra- SEBI had constituted a Committee on Corporate Governance under the

Chairmanship of Shri Kumar Mangalam Birla, Member, SEBI Board to promote and
raise the standard of Corporate Governance in respect of listed companies.
The SEBI Board in its meeting held on January 25, 2000 considered the recommendation
of the Committee and decided to make the amendments to the listing agreement in
pursuance of the decision of the Board, it is advised that a new clause, namely clause 49,
be incorporate in the listing agreement

(B) Confederation of Indian Industry (CII) Report (1996)

1. The full board must meet atleast 6 times a year with an interval of 2 months between
each meeting.
2. A listed company with a turnover of Rs. 1 billion must consist of competent and
independent non-executive directors who must form 30% of the board if the chairman is a
non-executive director and 50% of the board incase the chairman is an executive director.
3. No single person should hold directorships in more than 10 companies.
4. Non-executive directors must play an active role and must have defined tasks.
5. The non-executive directors must get a commission of 1% of the net profits incase
there is an MD or 3% incase there is no MD. They must also be offered stock options.
6. While reappointing members, the resolution being put to vote must specifically
mention instances when directors were absent for half or more than half of the meetings.
7. The following information must be placed before the board- (only 5 mentioned)
(a) Annual operating plans and budgets.
(b) Capital budgets, manpower and overhead budgets.
(c) Quarterly results for the company as a whole or its various business segments.
(d) Internal audit reports including material cases of theft and dishonesty.
(e) Details of any joint venture or collaboration agreement.

8. Listed companies which have a turnover of 1 billion or a paid up capital of 200 million
must set up audit committees consisting of atleast 3 members all drawn up from the
company’s non-executive directors who are financially literate within 2 years.
9. Audit committees must assist the board in its task related to corporate accounting and
provide effective supervision of the financial reporting process.
10. The audit committee must interact with statutory and internal auditors to ascertain the
quality of the company’s accounts as well as the capability of the auditors themselves.
11. The management must ensure that the committee has full access to the financial data
of the company, its subsidiaries and associated companies.
12. Listed companies must provide information about high and low monthly averages of
share prices in a major stock exchange where the company was listed in the reporting
year.
13. Major Indian companies must ensure that their company issues a compliance
certificate signed by the CEO and CFO which must clearly state that the company has
presented a fair picture in the financial statement and annual report.
14. For all companies with a paid up capital of 200 million or more, the quality and
quantity of disclosure that accompanied a GDR issue must be the norm for any domestic
issue.
15. Government must allow more funding towards the corporate sector against the
security of shares and other paper.
16. Financial institutions as creditors must not have nominee directors on the company
except in case of serious debt defaults.
17. If any company went to more than 1 credit rating agencies, it must declare the rating
given by all of them in its prospectus and issue document.
18. Companies making foreign debt issues cannot have exhaustive disclosure norms for
foreign entities and a miniscule one for the Indian entities.
19. Companies which defaulted on fixed deposits must not be allowed to accept further
deposits and make inter corporate loans or investments until the default is made good.
20. Financial institutions must take a policy decision to withdraw from boards of
companies in which their individual shareholding was 5% or less or where their total
holdings was under 10%.
21. This report didn’t have any legal backing and hence lacked enforceability.

(C) Naresh Chandra Committee Report-

1. Non-executive directors must be exempted from various civil and criminal liabilities.
2. There must be not less than 50% of independent directors and they must be made
responsible.
3. If the board consisted of 7 members, atleast 4 must be independent directors.

MANDATORY RECOMMENDATIONS
1. Disclosure of Contingent Liabilities
2. Management should provide a clear description in plain English of each
material contingent liability and its risks, which should be accompanied by the
auditor’s clearly worded comments on the management’s view. This section
should be highlighted in the significant accounting policies and notes on
accounts, as well as, in the auditor’s report, where necessary.
3. This is important because investors and shareholders should obtain a clear view of
a company’s contingent liabilities as these may be significant risk factors
that could adversely affect the company’s future financial condition and results of
operations.
4. For all listed companies, there should be a certification by the CEO (either
the Executive Chairman or the Managing Director) and the CFO (whole-time
Finance Director or other person discharging this function) which should state
that, to the best of their knowledge and belief: They have reviewed the balance
sheet and profit and loss account and all its schedules and notes on accounts, as
well as the cash flow statements and the Directors’ Report; These statements do
not contain any material untrue statement or omit any material fact nor do they
contain statements that might be misleading; These statements together present
a true and fair view of the company, and are in compliance with the existing
accounting standards and / or applicable laws / regulations;
5. They are responsible for establishing and maintaining internal controls and
have evaluated the effectiveness of internal control systems of the company; and
they have also disclosed to the auditors and the Audit Committee, deficiencies in
the design or operation of internal controls, if any, and what they have done or
propose to do to rectify these;
6. They have also disclosed to the auditors as well as the Audit Committee,
instances of significant fraud, if any, that involves management or employees
having a significant role in the company’s internal control systems; and
7. They have indicated to the auditors, the Audit Committee and in the notes on
accounts, whether or not there were significant changes in internal control and / or
of accounting policies during the year.
8. All audit committee members shall be non-executive directors

The Committee makes the following recommendation:

1. Legal provisions must specifically exempt non-executive and independent
directors from criminal and civil liabilities under certain circumstances.
SEBI should recommend that such exemptions need to be specifically spelt out
for the relevant laws by the relevant departments of the Government and
independent regulators, as the case may be.
2. However, independent directors should periodically review legal compliance
reports prepared by the company as well as steps taken by the company to cure
 any taint. In the event of any proceedings against an independent director in
connection with the affairs of the company, defence should not be permitted
on the ground that the independent director was unaware of this responsibility.

(D) NARAYAN MURTHY REPORT (2003)

Mandatory recommendation
1. Audit committees of publicly listed companies should be required to review
the following information mandatorily:
i) Financial statements and draft audit report, including quarterly /
half-yearly financial information;
ii) Management discussion and analysis of financial condition and
results of operations;
iii) Reports relating to compliance with laws and to risk management;
iv) Management letters / letters of internal control weaknesses issued by
statutory / internal auditors; and
v) Records of related party transactions.
2. All audit committee members should be “financially literate” and at least one
member should have accounting or related financial management expertise.
3. In case a company has followed a treatment different from that prescribed
in an accounting standard, management should justify why they believe such
alternative treatment is more representative of the underlying business transaction.
Management should also clearly explain the alternative accounting treatment in
the footnotes to the financial statements.
4. A statement of all transactions with related parties including their bases
should be placed before the independent audit committee for formal approval /
ratification. If any transaction is not on an arm’s length basis, management
should provide an explanation to the audit committee justifying the same.
5. The term “related party” shall have the same meaning as contained in
Accounting Standard 18, Related Party Transactions, issued by the
Institute of Chartered Accountants of India.
6. 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 risk through means of a
properly defined framework.
7. 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 limitations to the risk taking capacity
of the corporation. This document should be formally approved by the Board.
8. Companies raising money through an Initial Public Offering (“IPO”) should
disclose to the Audit Committee, the uses / applications of funds by major
category (capital expenditure, sales and marketing, working capital, etc), on a
quarterly basis.
9. It should be obligatory for the Board of a company to lay down the code of
conduct for all Board members and senior management of a company. This code
of conduct shall be posted on the website of the company.
10. 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.
11. There shall be no nominee directors.
12. Where an institution wishes to appoint a director on the Board, such
appointment should be made by the shareholders.
13. An institutional director, so appointed, shall have the same responsibilities and
shall be subject to the same liabilities as any other director.
14. Nominee of the Government on public sector companies shall be similarly elected
and shall be subject to the same responsibilities and liabilities as other directors.
15. All compensation paid to non-executive directors may be fixed by the
Board of Directors and should be approved by shareholders in general meeting.
Limits should be set for the maximum number of stock options that can be
granted to non-executive directors in any financial year and in aggregate. The
stock options granted to the non-executive directors shall vest after a period of at
least one year from the date such non-executive directors have retired from the
Board of the Company.
16. Personnel who observe an unethical or improper practice (not necessarily a
violation of law) should be able to approach the audit commitee without
necessarily informing their supervisors
17. Companies shall take measures to ensure that this right of access is communicated
to all employees through means of internal circulars, etc. The employment
and other personnel policies of the company shall contain provisions
protecting “whistle blowers” from unfair termination and other unfair prejudicial
employment practices.
18. Companies shall annually affirm that they have not denied any personnel access
to the audit committee of the company (in respect of matters involving alleged
misconduct) and that they have provided protection to “whistle blowers” from
unfair termination and other unfair or prejudicial employment practices.
19. The appointment, removal and terms of remuneration of the chief internal
auditor must be subject to review by the Audit Committee.
20. Such affirmation shall form a part of the Board report on Corporate Governance
that is required to be prepared and submitted together with the annual report.
21. The provisions relating to the composition of the Board of Directors of the
holding company should be made applicable to the composition of the
Board of Directors of subsidiary companies.
22. At least one independent director on the Board of Directors of the parent
company shall be a director on the Board of Directors of the subsidiary company.
23. The Audit Committee of the parent company shall also review the financial
statements, in particular the investments made by the subsidiary company.
24. The minutes of the Board meetings of the subsidiary company shall be
placed for review at the Board meeting of the parent company.
25. The Board report of the parent company should state that they have
reviewed the affairs of the subsidiary company also.
26. SEBI should make rules for the following:
 i) Disclosure in the report issued by a security analyst whether the company
that is being written about is a client of the analyst’s employer or an
associate of the analyst’s employer, and the nature of services
rendered to such company, if any; and
ii) Disclosure in the report issued by a security analyst whether the analyst or
the analyst’s employer or an associate of the analyst’s employer hold or
held (in the 12 months immediately preceding the date of the report) or
intend to hold any debt or equity instrument in the issuer company
that is the subject matter of the report of the analyst.

Non-mandatory recommendation
1. Companies should be encouraged to move towards a regime of unqualified
financial statements. This recommendation should be reviewed at an
appropriate juncture to determine whether the financial reporting climate is
conducive towards a system of filing only unqualified financial statements.
2. It also observed that the process of Board review of business risks will
be a mandatory recommendation of the Committee. Therefore, training
of Board members could be made recommendatory
3. Companies should be encouraged to train their Board members in the business
model of the company as well as the risk profile of the business parameters of the
company, their responsibilities as directors, and the best ways to discharge them.
4. The performance evaluation of non-executive directors should be by a peer
group comprising the entire Board of Directors, excluding the director being
evaluated; and Peer group evaluation should be the mechanism to determine
whether to extend / continue the terms of appointment of non-executive
directors.

The Committee noted that the definition of independent directors should be clarified in
the recommendations. It observed that the definition of independent directors as set out
in the code of the International Corporate Governance Network may be referred to.
The Committee also noted that the Naresh Chandra Committee report has attempted
to define the term “independent director”. The Committee was of the view that the same
definition may be used to define independent directors.
The term “independent director” is defined as a non-executive director of the company
who: Apart from receiving director remuneration, does not have any material
pecuniary relationships or transactions with the company, its promoters, its senior
management or its holding company, its subsidiaries and associated companies; is not
related to promoters or management at the board level or at one level

2.5 Corporate Management and Corporate Governance

2.5.1 Role of Directors in a Company

1. They are those who control and run the day to day affairs of the company. The
minimum directors in a public company are 3 and in a private company are 2.
2. The different types of directors are as follows-
(a) Permanent and Rotational Directors-There can be a maximum of 1/3rd permanent
directors and a minimum of rotational directors on the board. Rotational directors change
every AGM unless reappointed. Incase no new appointments are made, it is presumed
that the previous directors are reappointed. They can have a maximum term of 3 years.
(b) Executive and non-executive directors- Executive directors include all executive
persons taking part in day to day affairs which includes MD s, whole-time and part-time
directors, etc. S.23 of the Act defines the term ‘director’ as any person occupying the
position of director by any name called so. S.226 defines an MD as a director entrusted
with substantial powers of management. Such MD holds office till a term of 5 years. He
may be appointed from amongst permanent or rotational directors. Legally speaking non-
executive directors can become MD s but it is practically not feasible.
(c) Whole time and part time directors.
(d) Nominee directors- These are directors nominated by financial institutions who are
generally creditors of the company so as to exercise a check on the company. They
remain in position till the time the nominating body wants them to.
(e) Additional directors- These directors are appointed to assist the board based on their
expertise in various fields. They hold office till the next AGM.
(f) Casual vacancy filled-Casual vacancies may be created on the death, removal,
resignation, etc of directors and in such cases new directors are appointed in their place.
They hold office till the term of the original director comes to an end.
(g) Alternate directors- Such directors hold posts when the original director is not
available in a state where meetings are held or will not be there for three months.
Generally if directors do not attend 3 or more meetings, they may be disqualified. Such
persons are appointed by the original directors themselves and the board must decide
about the same. They hold office till the original director resumes office or till his term
comes to an end.
(h) Independent directors- They are mainly outsiders to the company and have no
connections with the company. They have no interest in the company as such and are
mainly there to get an outsider’s perspective on the company which would be unbiased.
(i) Directors appointed by the government- S.408 of the Companies Act provides for this.
Such directors can only be removed by the government.
(j) Representative directors- They represent different interest groups in the company
especially when such groups are in a minority.

3. Directors may also have to hold qualification shares which can’t exceed Rs. 5000
unless the nominal value of each share of the company is Rs. 5000 or more. However,
this is not applicable to nominee directors. If such qualification shares are not mentioned
in the AoA, the company need not comply with it.
4. All directors put together form the board of directors. The different types of boards
are-
(a) Constitutional board- Such a board is set up due to statutory requirements. Generally
1 person is all powerful.
(b) Consultative board- It is where there is consultation amongst all board members
though a single person might emerge as being an autocrat. It may have evolved from a
constitutional board.
(c) Collegial board- This is when the entire board is in harmony and there is a lot of
consultation.

5. The maximum number of members of every board must be left to the company and the
same must be stated in its AoA. Generally a larger board is considered to be more
efficient.
6. The advantages of having a large board are-
(a) Diverse opinions may be taken into consideration.
(b) It prevents autocracy.

7. The disadvantages of having a large board are-

(a) Diverse opinions may lead to complications and slower decision making.
(b) Greater costs.
(c) Shifting of burden.
(d) Lesser accountability.

8. Special committees may also be constituted under the board to take decisions on behalf
of the board. Such committees must always report to the board and the AoA must
mention about their size, composition, etc. However, such committees may also become
very powerful and take over the board or become individual power pockets within the
company. Nevertheless, their expertise is also required. Further, there would be proper
allocation of responsibilities.

9. Some of the various committees are as follows-

(a) Corporate Governance Committee- Ethical values could be checked which could be
used to frame rules and regulations to be internalized in the company’s framework.
(b) Compliance Committee- To see to it that various statutory requirements are adhered
to by the company like holding of AGM s with a gap of not less than 15 months between
2 successive AGM s. Non-compliance leads to fines which may have to be borne by
shareholders.
(c) Shareholders’ Committee- This committee protects the interests of shareholders which
include minority shareholders.
(d) Remuneration Committee- This is mainly to look into remuneration paid to executive
directors. This has been discussed by the Kumarmangalam Birla Committee and the
Naresh Chandra Committee as well.
(e) Audit Committees- This is a mandatory requirement provided under S.292A of the
Companies Act. Its main role is to look into accounts of the company. It has a chairman
and an external auditor may be an invitee to its meetings. Its origin may be traced back to
the 1930s in the US where an audit firm called Mackerson and Robinson had committed
several frauds. Thus, in 1939, the New York Stock Exchange introduced the concept of
audit committee as a special board. Some of its functions include-
(i) To discuss with independent auditors problems in completing the audits.
(ii) To discuss about timings when audits are to be done.
(iii) To look into efficiency of audits of company and check if there is any sort of
derogation.
(iv) To suggest as to who shall be auditors of the company.
(v) To control the internal audit system.
(vi) To review reports and to see whether all financial transactions are in accordance with
law.
(vii) To discuss with auditors, the extent of satisfaction with audited work.
(viii) To investigate and advise the company.
For people to be members of this committee, they must be financially literate. The Clause
49 of listing agreement also states that audit committees must have a minimum of 3
members, all non-executive directors, and majority independent directors. All must be
financially literate and the chairman must be an independent director. The Naresh
Chandra Committee report lays down that all companies with capital+ free reserves of 10
crores or a turnover of 50 crores must have an audit committee. An exception has been
made with respect to an unlisted public company with less than 50 members.

2.5.2 Importance of Independent Directors on the Board of Directors and their role

1. Employees of a company or its affiliates are generally not considered independent

directors. Directors having a family relationship with any of these persons are also
excluded.
2. They must not share such economic relationships with the company which includes
remuneration other than compensation received by all non-employee directors.
3. The role of an independent director is based on the business judgment rule. As per this
rule, there must be existence of a business decision, disinterestedness of the director,
good faith and due care and caution exercised by the director and finally absence of any
abuse of discretion.
4. If a majority of the board consists of disinterested independent directors, the same shall
help the board strengthen its ability to effectively use this rule.
5. There must also be a provision of Special Litigation Committees comprised of
independent directors to look into any matters of wrongdoings by persons and taking
action against the same.
6. Special Negotiating Committees are composed of disinterested directors to look into
‘interested’ transactions such as transactions with major stockholders.
7. A director will not be regarded as being independent in the following cases-
(a) When he has been employed by the corporation or an affiliate in an executive
company.
(b) He is an owner or employee of a firm that is one of the corporate’s or affiliate’s
advisor or consultant.
(c) He is employed by a significant customer or supplier.
(d) He has a personal services contract with the corporation or its affiliates.
(e) He is employed by a foundation or university which receives considerable grants from
the corporation or its affiliates.
(f) He is a relative of an executive of the corporation or one of its affiliates.
(g) He is employed by another corporation where the CEO of the corporation on which
he is a director is a board member.
8. An independent director may be studied with respect to –
(a) Disinterested outsider model -director’s lack of financial ties with company
(b) Objective monitor model-Monitoring managers to promote interests of shareholders.
By doing so, the company reduces agency costs and introduces a new system of
regulation. However, it may lead to divisiveness amongst the board.
(c) Unaffiliated Professional Model- This is when the independent director is an expert in
their field and looks at the situation professionally. However, this may make him stay
away from other board members and conflicts may arise.

9. The functions of an independent director may broadly be discussed as follows-

(a) Accountability function- Independence reduces agency costs by making the board
accountable to shareholders for firm performance. Their proximity to the management
allows them to monitor the situation rather than shareholders who neither have the time
not the resources.
(b) Informational Transparency function- The independent directors can help in providing
valuable information to investors which would have otherwise been suppressed by the
management. This may be done by information forcing or information validation (to
check if information is accurate). Also, for the stock markets to assess the performance of
the company, it must have information about its progress, decline, etc.
(c) Shareholder voice function- Independent directors help ensure that shareholders’
interests are given primacy and there is maximization of shareholder wealth by way of
decisions of the board.

10. It has been suggested that a board must consist of independent monitors, mediators
and managers. The monitors are necessarily disinterested unaffiliated persons. The
managers are essentially employees of the company and are those most closely related to
the company. The mediators on the other hand are affiliated with the company but help
reconcile the interests of the other 2 groups.
11. However, there are certain limitations to this model. First, it is not known whether the
monitors are actually completely independent.
12. There has been a mention about independent directors in the Cadbury Committee
report, the Kumarmangalam Birla Committee report, the Naresh Chandra Committee
report, clause 49 of the listing agreement, etc.
13. An independent directors’ term cannot exceed 9 years. Once removed or once he
resigns, he must be replaced within 180 days.

2.5.3 Whistle Blower Policy

1. A whistle blower is an employee or ex-employee or any other stakeholder who

provides information about his/her company which he/she reasonably believes provides
evidence of-
(a) A violation of a law or regulation by the company.
(b) Financial malpractice
(c) A danger to public health or safety.
2. Protection for such persons already exist in the US, Australia, New Zealand and
England.
3. In such cases, employees often do not reveal information for fear of being removed,
harassed or harmed in any way or the other. For e.g. the murder of Satyendra Dubey and
Manjunath.
4. They also do not feel driven to approach the media for fear of loss of individual
reputation and reputation of the company.
5. They also owe a certain degree of loyalty to the company and are required to keep
certain matters confidential and are hence hesitant. It leads to a breach of duty.
6. Directors of a company must make sure that such protection be provided to employees
and others. Companies must implement such measures in whichever way is best suitable
for them. However, existence and mechanism must be reviewed by the audit committees.
7. Victimisation of such employees must be avoided and they must not be harassed in any
way.
8. Such policy must be published and be made available to everyone. It must be
published in the annual report and the board report.
9. Also, a whistle blower protection officer must be appointed who should directly report
to the CEO or the audit committee.
10. Clause 49 talks of such a policy under non-mandatory requirements.
11. Even the Sarbanes Oxley Act under S.809 clearly mentions that every company must
have a whistle blower policy. This is to be looked into by the labour department.
12. This was talked about even in the Narayan Murthy Committee (under SEBI) report.
13. However, there are certain drawbacks to this. People may bring forth frivolous claims
and this would ultimately lead to loss of reputation of the company. Also, a long time
would be taken in disposing off cases.
14. Under the Sarbanes Oxley Act, such cases must be disposed off by the labour
department within 180 days.
15. The Whistle Blower’s (Protection in Public Interest) Bill, 2006 provides for such
protection. Earlier only government companies were being considered. Now even private
and pubic companies are being brought into its ambit.

2.6 Financial Reporting and Accountability

2.6.1 Ethics in Financial Reporting

2.6.2 Auditor’s independence and accountability

1. Under S.209, the company must prepare annual accounts, profit and loss accounts and
balance sheets which must be presented in the AGM s.
2. It instills confidence amongst shareholders and leads to transparency.
3. Financial institutions also inspect such accounts.
4. The annual accounts are prepared by the internal employees and are later checked by
the auditors.
5. The board must also prepare the board’s report on such accounts.
6. External auditors are generally appointed by the directors or in an AGM. Internal
auditors are the employees of a company but even they should be independent.
7. The Sarbanes Oxley Act, 2002 defines audit as-an examination of financial statements
of any issuer by an independent public accounting firm in accordance with the rules of
the board or commission for the purpose of exercising an opinion on such statements.
8. External auditors examine such statements on the basis of generally accepted auditing
and related standards.
9. An auditor as per the Companies Act must be appointed within a month from the
incorporation of the company and holds office till the first AGM and may be reappointed.
10. Ordinary matters are such matters with respect to which the company need not give
an explanation in the AGM such as the appointment of directors, declaration of
dividends, etc.
11. The primary role of auditors is to prevent mismanagement.
12. Threats to the independence of auditors may be stated as follows-
(a) An auditor having personal interest in the company.
(b) When an auditor has taken a huge loan from the company or a director.
(c) If the auditor is largely dependent on client firm due to fees receivable.
(d) Potential employment with Client Company. Generally, a 2 year cooling off period is
recommended.
(e) Close business relationship
(f) Familiarity
(g) Intimidation by company

13. Even incase of independent directors, it has been recommended to keep them for 3
years because of such threats of familiarity.
14. Read Caparo Industries v. Dickman
15. As per S.224 (3), if auditors are not appointed in AGM s, the centre may appoint
them or may fill any gaps.
16. When either the central government or financial institutions hold 25% stake in the
company, their permission is required before auditors may be appointed.

2.7 Role of Regulators in achieving Corporate integrity

2.7.1 Ethical framework by regulators

2.7.2 Clause 49 Listing agreement and initiatives taken by SEBI

1. SEBI came up as an administrative body in 1988. The SEBI Act was passed and the
SEBI board was created in 1992.
2. Some of its main functions include-
(a) Development of the securities market.
(b) Regulation of the securities market.
(c) Provide investor education.
(d) Regulating market intermediaries- These regulations say as to when one can be a
market intermediary.
(e) Prevention of insider trading.
(f) Regulation of substantial acquisition of shares.
3. SEBI derives power from S.11 of the SEBI Act.
4. It has come up with an insider trading regulation and a takeover code.
5. Insider trading is forbidden as such. Only one school in the US says that it must be
allowed as it would make the markets better. However, the Securities Exchange
Commission in the US has not accepted the same.
6. In India, SEBI came up with an insider trading regulation in 1992 punishing a defaulter
with 25 crores fine or 3 times profit a person has made in the entire process whichever is
higher.
7. However, this is very difficult to prove.
8. The 2002 amendment defined as to what is unpublished price sensitive information.
9. SEBI also came up with a takeover code in 1997. Regulations 10, 11 and 12 of this
code talk of public announcement to be made by a person who crosses the threshold limit
of shares and purchases more shares. Hence, there is an element of fairness involved.

MANDATORY REQUIREMENTS

I. BOARD OF DIRECTORS

A. Composition of the Board

i) It shall have an optimum combination of executive and non executive directors

with not less than 50% of the Board comprising of NED’s
ii) When the Chairman is a NED, the board should consist of at least 1/3rd NED’s
iii) When the chairman is a Executive Director, at least one-half should consist of
NED’s
iv) When the NED is promoter or related to any of the promoters or management
positions at the board level or one level below the board level. One half of the
board should consist of NED’s.
v) An independent director is a NED of the company who:
a) Apart from receiving remuneration does not have any pecuniary
relationship with the company, its members or affiliated companies.
b) Is not related to the promoters or management at the board level or one
level below the board level
c) Has not been an executive in the preceding 3 financial years
• In the company
• In the statutory audit firm or internal audit firm
• The legal or consulting firms which have material associations
with the company
d) Is not a material supplier, customer, lessor, lessee of the company
e) Is not a substantial shareholder in the company, i.e. holding more than
2% voting rights
f) Is not less than 21 years of age

B. NED’s Compensation and Disclosures

i) All fees and compensations paid to NED’s and independent directors, shall be
fixed by the BoD and shall require the prior permission of the shareholders.
ii) The maximum number of stock options to be granted in a financial year shall be
determined by the shareholders resolution
iii) Sitting fees shall not be determined by shareholders if within prescribed limits of
the Companies Act

C. Other Provisions

i) The Board shall meet 4 times a year with a maximum gap of 4 months
between two meetings.
ii) A director shall not be a member of more than 10 committees or act as a
chairman in more than 5 committes across all companies where he is a director.
iii) All information regarding committee positions of the director and changes
therein shall be made available to the company

D. Code of Conduct

i) A code of conduct shall be laid out for all Board members and the
management and posted on the website
ii) All members of the Board and senior management shall comply with the
code and this shall be reported in the Annual reports signed by the CEO

II. AUDIT COMMITTEES

A. Qualified and Independent Audit Committee

i) A qualified and independent audit committee shall be set up.

ii) Shall have a minimum of 3 directors as members. 2/3rds of the members
shall be independent
iii) The chairman of the Committee, shall be an independent director
iv) The chairman shall be present at the AGM to answer shareholders
questions
v) The committee may have special invitees they may consider appropriate
vi) The Company Secretary shall be the secretary of the Committee

B. Meeting of the Audit Committee

i) They shall meet 4 times a year and not more than 4 months shall elapse
between 2 meetings.
ii) The quorum shall be 2 members or 1/3rd which is greater.
iii) There should be a minimum of 2 independent directors present

C. Powers of the Committee

 i) Investigate any activity within its terms of reference
ii) To seek information from any employee
iii) To obtain outside legal or professional advice
iv) Secure attendance of outsiders with relevant expertise

D. Role of the Committee

i) Oversight company’s financial reports and disclosure of its financial information

ii) Recommending to the Board the appointment, approval, re-appointment,
replacement and removal of the statutory auditors and fixing audit fees
iii) Approval of payment to statutory auditors
iv) Reviewing with the management financial reports before submitting it to the
Board
v) Reviewing with the management quarterly financial statements before submission
to the Board
vi) Reviewing with the management application of funds raised through an issue etc.
and makes appropriate recommendations to the Board
vii) Reviewing with the management performance of statutory and internal auditors
etc.
viii) Reviewing the adequacy of internal audit function
ix) Discussion with internal auditors findings and following up
x) To review the functioning of the Whistle Blower policy

E. Review of Information by Audit Committee

i) Management discussions and analysis of financial condition and results of

operations
ii) Statement of significant related party transactions submitted by management
iii) Management letters of internal control weaknesses issued by the statutory auditors
iv) Internal audit reports relating to internal control weaknesses
v) The appointment, removal and terms of remuneration of the Chief auditor

III. DISCLOSURES

i) Basis of related party transactions

ii) Disclosure of accounting treatment
iii) Risk management by the board
iv) Remuneration to directors

IV. REPORT ON CORPORATE GOVERNANCE

i) There shall be a separate section in the Annual Report on Corporate Governance.

ii) It consists of detailed information regarding non compliance of mandatory
requirement and compliance of any non-mandatory requirements
 iii) A quarterly compliance report to be sent to the stock exchange within 15 days of
closure of the quarter

V. COMPLIANCE

i) A certificate from the auditors or company secretary regarding compliance

conditions along with the directors’ report to be sent to shareholders annually and
also to the Stock Exchange
ii) Non- mandatory requirements to be complied with at the discretion of the
company and the mention of compliance of mandatory requirements and non-
compliance or compliance of non-mandatory requirements shall also be
mentioned

NON- MANDATORY REQUIRMENTS

I. THE BOARD
i) A NED may be entitled to maintain an office at the company’s expense and
will be entitled to a reimbursement of any expenses incurred in the course of
business
ii) Independent directors cannot have a tenure exceeding 9 years
iii) Independent directors should have the requisite qualifications and experience
to be of use to the company and perform effectively

II. REMUNERATION COMMITTEE

i) The board may set up a remuneration committee which determines the
remuneration to be paid to each director on behalf of the board and the
shareholders.
ii) To avoid conflict of interest, the committee must consist of at least 3 directors
who should be non-executive directors and the Chairman being an
Independent Director
iii) All members to be present at the time of meeting
iv) The chairman to be present at the AGM to answer shareholders queries

III. SHAREHOLDERS RIGHTS

i) A half yearly declaration of financial performance of a company may be sent
to shareholders along with a summary of significant events

IV. AUDIT QUALIFICATIONS

i) Company may move towards a regime of unqualified financial statements
 V. TRAINING BOARD MEMEBERS
i) A company may train its Board members in the business model, risk profile,
responsibilities of the directors etc.

VI. MECHANISM FOR EVALUATING NON-EXECUTIVE BOARD

MEMBERS
i) Performance evaluation of NED’s to be done by the peer group consisting of
the BoDs, except that director who is being evaluated

VII. WHISTLE BLOWER POLICY

i) The company may establish a mechanism to check unethical behavior, fraud
etc.
ii) This would provide adequate measures to protect the employees from being
victimized
iii) Provide a mechanism to access the Chairman of the Audit Committee in such
cases

VIII. ACCOUNTING STANDARDS

i) Company shall comply with all accounting standards issued by ICAI from
time to time.

UNIT I-FINANCIAL MANAGEMENT

Finance:
It is the art or science of managing money.
1. Financial service
2. Financial management (FM)

Financial Management:
It deals with the functions of a financial manager.
It deals with:
• Procurement of funds
• Effective utilization of the same in business

1.1 Introduction, Source of Finance and utilisation of funds.

Approaches to FM:

Traditional Approach:
In 1950s and 60s, it was a narrow approach. It said that FM deals with the procurement of
funds from corporates.
(i) But it is not only corporates who need funds but even non-corporates
 (ii) It only talks about procurement
What after that? What about day to day management of financial capital? Therefore it is
seriously criticized.

Modern Approach:
It involves 3 questions:
(i) It talked about capital structure- what is the total value of funds a company
requires?
(ii) What specific assets should an enterprise have?
(iii) How should the funds required be financed?
To answer these questions, the modern approach talks of 3 decisions a finance manager
needs to make:
• Investments
• Finance
• Dividends ( amt of profits for shareholders)

Types of procurement of funds:

1. Long term financing
2. Short term financing

LONG TERM FINANCING:

I. Equity share capital:

It is the owner’s funds.
In private ltd companies, the amount the owners have invested is called the ESC.
Usually done for 10 yrs
In a public ltd co, there is the public and the promoters – who hold substantial shares.
• The ES holders are given right to appoint BOD s.
• It is the most basic and common way of acquiring funds.
• There is no specific time when the money invested (principal amt) is paid back. It
can only be paid back when the co winds up and if there is any money.

II. Dividend:
Owners expect something from the co.
The dividend is not a company’s expenditure.
It just pays back its owners.
A dividend comes in after paying income tax.
Therefore, it is the costliest source of funds as their must be sufficient funds to pay back
the shareholders.
Extra info:
The basic structure of finance side includes sale, expenses, income and dividend.
• Very costly source of fund
• A dividend can only be paid back if there are profits. Some companies adopt a no
mandatory requirement of payment of dividends, even if there are profits.
ES capital and preference equity are 2 ways of getting investments through shares. The
ESH s have the least risk involved as you don’t have to pay them back.

Sources of long term financing:

1. Equity share capital:
How do u increase the ES capital?
1. By going to the public and IPOs.
2. Right shares
Approach only existing shareholders.
It is when existing SH s get priority over general public and only if they are not
interested in buying SH s you approach the public.
It has an advantage that it can continue to help ownership and involvement to a select
group of people.
3. Bonus shares
These are issued only by companies which have a good amt of profit.
These SH s are given free of cost.
They are essentially freebies.
Where if a person has one share, he is essentially given another share.

2. Preferential Equity:
Preferential SH s are not actual owners of the co.
They get preference pmt of dividends.
• Get preference over equity SH s
• Not owners of the co.
• When co winds up, first preference is given to them
• They have to be appointed as they are not owners. Their SH s have to be
converted to equity share or redeemed.
• The preferential SH s get dividend only when the co starts making profits but
also in the previous yrs when it has made losses.
• Generally companies don’t opt for preferential SH s

Why should a co raise preferential shareholding?

While going thru a bad time a co takes a loan, (for which they need to show assets) which
is a very tough procedure. Then you use the whole preferential holding concept to
convince people to invest in your co and tell them that you will be the 1st person. I will
get dividends when I get profits.

Equity SH doesn’t have the right to come to a co and demand pmt, either the principal
amt or dividend. Therefore, a co faces lesser risks if it asks for equity, instead of
approaching a bank for a loan.

3. Debentures:
These are loans issued from financial institutions.
 Debentures are easier to get than loans as there are lesser conditions involved and
financial institutions give loans more willingly as they look into the practicability of
things and they are interested in getting returns from such loans.
This is also done as it becomes very different to always go to the public and issue equity
SH s.
Also, tax liability on dividends is very high
Features:
• Cost of capital for raising debentures is quite low- lot of capital is nt required.
One can just go to financial institutions.
• Secured against assets- collateral securities required to be made to get loans. This
is mainly because debenture holders are not co owners.
• No dilution of control- incase of issuing equity SH s some persons may have more
shares than the rest and thus control changes. But if debs are issued, such
debenture holders are not owners. Thus, the ownership and control of co remains
the same.
• Obligation of making pmts on a regular basis- pmts need not be made to equity
shareholders on a regular basis and only to be paid during times of profit. Deb
holders to be paid principal and interest. If interest not paid on time then there will
be interest on interest.
• Results in increased financial risk for co- this is mainly because the co is to pay
on a regular basis. When the co goes for a wind up, the 1st priority is given to debs
as they give loans. Deb mainly accepted on a long term basis.
• Den are also convertible- if a co is not in a position to pay interest, they will ask
the fin institutions to charge a lower interest and convert their debentures into
equity shares within a given time period.

4. Loans from commercial banks/ financial institutions:

• Banks primarily engaged in lending ST loans
• Banks enter into term financing through term lending- term lending is given of LT
loans by banks. ( find out what is term lending?)
• While doing so, strict terms and conditions are laid down and bankers analyse the
company status etc. it thus disciplines the banker. It also disciplines the borrower
as interest rates are very high which if not paid on a regular basis will increase.
• Secured against assets of the co- if loan is not paid, assets are seized
• Higher rate of interest- as it is a huge risk taken by the bank.
Note- last 2 or 3 points same for banks and fin institutions.
General bank loans are taken when companies are in trouble and they want to raise
money.

Difference between banks and financial institutions:

Financial institutions need to analyse and ensure that returns are recd but this is not in
case of institutions like NABARD. Even commercial banks would like to ensure that
returns are gotten.
The main diff is wrt terms and conditions. Thus it depends on kinds of institutions.
SHORT TERM FINANCING

This is generally to get funds for a ST period.

Here it is not viable to go for equity SH s or debs
ST sources refer not to raising funds but managing funds.

I. Trade Creditors:
• Credit granted by the supplier of goods- a credit period given between 60-90
days is specified. The money is utilized within the certain time limit. There is no
interest involved and thus no cost.
• It is a source of finance without any explicit cost- this system is generally
followed in India.
• Amount of trade credit increases with increase in volume of business- by
increase in volume of purchases more money is kept within the same period of
time.

II. Advance to customers:

Opposite of trade credit.
Advance is taken on a regular basis and these funds are utilized for a specific period of
time to give the final product.
• Cost free source of finance
• Usually used in case of transactions involving high values.
Eg: during the booking of nano, advance money of people was taken and utilized. Interest
rates are also very low. There is time to give up the product.

III. Bank advances:

1. Short term loans
2. Bank overdraft
Generally given to big business houses or co. even if there are no funds in the
account, more can be withdrawn from it and the bank pays for it. The banks
prescribe and bank pays for it. The banks prescribe a credit limit. Some interest
whc is very high will be charged and the amt has to be paid back within a certain
time period. Such interest is charged on a daily basis.
3. Bill discounting
A promissory note to pay money on a certain date.

FUNCTIONS OF FINANCIAL MANAGER:

 1. Estimation of funds
2. procurement
3. utilization
4. dividend payments
5. supply of funds to all parts
6. evaluation of financial performance
The Financial Manager needs to ensure as to the proper utilization of funds/ money etc.

1.2 Time Value of Money

1.3 Present Value, discounted cash flow

Very important for a finance manager to secure funds in such a manner, to have
sufficient funds to pay off liabilities.
With time, the purchasing power etc of money reduces. Therefore, instead of
investing / utilizing funds, if a FM helps the money in the bank to pay off the
liabilities, the time value of money will depreciate.
Definition: Time value of money means worth of a rupee recd today is different
from worth of one rupee recd tomorrow.

Time difference of money: money is always preferred today than tomorrow, as

with time, the worth of money will reduce. Also, ppl prefer money back today
because in the future they may not get the money.

An FM needs to keep a specific amt of funds in mind and the reqd returns.

COMPOUNDING:
Compounding means finding the future value of present money
Unless specified, interest is always paid per annum
Single cash flow- only a single investment

F.V = P.V (1+R/100)N

F.V – Future value

P.V – Present value
R – Rate of interest
N – Number of yrs

DISCOUNTING:
Discounting means the present value of future money

P.V = F.V
(1+R/100)N
QUESTIONS:

1. The present value of money is Rs. 1000 with 5% rate of interest p.a. for 3 yrs.
Find out the future value.

F.V = P.V (1+R/100)N

= 1000 (1+ 5/100)3
= 1000 x 21/20 x 21/20 x 21/20
= 1157.625

2. The present value of money is Rs. 60000 for 5 yrs at 12% p.a. find out
• F.V
• Will there be any difference if the same compounding is done half yearly?

F.V = P.V (1+R/100)N

= 60000 (1+12/100)5
= 60000 (112/100)5
= Rs. 1,05,740.50

= 60000 (1+12/200)5 x 2
= 60000 (1+6/100)10
= 60000 (1+106/100)10
= Rs. 1,07,450.86

there is a difference between yearly and half yearly compounding.

3. present value is Rs. 3000 for 9 yrs at 12%p.a. find out about the future
value.

F.V = P.V (1+R/100)N

= 3000 (1+12/100)9
= 3000 (112/100) 9
= Rs. 8319.23

4. present value is Rs. 1,00,000 at 10% p.a and future value is 1,21,000. wat is
the number of yrs?

1,21,000 = 1,00,000 (1+ 10/100)n

121/100 = (11/10)n
(11/10)2 = (11/10) n
since bases are same, comparing powers
n = 2yrs
5. T invests Rs. 500, Rs. 1000, Rs. 1500 and Rs. 2000 at the beginning of year 1,2,3,4
respectively. How much will be the value of his deposit at the end of 4 yrs at 5%p.a.

P. A TIME OF INT RATE F.V.

Rs. 500 4 5 605.75
Rs. 1000 3 5 1157.62
Rs. 1500 2 5 1653.75
Rs. 2000 1 5 2100
Total value after 4 yrs is Rs. 5519.12

6. In the above question will it make any difference if he invests at the end of the year
instead of the beginning of the year? (Discounting question)

P.A TIME OF INT RATE C.F

500 3 5 578.81
1000 2 5 1102.50
1500 1 5 1575.00
2000 0 5 2000.00
No interest on Rs.2000 as pmt at the end of the yr.
F.V if counted at the end of the yr is Rs. 5256.31
* C.F = Compounding factor

Present value of money:

P.V= F.V.
(1+ r/100)n

1. You need Rs10,000 to buy a book next yr. you can earn 7% on your money. How
much will u invest today?
P.V = 10000 / (1+ 7/100)1
= 9345.79

2. what is the PV of income stream which provides Rs1000 at the end of the first yr, Rs.
2500 at the end of the 2nd yr and Rs. 5000 each at the end of yrs 3-10, if discounting rate
is 12%.
D.F = 1/ (1+r)n
F.V YRS D.F P.V (f.v * d.f)
1000 1 0.8929 892.9
2500 2 0.7971 1992.75
5000
For 5000 – 5000 * add discounting factors frm yr 3-10
= 5000 * 3.9598
= 19,799
Total P.V= 892.9 + 1992.75 + 19799
= 22,684.65
3. Assume deposit is to be made at yr 0, considering it will earn 8% compound interest
annually. It is desired to withdraw 5000, 3 yrs from now and 7000, 6yrs from now. What
is the size of the deposit at year 0, which will provide for these future values? ( not
answered)

4. At the time of retirement X is given two alternatives:

i) An annual pension of 10,000 as long as he lives
ii) A lump sum amount of 50,000. If X expects to live for 15 yrs
Interest rate is 15%. Which option is better? (answer in Bhoomika’s notes)

5. X borrowed 5, 00,000 at 14% p.a repayable in 5 equal installments payable at the end
of the yr. find out:
i) Total sum payable to the bank
ii) Will it make any difference if 1st installment is to be made at the end of the 2nd yr.
(answer in Bhoomika’s notes)

Pg 2.23 to 2.26… all questions for time value of money…

1.4 Working Capital Management

 Current assets: funds which are received or receivable in one year. Eg:
Debtors / promissory notes
 Gross working capital: Investment in all current assets of the company (total
current assets)
 Net working capital: it refers to excess of total current assets over liabilities.
 Permanent working capital: Minimum amount of money that the business has
to maintain at each point of time.
 Temporary working capital: Working capital cycle refers to the length of time
between the point from which a firm pays cash for raw material, enters into
production process and receives cash from debtors.
A company holds raw materials on an average of 60 days. It gets credit of 15 days from
its suppliers. Production process further needs 15 days. Finished goods are held for 30
days and 30 days credit is extended to debtors.
= 60 – 15 + 15 + 30 + 30 = 120

The operating cycle consists of the following events which continue throughout the life
of business:
1) Conversion of cash to raw material
2) Conversion of raw material into work in progress
3) Conversion of work in progress into finished goods
4) Conversion of finished goods to accounts receivable throughout sale
5) Conversion of accounts receivable to cash

OPERATING CYCLE: R.M + W.I.P + F.G + DEBTORS - CREDIT

FORMULAS NEEDED:
1) Raw material storage period = Avg stock of raw material
Avg cost of raw material consumption per day

2) W.I.P holding period = Avg WIP holding inventory

Avg cost of production per day

3) Finished goods storage period = Avg cost of finished goods

Avg cost of gds sold (cogs) per day

4) Debtors collection period = Avg book debts

Avg credit sales per day

5) Credit period availed = Avg trade creditors

Avg credit purchases per day

• Avg stock of raw material means the value of the raw material
• WIP is the raw material and add additional costs which include labour cost and
other administration costs. This total cost is known as cost of production.
• COGS means the entire cost incurred from the time the raw material bought till
the finished goods are sold.
• Avg credit sales per day are how much you sell to the debtors.
• Avg credit purchases per day are how much you purchase from creditors.
Working capital mgmt mainly focuses on how long funds or cash are locked in.
Factors to be taken into consideration while determining WC are:
1) Production policy: In a seasonal industry the WC is required during a specific
period when production takes place. Eg: mango pickle industry
2) Nature of business: shorter the manufacturing process, shorter the WC blockage
3) Labour intensive/ machine intensive organization: funds are blocked for longer in
labour intensive and capital in machine intensive
4) Credit policy: liberal credit policy allows debtors a longer period and the WC
cycle increases
5) Inventory mgmt: 2 inventories: raw material and finished goods. FG can be
managed by looking at market factors while RM can be managed by using a few
basic theories.
6) Abnormal factors: like strikes and lockouts- this increases the finished stock
holding period
7) Market conditions: in a market where there is tough competition, one has to work
towards immediate delivery of goods
8) Growth and expansion: growth of co leads to increase in WC
9) Dividend payment policy: such payment leads to cash outflows and thus WC
needs to be managed
10) Tax payment: Advance taxes need to be paid as well as this affects the WC

COMPUTATION OF WORKING CAPITAL AMT:

1. Estimation of current assets:
i) Minimum desired cash and bank balances
ii) Inventory : raw material, WIP and finished goods
iii) Debtors

2. Estimation of current liabilities

i) Creditors
ii) Wages
iii) Overheads

3. Net working capital (1-2)

Estimation of current assets – estimation of current liabilities + contingent factor

Sums from the notes

Khan n Jain problems 13.22- 13.38

1.5 Management of Cash and Inventory

MANAGEMENT OF CASH:

Khan and Jain: unit 14

To do:
 • Introduction
• Motives for cash holding
• Objectives of cash mgmt
• Examples 14.1 to 14.6 : basic
• Examples 14.7 to 14.8 : cash cycle and cash mgmt technique questions
• Sums from page 14.31 to 14.35 : question no 7

INVENTORY MANAGEMENT:

Khan and Jain: Unit 16

To do:
• Basic introduction : pg 16.1 to 16.5
• Examples 16.1 to 16.6
• Whole chapter is very basic
• Problems: pg 16.15 to 16.21, 10 questions
• Review questions from 16.21

To get these photocopied

Find out till where management of cash has to be done and do we have to do
management of securities!!!