Inside Clause 49

Tough regulations such as Clause 49 are the outcome of a series of scams that have hit the corporate world. These rules aim to shine a light on operations management and ensure that top management is held accountable when things go wrong. The intentions are laudable but the question remains: can Indian companies comply with such stringent requirements? Manesh Patel looks at the provisions of the clause and suggests ways and means of coping with it

The term ‘Clause 49’ refers to clause number 49 of the Listing Agreement between a company and the stock exchanges on which it is listed (the Listing Agreement is identical for all Indian stock exchanges, including the NSE and BSE).

This clause is a recent addition to the Listing Agreement and was inserted as late as 2000 consequent to the recommendations of the Kumarmangalam Birla Committee on Corporate Governance constituted by the Securities Exchange Board of India (SEBI) in 1999.

Manesh Patel

Clause 49, when it was first added, was intended to introduce some basic corporate governance practices in Indian companies and brought in a number of key changes in governance and disclosures (many of which we take for granted today). It specified the minimum number of independent directors required on the board of a company. The setting up of an Audit committee, and a Shareholders’ Grievance committee, among others, were made mandatory as were the Management’s Discussion and Analysis (MD&A) section and the Report on Corporate Governance in the Annual Report, and disclosures of fees paid to non-executive directors. A limit was placed on the number of committees that a director could serve on.

In late 2002, SEBI constituted the Narayana Murthy Committee to assess the adequacy of current corporate governance practices and to suggest improvements. Based on the recommendations of this committee, SEBI issued a modified Clause 49 on October 29, 2004 (the ‘revised Clause 49’) which came into operation on January 1, 2006.

What’s new in Clause 49?

The revised Clause 49 has suitably pushed forward the original intent of protecting the interests of investors through enhanced governance practices and disclosures. Five broad themes predominate. The independence criteria for directors have been clarified. The roles and responsibilities of the board have been enhanced. The quality and quantity of disclosures have improved. The roles and responsibilities of the audit committee in all matters relating to internal controls and financial reporting have been consolidated, and the accountability of top management—specifically the CEO and CFO—has been enhanced.

Within each of these areas, the revised Clause 49 moves further into the realm of global best practices (and sometimes, even beyond). To illustrate:

Clarifying standards of independence for directors. The requirements for independence have been made more stringent by precisely defining ‘independent’ and excluding any relatives of promoters, senior management, any former auditors or consultants. In this area, the Indian Clause 49 is perhaps the most demanding of any similar legislation in the world in requiring a ‘cooling-off period’ for any member of any advisory firm (not just statutory auditors, but also lawyers, consultants and internal auditors). The cooling-off period at three years is also the most onerous. The standard in the western world is generally one year, and that too is restricted to statutory audit partners who have been associated with the company, not all consultants or advisors. It has been argued that this stringent measure is more likely to deprive a company of competent independent directors rather than enhance independence.

The requirements relating to the number of independent directors on a board remains unchanged from the original clause. However, much discussion has followed a recent qualification from SEBI that government nominees on boards should not be considered independent. This was not explicitly stated previously.

Clarifying and increasing the responsibilities of the board of directors. Another recurring theme of the revised clause is to enhance the responsibilities of the board. As a part of this, a large number of matters which were not explicitly part of the board’s role have now been included. Primary among them are a company’s compliance with all applicable laws and enhanced oversight over its subsidiaries. The board is now also required to review the company’s risk management framework. Board members also have to review all significant transactions entered into by any subsidiary as well as review minutes of all the subsidiaries’ board meetings, and they have to sign-off on compliance with the company’s code of conduct as well.

Improving the quality and quantity of disclosures. There has been an across-the-board increase in the number and quality of disclosures required. Some of these are regarding disclosure of directors’ shareholding in the company, disclosure of compensation paid to non-executive directors, disclosure of all related-party transactions, use of funds raised through public issues (in case of any use of funds for purposes other than that originally stated in the offer prospectus), an audited statement on the deviation to be included in the annual report, and any changes in accounting policies and practices.

These have generally been accepted by most parties as a step in the right direction.

Consolidating the primacy of the audit committee in all matters relating to internal controls and financial reporting. Changes in accounting policies are required to be reviewed by the audit committee; financial statements of subsidiary companies are required to be reviewed by the audit committee; the MD&A section of the annual report, which was previously only a board responsibility, now needs to be reviewed and cleared by the audit committee before going to the board.

Enhancing accountability of the CEO and CFO. This has been done through the CEO or CFO certification process (and inspired by the Sarbanes-Oxley Act). The CEO and CFO are now required to certify to the board at least annually on matters relating to the accuracy of financial reporting, evaluation of design and operation of internal controls, disclosure of any significant changes in internal controls, and disclosure of frauds.

Most corporate managers and investors now agree that while it could be argued that the requirements involve a significant amount of effort, there can be no doubt that these requirements are an essential step towards bringing Indian capital markets and governance standards in line with the rest of the world.

What it takes

Achieving compliance in many of the areas such as additional disclosures is not likely to be difficult. But some of the other requirements will need significant effort if a company aims to fulfill the requirements of the clause in the right spirit. This is true with regard to the composition of the board, for while the requirements are fairly explicit, given the narrowing of the definition of independence and the clarifications around government nominees, several companies will struggle to re-do the composition of their boards in time to meet the deadline.

Board and audit committee procedures. A significant number of new responsibilities have been added to the board’s and audit committee’s functions. As a result of this, the board and audit committee meeting agendas will have to be carefully thought through to ensure that all the requirements of the clause are covered during the course of  a year.

Legal compliance. One of the more stringent requirements is for the board to review compliance with all applicable laws. Historically, compliance declarations in companies have been high-level affairs with senior management signing-off blindly on one-line catch-all declarations largely modelled around the negative assurance concept (Example: no notices received implies no violations). The new requirement has focussed the minds of board members to look at specific regulations and their requirements, and on getting a far greater degree of positive assurance. This will therefore lead to significant effort in terms of identifying all applicable laws, identifying all the compliance requirements within these laws, reviewing the compliance status for each identified requirement, and following through with a system to track this on an ongoing basis.

Risk management. Boards must ensure that all significant risks are managed through a well-defined framework. This will require substantial effort, the task at hand being to first identify all the risks applicable to a company, then from within these to cull out those risks that are most significant, and finally to identify owners for these key risks and to put in place mitigation plans.

Of course, the company would also need to put in place the structural elements of a Risk Policy (building a Risk Register and building a framework to track progress on mitigation plans and review the risks on a continuous basis).

Internal control evaluation. While some internal controls are in place in organisations, the real effort will be in building the evidence around the evaluation of these controls—the specific identification of risks and controls within processes, performing walkthroughs to validate design effectiveness, and the testing process to evaluate the operating effectiveness of the controls.

Clearly, at least the companies with best-in-class governance practices are steeling themselves for this process. Most have already taken the first steps down this path. Although all of them are concerned about the costs involved, most are aware that this is a process which yields substantial benefits in the long run as the US experience is beginning to show.

The author is Partner, Ernst & Young. He can reached at manesh.patel@in.ey.com