CONTENTS · 2008. 5. 31. · CONTENTS 1. Restructuring Professional Firms For GATS Regime — N K Jain 1 2. Corporate Criminal Liability — The Issue Revisited in the Context of

CONTENTS

1. Restructuring Professional Firms For GATS Regime— N K Jain 1

2. Corporate Criminal Liability — The Issue Revisited in the Context ofRecent Supreme Court Decision

— V K Aggarwal 9

3. Global Marketing and Brand Building of Company Secretaries— Balwant Kulkarni 15

4. The Indo-Singapore Treaty and Globalisation of Company Secretaries Firms— Balwant Kulkarni 22

5. Global Convergence in Governing Banking and Financial Sector— V P Sharma & M A Joseph 40

6. Attuning to Global Governance Norms — Indian Perspective— Dr. S K Dixit 49

7. Securities Laws and Capital Market — Global Benchmarking— Sonia Baijal 59

8. Juristic Personality — A Novel Dimension— Archana Kaul 73

9. Cross Border Consumption Taxation under VAT Regime — A New Area ofSpecialization for Professionals

— Yogindu Khajuria 79

10. Limited Liability Partnership — A New Business Model— Aurobindo Saxena 92

11. Codes of Corporate Governance : An Asian Perspective— Shikha Katoch 98

12. Global Corporate Governance and Family Owned Entities— Ritu Vij Kohli 111

13. Emerging Avenues & Company Secretaries(BPO, KPO and LPO)

— Monika Goel 117

14. Modernisation of Company Law for Global Competitiveness— Alka Kapoor 125

B A C K G R O U N D E R

Restructuring Professional Firms for GATS Regime 1

RESRESRESRESRESTRTRTRTRTRUCTURING PRUCTURING PRUCTURING PRUCTURING PRUCTURING PROFESSIONOFESSIONOFESSIONOFESSIONOFESSIONAL FIRMSAL FIRMSAL FIRMSAL FIRMSAL FIRMSFOR GATS REGIMEFOR GATS REGIMEFOR GATS REGIMEFOR GATS REGIMEFOR GATS REGIME

N K JAIN*

* Secretary & Chief Executive Officer, The ICSI. The views expressed are personal views of the author and do not necessarily reflectthose of the Institute.

INTRODUCTION

Services have come to dominate the economicactivities of countries at virtually every stage ofdevelopment, making liberalisation of trade in servicesa necessity for the integration of the world economy. Inmany developing economies as well, the service sectoris the single largest contributor to economic output,ahead of both agriculture and industry. Even allowingfor the fact that governments are major service providers(education, healthcare, sanitation, etc.), the commercialmarket for services is huge and growing in virtually everycountry. And the trend is clear: as national economiesdevelop and incomes rise, the commercial service sectoraccounts for an ever-larger share of GDP.

Services today accounting for 20% of global tradeand 5% of global GDP, are a high employmentgenerating sector and employ as high as 40% and 70%of the workforce in developing and developed countries,respectively. Although large OECD countries dominateglobal trade in services, developing countries top thelist of countries that are most specialized in servicesexports as a source of foreign exchange. Manydeveloping countries like India and Philippines havebecome major exporters of BPO services and emergedas an important destination for investment in serviceslike insurance, transport, telecommunication and retailtrading by the developed countries.

In line with the global trend, the services sector inIndia is also growing rapidly as is evident from its sharein GDP. In 2000-2001, the share of services in thecountry’s GDP at 52.4% was up from 51.5% in theyear 1998-1999. More importantly the services sectorin India account for about a quarter of India’s trade flowsduring the same period. High growth of service exportsdemonstrate higher share of India in global trade forservice i.e.,1.4% compared to 0.9% in case of globalmerchandise trade. The service sector has also playedan important role in attracting foreign capital, with key

1

producer services amounting for a growing share offoreign direct investment (FDI) inflows into the countrythus exhibiting a strong revealed comparative advantagein services vis-à-vis goods.

The year 2004-2005 was especially very encouragingin terms of growth of export in services doubling to$51.3 billion from $24.9 billion in 2003-04 an astoundinggrowth of 105.7%. There was substantial growth invalue added services in communication, construction,financial, news agency, royalty, copyright, licence feeand management. Exports of these services categorizedas “miscellaneous services” (excluding software) arebelieved to have increased more than four-fold to $22.5billion in 2004-05 from $4.7 billion in 2003-2004.Though the miscellaneous services category registeredhighest growth, software exports went up by 41.8% to$ 17.3 billion in 2004-2005, the highest increase in thelast four years. A report by NASSCOM and Mckinseypointed out that the exports of IT related services fromIndia are expected to increase to US$57 billion by 2008-2009. Another study by Deloitte reveals that the globalmarket for off-shore financial services could be as largeas US$356 billion by 2008-2009, of which a large shareshould go to India.

India’s main source of comparative advantage inservices is its labour endowment. India is also animportant source country for low and semi-skilled serviceproviders in services like construction, domestic work,and transport operations. It also has the potential to exportlabour-intensive services though technology-enableddata, voice, and information flows, i.e. cross-bordersupply.

India is also ranked as the leading global outsourcingdestination in services. In all, 60% of the Fortune 500companies outsourcing services to India, ranging fromsimple back office services like processing and billing,to intermediate service like technical help and systemsdesign to specialized services, like research and


2 33rd National Convention of Company Secretaries

development and technical analysis. The cost-qualityadvantage in labour-based services combined with itshigh quality institutions has also enabled the country toconsiderably diversify its services exports to emergingareas, like health care, research & development andeducational services. Thus, the range of activities modes,and markets where India has global export opportunitiesis vast.

Undoubtedly, the growing volume and scope ofexportable services and the possibility of growingprotectionism towards outsourcing calls for a determinedand innovative GATS negotiation and export promotionstrategy. The need to identify newer export sectors inservices trade based on the comparative advantageand professional competence available in Indiaassumes greater importance given the internationalopportunities.

PROFESSIONAL SERVICES UNDER GATS REGIME

Professional services have a wide range of activitieseven though many of them have certain commoncharacteristics. Professional services primarily purchasedby the others are mostly delivering expertise calling forinputs from skilled professional, technical and managerialpersonnel and comprises a mix of activities, such asaccountants, legal and secretarial services, auditing etc.which require some type of accrediting. However, largefirms have considerable advantage in providing a packageof professional services. Many specialized firms inspecific sectors may also prove to be very competitivein view of the fact that they are able to access thedelivery channel as comfortably as the large firms do.

In the case of professional services, despite theconsiderably varied nature of the services making upthis category, there are several important commonalities.Firstly, India has considerable export potential in manyof these activities due to its skilled, low-cost labourresources and demand-supply imbalances in manydeveloped countries resulting from demographic trendsand rapid advances in technology. In some professionalservices, India has considerable export potential; exportsare constrained by a variety of restrictions, includinglack of recognitions of Indian qualifications, nationalityand residency conditions, needs-based tests andcommercial presence requirements in host markets. Inaddition to relying on its endowment of skilled labour,India also has the potential for cross-border exports ofvarious IT-enabled professional services, such as back-office activities which include processing, billing,handling calls, medical and legal transcription, telemedicine, tele-education and a variety of on-line andoutsourced services.

STRUCTURE OF GATS REGIME

The creation of the GATS was one of the landmarkachievements of the Uruguay Round, whose resultsentered into force in January 1995. The GATS for thefirst time extended internationally agreed rules andcommitments into the rapidly growing area ofinternational trade viz. services, which was never donebefore. The preamble of GATS expresses desire tofacilitate the increasing participation of developingcountries in trade in services and the expansion ofservices exports through the strengthening of theirdomestic capacity, efficiency and competitiveness.

GATS framework consists of six parts and annexes.The GATS is based on the same objectives as that ofGATT of creating a credible and reliable system ofinternational trade rules; ensuring fair and equitabletreatment of all participants (principle of non-discrimination); stimulating economic activity throughguaranteed policy bindings; and promoting trade anddevelopment through progressive liberalisation. Furthernegotiations for progressive liberalisation commencedby 1.1.2000, as mandated under GATS and theforthcoming negotiations on services are scheduled inthe month of December 2005 at Hong Kong.

The GATS applies in principle to all service sectorsexcept “services supplied in the exercise ofgovernmental authority”. These are services that aresupplied neither on a commercial basis nor incompetition with other suppliers viz. social securityschemes and central banking.

MODES OF SUPPLY OF SERVICES UNDER GATS

The GATS sets out four modes of supply ofservices. These include cross border trade,consumption abroad, commercial presence andmovement of natural persons.

GENERAL PRINCIPLES

Following are the basic rules/principles applicableto all members and to all services.

MFN Treatment

Article II of the GATS provides that each Membershall accord, immediately and unconditionally, to servicesand service suppliers of any other Member, treatmentno less favourable than it accords to like services andservice suppliers of any other country. However, amember is permitted to maintain a measure inconsistentwith the general MFN requirement if it has establishedan exception. However, all exemptions are subject to



review and they should, in principle, not last more than10 years.

Transparency

The GATS requires each member to publishpromptly “all relevant measures of general application”that affect operation of the agreement. Members mustalso notify the Council for Trade in Services of new orchanged laws, regulations or administrative guidelinesthat affect trade in services covered by their specificcommitments under the agreement. Each member isrequired to establish an enquiry point, to respond torequests from other members for information.

Specific Obligations

Obligations, which apply on the basis ofcommitments, are laid down in individual countryschedules concerning market access and nationaltreatment in specifically designated sectors. Theserequirements apply only to scheduled sectors.

Market Access

Market access is a negotiated commitment inspecified sectors. The GATS also sets out different formsof measures affecting free market access that shouldnot be applied to the foreign service or its supplier unlesstheir use is clearly provided for in the schedule. Theyare:

(i) Limitations on the number of service suppliers.

(ii) Limitations on the total value of servicestransactions or assets.

(iii) Limitations on the total number of serviceoperations or the total quantity of service output.

(iv) Limitations on the number of persons that maybe employed in a particular sector or by aparticular supplier

(v) Measures that restrict or require supply of theservice through specific types of legal entity orjoint venture.

(v) Percentage limitations on the participation offoreign capital, or limitations on the total valueof foreign investment.

National Treatment

A commitment to national treatment means that inthe sectors covered by its schedule, subjected to anyconditions and qualifications set out therein eachmember shall give treatment to foreign services andservice suppliers treatment, in measures affecting supplyof services, no less favourable than it gives to its own

services and suppliers. The extension of nationaltreatment in any particular sector may be made subjectto conditions and qualifications.

Members are free to tailor the sector coverage andsubstantive content of such commitments as they deemfit. The commitments thus tend to reflect national policyobjectives and constraints, overall and in individualsectors. While some Members have scheduled less thana handful of services, others have assumed marketaccess and national treatment disciplines in over 120out of a total of 160-odd services.

Exemptions

Members in specified circumstances are allowedto introduce or maintain measures in contravention oftheir obligations under the Agreement, including theMFN requirement or specific commitments. Thesecircumstances cover measures necessary to protect publicmorals or maintain public order, protect human, animalor plant life or health or secure compliance with laws orregulations not inconsistent with the Agreementincluding, among others, measures necessary to preventdeceptive or fraudulent practices. Also, in the event ofserious balance-of-payments difficulties, members areallowed to temporarily restrict trade, on a non-discriminatory basis, despite the existence of specificcommitments.

CLASSIFICATION OF PROFESSIONAL SERVICESUNDER GATS

The WTO Secretariat has divided all services intotwelve categories, covering business services,communication services, construction and engineeringservices, distribution services, education services,environment services, financial services, health services,tourism and travel services, recreation, cultural andsporting services, transportation services and otherservices.

The professional services covered under Businessservices, include legal services, Accounting, Auditingand Book keeping services, taxation services etc., butdoes not include secretarial services. The services beingrendered by Company Secretaries are therefore spreadover various sub-sectors such as financial intermediationservices and auxiliary services thereof, professionalservices and computer and related services.

RESTRUCTURING PROFESSIONAL FIRMS FORGATS REGIME

While many people like to refer to themselves asprofessionals the number of individuals who qualify



according to the formal definition of the term is relativelysmall. Strictly speaking, a professional is someone whohas won the right to membership of a professionalassociation by completing an accredited programme ofexaminations and training. However, in the broaderperspective, a professional firm is any firm that uses thespecialist technical knowledge of its personnel to createcustomised solutions to clients.

Until recently professional firms principally actedwithin a domestic market which was governed bynational rules and protected by national barriers but nowthe boundaries between national economies arebecoming blurred thus giving rise to new dynamics interms of markets for professional services. This changeis universal and is increasingly evident in every form ofactivity where increasingly external factors are becomingimportant in maintaining profitability, and ensuringnational competitiveness. Accordingly, every enterprisehas to deal with new forms of competition and neweconomic framework. The change is not confined tolocal markets or regional markets; it is in fact witnessedat international level. More and more global competitorsare entering markets fuelling the intensity of competition.It is for this reason that restructuring through networkingamong professional firms becomes important in facingthe onslaught of global competition which can be lookedupon as providing opportunities and platforms for futuregrowth.

Restructuring professional firms for GATS regimerequires managing clients globally but not necessarilythrough global control. Therefore, consistency isprerequisite for professional firms to globalise. A firmwhich moves on the process of globalisation, needs tounderstand that relationships with clients across the globemay not be the same. Therefore, what is important forprospective global professional firms is not only providingthe same service globally but achieving global serviceconsistency.

Services have now become a powerful source ofincome in many countries including India. This appliesto professional services as well. But even in the servicesindustry there is an overriding need to deal with globalforces, regulatory and otherwise, and to ensure that thebenefits of the services industry are maximised not onlyregionally but internationally. Professional firms thereforeneed to look carefully at how well they compete? Howto differentiate themselves in the marketplace and whatare the ways to stand out from the competition? Andhow to communicate their differentiation? Thisdifferentiation can be indeed achieved by providingclients with value-added services; developing a positive

organization culture and identifying and implementingstrategies that ensure long-term competitive advantageand profitability.

In the context of rapidly changing competitiveenvironment, the value added services can be providedby the pace at which the firm responds to a client’sneeds. In fact the value added services for a professionalfirm is to bring value added benefits to the client byproviding solutions with greater detail than peer firms,strongly demonstrating commitment to clients. Thisenhances the reputation of the professional firm andacts as differentator for firm.

The organizational culture plays an essentiallyimportant role in the success of a professional firm.Culture is a stronger force for unity and coherence thanany formal document. World-class organizations havebeen able to maintain consistent strategic andorganizational approaches due to the strength of theircultures. Wherever these firms operate, theirprofessionals share a culture that binds them intocommon practices, sustains their alignment, and givesthem an advantage in attracting clients.

Top management’s expressed beliefs, attitudes, andpriorities set the tone for the firm’s moral and behavioralnorms, thus creating the firm’s organizational culture.Cultures though generally created unconsciously basedon the actions and values demonstrated by or the firm’sfounders, can also be planned and managed so as toattract and appeal to the best employees as well as servethe interests of stakeholders. A good organizationalculture stimulates efficiency and regulation of the firmand also the employee performance and career longevity.

STRATEGIES TO LEVERAGE THE GATS REGIME

There is not doubt that any organization, be it acompany, firm or any other kind of association, cannotmove ahead effectively without a plan – a strategy. Inthis challenging and fast moving market placeprofessional firms of all sizes and all specialties shouldtherefore devise a specific strategic plan, developmethods for measuring their progress, and be ready tomake changes as and when they are required. Thefollowing six areas could help professional firms developstrategies for growth, profitability and competitiveadvantage.

Strategic Alliances

It is important for professional firms to buildsynergies by making reliable strategic alliances tocompete successfully and operate profitably. Professionalfirm should also develop capability and demonstrate its



ability to take on challenging, complex and sophisticatedtasks and be able to complete them in a timely andprofessional manner. Partnering with reputed anddependable firms gives an assurance for, sustainingcontinuing growth, gaining new assignments andcompeting with larger firms.

Managing the Knowledge Pool

One of the most important factors contributing tothe achievement of growth and prominence of a firm isto devise strategy to effectively manage and leverageits pool of knowledge.

All accredited professionals share a common bodyof codified knowledge acquired through professionaltraining. A large part of their competitive advantage,therefore, derives from possessing a unique base ofexpertise. Traditionally, professional services firms havebeen regarded as organisations of highly trained,extremely technical specialists, who apply their esotericknowledge to the creation of innovative andsophisticated solutions of clients’ complex problems. Itis believed that some firms operate successfully in thisway. As a result, most highly expert professional firmsremain small and specialised. A professional firm wishingto grow large must therefore learn to codify the esotericand tacit knowledge accumulated within experiencedstaff and disseminate this throughout its organisationalstructure. If this knowledge can be expressed in termsof established procedures and applied to a wide rangeof client problems, the potential for leverage increases.

A study, sponsored by PricewaterhouseCoopers andthe University of Florida Law School, looked at the stateof knowledge management in law firms. The findingsof the study are -

— Almost half (49%) of law firm respondentsreported having initiated a KnowledgeManagement program

— Over 40% of law firm respondents believe theabsence of a strategy is a barrier that preventstheir respective organization from launching aKnowledge Management initiative.

— Law firm respondents indicated that searchingacross differing internal work productrepositories was the most immediate andcompelling concern regarding KnowledgeManagement.

— More than 40% of law firm respondentsindicated that contributions to the KnowledgeManagement initiative are considered as partof the evaluation process.

— Over three-fourths of law firm respondentsreported that standard legal forms and researchmemoranda are the most likely candidates forKnowledge Management repositories.

— Almost 70% of law firm respondents indicateddocuments in the knowledge repositories arebetween one and five years old.

Leverage the Technology

There is a revolution happening in the world today,and it is occurring faster than anyone expected. Thisrevolution is not in technology, but in the way we interactwith information. Examples of the changing ways inwhich we interact with information are everywhere:home and business networks, cell phones, cordlessphones and tollbooths.

The overhead expenses of a professional firmaccount for more than one third of the cost. Therefore,as a part of strategy to reduce not only the cost but tocreate efficiencies of scale, a firm must leverage thetechnology. A focus on fully utilizing all applicabletechnology breakthroughs open important vistas forcontinuing growth, market leadership, and profitabilityfor a professional firm.

Technology in recent years has reduced the costsand generally improved productivity. Technology allowscreating virtual private networks providing direct accessfrom anywhere. New technologies also allows operationsto be managed efficiently by making internaldocumentation easily available without the need forprinting and distribution. The Internet can be used tobring all the resources of the individual parts of the firmto each individual professional of the firm.

It is both compelling and confusing. There are somevery fundamental reasons why this change is takingplace— it allows us to work anytime, anywhere with allinformation; it is more personal and tailored; and alsoallows us all to move more freely. Let us have a look atsome very interesting facts and figures that exemplifythe importance of technology to individual andprofessional firms.

A recent Pew Foundation study highlighted the rapidgrowth in Americans’ use of the Internet to findinformation. The findings of the study are -

— More than 8 out of 10 Internet users havesearched the Internet to answer specificquestions.

— Spurred by an increase in content and the



momentum of important news events in recentyears, the online news population grew by50%.

— The number of those who have usedgovernment Web sites grew by 56%between2000 and 2002.

— Those who have searched for political newsand information online grew by 57 between2000 and 2002.

— The population of those who have done workor research for their job online (not includinge-mail) grew by 45% between March 2000and November 2002.

Leverage the Regulatory Change

It is important to for a professional firm todemonstrate its leadership in its area of specialization.This requires professional firm to keep a watch onlegislative and regulatory changes impacting the client’splans, as they may not only slow the developmentprocess but can make development considerablyexpensive for clients. Therefore, an advance advise toclient about the potential impact of regulatory changesand suitable prescription can help professional firmestablish that it cares for clients time, money and energy.

Similarly, the critical thinking can permeate an entireorganization if identified as a strategy for competitiveadvantage and growth. That means finding creativesolutions, new ways to save clients time and money,approaches to identify problems before they occur etc.Critical thinking which includes good client listening,unbiased thinking, effective questioning, and creativeproblem solving can be accomplished at all levels in thefirm individually or collectively.

Managing Star Professional

The Professional Service Firms with more than atrillion dollars in annual revenues are a major factor inthe global economy and in the operations of myriadcompanies around the world that seek their help. Butwhat makes these firms themselves work effectively isan issue to be deliberated. The management ofprofessional firms presents a unique set of circumstances.

A firm’s only means of revenue generation is itsthe pool of knowledge and expertise of its professionalstaff. Therefore, how it manages those people, how italigns their individual goals with those of the firm, directlyaffects its ability to survive and prosper. The competitiveadvantage of a firm lies in its ability to get starprofessionals committed to the firm’s strategy; to

manage them across the geographies, business lines,and generations; and to govern and lead them so thatboth the firm and such professionals prosper and feelrewarded.

PROFESSIONAL FIRM - A FUTURE ROLEMODEL

Professional firms embodying many of the qualitiesare relatively efficient mechanisms for developing anddisseminating knowledge; create an environment inwhich highly motivated individuals can enjoy areasonable degree of autonomy; and place dedicationto client service above all other considerations. All thisoccurs in an environment , which enshrines mutual trustand collaboration within the professed value system.Professional firms represent a large and rapidly expandingsegment within most industrialised economies.According to statistics from the Organisation forEconomic Co-operation and Development (OECD), theprofessional services sector accounts for 17 per cent ofall employment in the US and major western Europeancountries. The sector has enjoyed annual growth of 15per cent in revenue terms over recent years. The PriceWaterhouse Coopers, the accountancy firm for example,with 155,000 professional staff worldwide and annualrevenues of US $ 15billion, if publicly quoted, wouldqualify as a Fortune 500 company.

There are various large professional firms withthousands of professional staff and billions of dollors ofrevenues. It is therefore advisable that a professionalfirm must operate like a business. To be effective as abusiness, a firm needs a strong and tight managementteam. Gone are the days when fiefdoms of informationtechnology, marketing, finance, human resources, legalrecruiting, professional development, informationresources and administration operated independentlywithin the firm. Today, professional firm must realizethe importance of non professional team, such asInformation Resources and Marketing and Sales. Withoutinvestment in information resources, and its strongmanagement, a firm has a strategic disadvantage intoday’s competitive world. Marketing and Sales is themechanism that drives the firm into the marketplace.Even the best company with a great product is nothingwithout a strong sales team. When the informationresources and marketing and sales team work together,the results can be amazingly rewarding. The outward-looking teams working together help drive the strategicmarketing goals of the firm and have a significant impacton firm revenue.

At present, the Code of Conduct mandatory forCompany Secretaries prohibits direct or indirect soliciting



of professional work and the concept of marketing isforeign to the modus operandi of the profession. Asthe future is evolving under the GATS regime, slowlybut surely the taboos of today will slacken as the daysgo. Till then the concepts of marketing and sales by aprofessional firm will remain innate qualities of theprofessional services and professional relationshipbuilding.

No firm today can be relaxed about driving itsrevenue through the top clients of the firm. The followingis a list of critical steps:

1. Identify the top 50 to 100 clients of the firm.

2. Identify the primary business focus of corporateclients. By identifying this important information,a firm can begin to identify industries in whichit has market share and strength, which willthen help drive strategic marketing decisionsfor the future.

3. Create a tracking mechanism that allows thefirm to stay current with published informationabout its clients, including the activities of keyexecutives.

4. Develop client interview forms to learn aboutimportant client goals that may impact the firm.

5. Create targeted financial goals for building thefirm’s business with each company.

6. Manage information on an ongoing basis aboutthe board members and executive leadershipfor dissemination to appropriate firm teammembers.

CODE OF CONDUCT – AN IMPERATIVE FORPROFESSIONAL FIRMS

All professional firms conduct their operations withinthe framework of applicable professional standards, laws,regulations and internal policies. However, these cannot govern all types of behaviour, therefore it is advisableto have a Code of Conduct based on the values of thefirm. Everyone working in the firm must be under anobligation to follow the guidelines and practice the valuescontained in the Code. While the Code can not addressevery situation, the individuals should be given libertyto exercise good judgment and obtain guidance onproper business conduct. They should be encouragedto seek additional guidance and support from thoseresponsible for conduct of affairs of the firm. Thestrength of every firm is the strength in collective

knowledge and sharing of that knowledge andexperience.

MODEL CODE OF CONDUCT FORPROFESSIONAL FIRMS*

The Code of Conduct provides the ethical frameworkon which the individuals should base their decisions asmembers of the organisation. The Code should beanchored in values and beliefs which the firm practicesand underpin everything that the firm does. The Codeof Conduct may be divided into categories containingguiding principles that should be used by everyone withinthe professional firm to guide their behaviour across allareas of activities.

It should be expected of everyone working for theprofessional firm to behave in accordance with theprinciples contained in the Code of Conduct. In casethere is difficulty in understanding the principlescontained the Code or in applying them, the concernedindividual should be advised to consult an appropriatelyqualified colleague

1. Teaming

In working with each other all members of thefirm should be advised to rely on each other todeliver a quality service to clients and forindividual development. They should be advisedto communicate openly and honestly; Nurturediversity, integrity, respect, and team spirit;Consult each other and value the differentperspectives; Embrace diversity and multiculturalexperience as strengths of the firm; Respectone another and strive for an inclusiveenvironment free from discrimination,intimidation, and harassment; and Encourageand support the professional development ofcolleagues and promote individual achievementand continuous learning; Expect and deliverfeedback regularly, candidly and constructively.

2. Relationship with Clients and Others

In dealing with clients and others, it should bemade clear to all members of the firm that noclient or external relationship is more importantthan the ethics, values, integrity and reputationof the firm. The members of the firm shouldthen commit themselves, as professionals, touphold the trust reposed by others. They shouldbe committed to delivering quality services that

* This Model Code of Conduct has been conceptualized and devised on the basis of Code of Conduct of Ernst & Young andPrincewaterhouse coopers.



reflect professional capabilities and areappropriate to the specific issues and needs ofthe clients.

They should uphold the professional standardsand rules applicable to and actively work withthe regulators who oversee the professionalconduct to ensure that rules and standardsmeet the continuously changing needs of themarket. The members of the firm should beclearly cautioned that they should avoidworking with those whose standards areincompatible with firm’s Code of Conduct butcoordinate, as appropriate, with other membersof the profession in matters of public interest;and recognise the responsibility for playing anactive and positive role in building a successfuland sustainable society .

Professional Objectivity and Independence

The objectivity being critical to professionalindependence, the members of the firm should beadvised to maintain objectivity and affirm independencein relation to services. They should employ professionalskepticism; reject inappropriate pressure from clientsor others; and do not accept or give payments or itemsof value if this could reasonably be viewed as influencingconclusions or advice. The members of the firm shouldbe advised to refrain from such relationships that impair,or may appear to impair, objectivity and independence.

Confidentiality

The confidentiality being the hall mark of thecredibility, the firm should respect and protectconfidential information obtained from, or relating to,its clients or third parties, as well as personal informationabout its people, in accordance with local laws andprofessional standards. The firm should obtain, developand protect intellectual property in an appropriate mannerand respect the restrictions on its use and reproduction.

CONCLUSION

The GATS regime requires Company Secretaries toshow a visionary approach and a positive mindset thatviews the seemingly insurmountable pains anddifficulties as opportunities and not as shackles. The daysof global competition will be harder and longer; thepath will be obscure as well as tiresome; but CompanySecretaries will have to awaken the spirit ofprofessionalism and build up future firms and the futureof the firms with smiling and tireless zeal. The presentConvention with involvement of professional leaders

from foreign countries is a momentous opportunity fornational and International networking to build the future.

REFERENCES

1. GATS Negotiations : Options for India, Draftfor discussion purposes prepared by UNCTADIndia Team and circulated at Pre Hong KongMinistrial Consultation : GATS Negotiations,organised under the aegis of the UNCTAD,Ministry of Commerce, Government of Indiaand DFID Project Strategies and Preparednessfor Trade and Globalisation in India, onAugust 8-9, 2005 at New Delhi.

2. Ross Dawson, Managing ProfessionalKnowledge (http://www.ahtgroup.com).

3. Managing a Multicultural Workforce (July 2001)(http://www.findarticles.com).

4. Ajay Srivastava, GATS – The Indian Scenario(2004).

5. Jim Gordon & Poonam Gupta, UnderstandingIndia’s Services Revolution, Paper prepared forthe IMF – NCAER Conference on A Tale ofTwo Giants – India’s and China’s Experiencewith Reforms, November 14-16, 2003 at NewDelhi.

6. Marion Williams, Regional Growth ofAccounting and other Service Firms, speechdelivered at the launch of the New Deloitte(Barbados) St. James, May 12, 2005.

7. Richard Smith, Managing for More Profitable,consistent Firm Growth, February 2003 issueof Land Development Today.

8. Peter K Jacobs, Star Guide – A research by JayW.Lorsch (http://www.leadingreasch.hbs.edu).

9. FT Mastering Strategy Articles – Lessons fromProfessional Services Firms, November 1999.(http://www.sbs.ox.ac.uk/html/news).

10. Silvia Coulter, Driving Firm Revenue by Buildingthe Perfect Team, Practice Innovations (March2004).

11. William Scarbrough, Shared Services Centers–Are Law Firms Ready for the latest CorporateTrend ? Practice Innovations (March 2004).

12. Don Philmlee, Going Wireless in the law Firms,Practice Innovations (March 2004).

13. Ernst & Young, Global Code of Conduct(http://www.ey.com).

14. PriceWater House Coopers, Code of Conduct(http://www.pwc.com).


Corporate Criminal Liability 9

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V K AGGARWAL*

INTRODUCTION

The debate on appropriateness of attributing criminalliability to corporations is far from over. There are viewsexpressed in favour and against corporate criminalliability. The opponents argue that a corporation has nomind of its own, so it cannot demonstrate the moralturpitude required to establish criminal guilt. It iscompletely artificial to treat a corporation as if it had ablameworthy state of mind which, by definition, itcannot have. Furthermore, the impossibility of jailingan organization foils any attempt to attain the goals ofdeterrence, punishment and rehabilitation pursued bypenal sanctions. The view in favour of corporate criminalliability - advocates that Corporations, are not merefictions. They exist and occupy a predominant positionwithin the society, and are as capable as human beingsof causing harm. It is only just and consistent with theprinciple of equality before the law to treat them likenatural persons and hold them liable for the offencesthey commit. Companies which have a major impacton the social life, must be required to respect thefundamental values of the society upheld by the criminallaw.

Today the crime has shifted from almost solelyindividual perpetrators only 150 years ago, to white-collar crimes on an ever-increasing scale to acquireinternational character.

With the process of globalization and the growthof interdependence in economic, social andenvironmental activities by corporate entities, one ofthe most pressing global issues is the predominance ofnational and multinational corporations in economictransactions and their accountability. The corporatevehicle now occupies such a large portion of theindustrial, commercial and sociological sectors that

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* Principal Director, The ICSI. The views expressed are personal views of the author and do not necessarily reflect those of theInstitute.

amenability of the corporation to criminal law is asessential in the case of the corporation as in the case ofthe natural person.

The question of criminal liability of corporationsillustrates the increasingly relative and functionalinterpretation of corporate responsibility. Thecomplexities of corporate personality have nowherebeen so troublesome as in the field of criminal law.

Two fundamental postulates of criminal law beingpresence of mens rea i.e. guilty mind and the principleof vicarious liability, the criminal law treats the companyliable for an act of its agent or organ done with guiltyintentions. It is well settled that in case the companycontravenes or does not fulfil any statutory obligationsit can be convicted of a statutory misdemeanor and therecan be no other way except the indictment of thecorporation itself. Although there is generally novicarious responsibility in crime and people areresponsible for their own acts, by means of fiction, acorporation could be made accountable as if it is itsown act provided that the act is committed or omissionis made by an organ of the company.

ORGANIC LIFE OF THE COMPANY ANDCAPACITY TO COMMIT CRIME

Lord Denning in Botton Engineering Company Ltd.v. Grahm and Sons (1957, 1 QB 15) 9 CA) observedthat ‘a company, in many cases is linked to a humanbody. It has a brain and a nerve center, which controlswhat it does. It has also hands, which hold the toolsand act in accordance with directions from the Cenozoic.Some of the people in the company are mere servantsand agents, who are nothing more than hands to do thework, and cannot be said to represent the mind or will.Others are directors and managers who represent the



directing mind or will of the company and control whatit does. The state of mind of these managers is thestate of mind of the company and is treated by the lawas such.

In Trustees of Dartmouth College v. Wood Ward(1819) 17 US (4 wheat) 518, Chief Justice Marshalobserved, that a corporation is an artificial being, invisible,intangible, and existing only in contemplation of law.Being the mere creature of the law, it possesses onlythose properties which the charter of creation conferson it. This observation of Justice Marshal led to theconcept that a corporation is an entity distinct from itsmembers and officers, and with rights and liabilities ofits own.

It was said that the corporate body could not : havecriminal intent; be indicted by criminal procedure; bepunished corporally; or be capable of certain criminalacts which were either void as ultra vires or by theirvery nature were inherently human. In most instancesthese barriers to liability have been overcome by judicialdecisions and legislative enactments. The impossibilityof harboring criminal intent, is a vestige of traditionstemming from the theory that a corporate body, withouta mind and a will cannot harbor any intent in its ordinarycapacity. However, most courts have now come to thesettled position that a corporation may be capable ofmens rea.

As most corporate crimes stem from economicobjectives, it is entirely possible that a corporation mightreadily subject itself to the fine. But incalculable effectof conviction on the public attitude towards thecorporation is probably the most forceful deterrent.There are corporate acts which are ultra vires and of nolegal effect. The outlook sometimes prevails that acorporation can not be guilty of a particular crime, forthat is ultra vires in itself, but it is not impossible to tearoff logic to reason that no such crime exists. Theconsidered range of these ultra vires acts has been sonarrowed by the modern extension of corporate liabilitythat the paths of this trend become a prime concern.

CORPORATE CRIMINAL LIABILITY – HISTORICALPERSPECTIVE

Generally, the common law did not allow acorporation to be convicted of a crime. There wereexceptions and these exceptions were based on thedoctrine of respondent superior or vicarious liability –the master is liable for the conduct of his servant in thecourse of employment. The doctrine of vicarious liabilitywas created in the law of tort in the seventeenth centuryin order to provide compensation to third parties and

justified on the ground that since the master acquiredthe benefits of the servant’s work, he should also carrythe burdens.

While the common law recognized theappropriateness of vicarious liability for tortcompensation, it rejected vicarious liability for crimessince crimes required mens rea or guity mind. Themere existence of the master-servant relationship wasnot considered to be a sufficient criterion for imputingpersonal fault to the master. However, there were threecommon law crimes which did not require mens rea.These include public nuisance, criminal libel andcontempt of court. In these categories of offences, thecourts applied vicarious liability, allowing the master(which could be either an individual or a corporation) tobe convicted for offences of his servant. Apart fromthese vicarious liability exceptions, corporations wereimmune from liability under the criminal law.

The courts in early twentieth century began todismantle the corporate immunity from criminal law byholding that words like everyone in criminal statutescould include corporations. Courts also rejected theargument that corporations cannot be held criminallyliable for offences committed by their officers for reasonsof being ultra vires unless those employees wereexpressly ordered to commit the act in question.However, the most challenging obstacle to imposingcriminal liability on corporations was the difficulty ofattributing mens rea to an artificial person - a corporation.The breakthrough came in 1915 when the House ofLords in Lennard’s Carrying Co. Limited, v. AsiaticPetroleum Co. (1915) AC 705 at 713 (H.L.) layed downthe general principle of directing mind (identificationtheory). In this case Viscount Haldane stated that“corporation is an abstraction. It has no mind of it ownany more than it has a body of its own; its active anddirecting will must consequently be sought in the personof somebody who for some purposes may be called anagent, but who is really the directing mind and will ofthe corporation, the very ego and centre of thepersonality of the corporation”. Subsequently, in R v.Fane Robinson Ltd., (1941) 76CCC 196 at 203 (AllaC.A.), the Canadian Court applied the principle ofdirecting mind and held that there is no reason why acorporation which can enter into binding agreementswith individuals and other corporations cannot be saidto entertain mens rea when it enters into an agreementwhich is the gist of a conspiracy and a false pretence.

THEORIES OF CORPORATE CRIMINALLIABILITY

There are two theories, i.e. Theory of Vicaricous



Liability and Identification; theories which have beenused, in different contexts, to hold corporations criminallyliable for true crimes and regulatory offences. Thetraditional theory of vicarious liability holds the masterliable for the acts of the servant in the course of themaster’s business without proof of any personal faulton the part of the master. Whereas the identificationtheory recognises that the acts and state of mind ofcertain senior officers in a corporation are the directingminds of the corporation and thus deemed to be theacts and state of mind of the corporation. Thecorporation is considered to be directly liable, ratherthan vicariously liable under this theory. Let us examine,the various components of these two theories.

1. Doctrine of Vicarious liability

Generally the doctrine of vicarious liability recognisesthat a person may be bound to answer for the actsof another. Similarly in the case of corporations –the company may be liable for the acts of itsemployees, agents, or any person for whom it isresponsible. The doctrine of vicarious liabilitydeveloped originally in the context of tortiousliability, was imported into the criminal law, whenthis type of offences were essentially absoluteliability offences. [See for brief historical account ofthe importation of this common law doctrine inCanadianLaw, Canadian Dredge & Dock Co. v. TheQueen (1985) 1SC R662)].

2. Identification theory

Contemplates an identity between the corporationand the persons who constitute its directing mind -the individuals whose duties within the corporationare such that, in the course of their duties, they donot take orders or directives from a higher authoritywithin the organization. The commission of anoffence by such person or group of personsidentified with the organization and constitutes anoffence by the corporation as well. The criminalliability of the corporation, like that of naturalpersons, indeed is primary and is not actually basedon an application of the theory of vicarious liability.

The identification doctrine developed out of theperceived need to hold corporations liable for mens reaoffences has created a pragmatic median between theextremes of total vicarious liability for all criminal actsand no corporate liability unless expressly authorizedcriminal acts. This doctrine stipulates that the actionsand mental stage of the corporation found in the actionsand state of mind of employees or officers of thecorporation who may be considered the directing mind

and will of the corporation in a given sphere of thecorporation’s activities. A crucial point as to whichemployees or officers of a corporation are its directingmind for the purpose of the identification doctrine wasconsidered and decided by the Supreme Court of Canadain Dredge & Dock case. The Supreme Court describedthe characteristics of the doctrine of identification theory,which may be summarized as follows :

1. It is a court adopted, pragmatic, but fictionaldevice used to attribute a human element(mental state of mind) to an equally abstractentity called a corporation, for the purpose ofincluding corporations within the control of thecriminal law similar to natural persons.

2. If a corporate employee (or agent) is, in theCourt’s assessment virtually the directing mindand will of the corporation in the sphere ofduty and responsibility assigned to the employeeby the corporation, the employee’s action andintent are the action and intent of the companyitself, provided the employee is acting withinthe scope of his/her authority either express orimplied.

3. The essence of the test is that the identity ofthe directing mind and the company coincidewhen the directing mind is acting within his/her assigned field of corporate operations i.e.field of operations may be geographic, orfunctional, or it may embrace the coporation’sentire operations.

4. A corporation may have more than onedirecting mind. Where corporate activities aregeographically widespread or diffused, it willbe virtually inevitable that there will bedelegation and sub delegation of authority fromthe corporate centre and therefore there willbe several directing minds.

5. Since the actions and intent of the directingmind within his or her assigned field are mergedwith and become the actions and intent of thecorporation, it is no defence for a corporation,to claim that,

(i) the Board of Directors or other corporateofficers issued general or specificinstructions prohibiting the criminalconduct;

(ii) the corporation and its directing mind areone, and thus the prohibition from onecontrolling arm of the corporation to



another controlling arm can have no effectin law;

(iii) the Board of Director had no awareness ofthe criminal conduct and did not authorizeor approve it.

6. Although the directing mind and thecorporation merge as one for the purposes ofallowing the corporation to be convicted of anoffence, both the directing mind and thecorporation can each be prosecuted, convictedand punished for the offence.

Corporate Criminal Liability – Indian Context

The question whether a company could beprosecuted for an offence for which mandatory sentenceof imprisonment is provided continued to agitate theminds of the courts and jurists and the law continued tobe the old law despite the recommendations of theLaw Commission and the difficulties were expressed bythe superior courts in many decisions.

Different High Courts have taken different viewson this question. In State of Maharashtra v. SyndicateTransport Co. (P) Ltd. (1964) 66 Bom L.R. 197; AIR1964 Bom 195, the Bombay High Court held that thecompany cannot be prosecuted for offenceswhich necessarily entail consequences of a corporalpunishment or imprisonment and prosecuting a companyfor such offences would only result in the court stultifyingitself by embarking on a trial in which the verdict ofguilty is returned and no effective order by way ofsentence can be made. In Kusum Products Ltd. v. S.K.Sinha (1980) 126, ITR 806 (Cal.) the Calcutta High Courttook the view that even though the definition of “person”under section 2(31) of the Income Tax Act is wideenough to include a company or a juristic person, theword “person” could not have been used by Parliamentin Section 277 (Income Tax Act) in the sense given inthe definition clause. The Calcutta High Court furtherheld that the intention of Parliament is otherwise becauseimprisonment has been made compulsory for an offenceunder Section 277 of the Act and a company being ajuristic person cannot possibly be sent to prison and it isnot open to a court to impose a sentence of fine or notto award any punishment if the court finds the companyguilty under the said section, and if the court does it, itwould be altering the very scheme of the Act andusurping the legislative function.

In Badsha v. ITO (1987) 168 ITR 332(Ker) JusticeThomas, J., following the decision of the Allahabad HighCourt in Modi Industries Ltd. v. B. C. Goel (1983) 144ITR 496(All) held that a company registered under the

Companies Act, 1956, is a juristic person and cannotbe awarded the punishment of imprisonment and hencecannot be prosecuted for breach of Sections 277 and278 of the Act”. In P. V. Pai v. R. L Rinawma (1993)l Com.LJ 314; (1993) 77 Comp.cas 179 (Kant) it washeld that imprisonment alone was the punishment thatcould be imposed on a person found guilty and that thelegislature intended that the offence under Section 277should be met with punishment of compulsoryimprisonment and fine, and courts have no jurisdictionto impose fine only and if that is done it would be alteringthe very scheme of the Act.

The Supreme Court in Asstt. Commissioner v.Velliappa Textiles Ltd. (2003) 7SCC 405 held by amajority decision that the company can not beprosecuted for offences which require imposition of amandatory term of imprisonment coupled with fine. TheSupreme Court further held that where punishmentprovided is imprisonment and fine, the court can notimpose only fine. The Supreme Court in ANZ GrindlaysBank Ltd. v. Directorate of Enforcement (2004) 6 SCC531 held that the correctness of the decision in VelliappaTextiles Ltd. case requires reconsideration by aconstitution Bench and thus referred the matters to aconstitution Bench for an authoritative pronouncementon the subject.

Evolution of Corporate Criminal Liability in India

In Oswal Vanaspati & Allied Industries v. State ofU.P. 1993 1 Comp LJ 172, the Full Bench of the AllahabadHigh Court held that a company being a juristic personcannot obviously be sentenced to imprisonment as itcannot suffer imprisonment. The question that requiresdetermination is whether a sentence of fine alone canbe imposed on it under Section 16 of the Act or whethersuch a sentence would be illegal and hence cannot beawarded to it. It is settled law that sentence orpunishment must follow conviction and if only corporalpunishment is prescribed a company which is a juristicperson cannot be prosecuted as it cannot be punished.If, however, both sentence of imprisonment and fine isprescribed for natural persons and juristic persons jointlythen though the sentence of imprisonment cannot beawarded to a company, the sentence of fine can beimposed on it. Thus, It cannot be held that in such acase the entire sentence prescribed cannot be awardedto a company as a part of the sentence, namely, that offine can be awarded to it. Legal sentence is the sentenceprescribed by law. A sentence which is in excess of thesentence prescribed is always illegal but a sentencewhich is less than the sentence prescribed may not inall cases be illegal.”



Recently, The Supreme Court in Standard CharteredBank & Others v. Directorate of Enforcement & Others(2005) 4 SCC 530, considered the issue as to whether acompany, or a corporation, being a juristic person, couldbe prosecuted for an offence for which mandatorysentence of imprisonment and fine is provided; and whenfound guilty, whether the court has the discretion toimpose a sentence of fine only. The Supreme Courtheld that there is no dispute that a company is liable tobe prosecuted and punished for criminal offences.Although there are earlier authorities to the effect thatcorporations cannot commit a crime, the generallyaccepted modern rule is that except for such crimes asa corporation is held incapable of committing by reasonof the fact that they involve personal malicious intent, acorporation may be subject to indictment or othercriminal process, although the criminal act is committedthrough its agents.

In the Standard Chartered Bank case the SupremeCourt observed that as in the case of torts, the generalrule prevails that the corporation may be criminally liablefor the acts of an officer or agent, assumed to be doneby him when exercising authorised powers, and withoutproof that his act was expressly authorised or approvedby the corporation. In the statutes defining crimes, theprohibition is frequently directed against any “person”who commits the prohibited act, and in many statutesthe term “person” is defined. Even if the person is notspecifically defined, it necessarily includes a corporation.It is usually construed to include a corporation so as tobring it within the prohibition of the statute and subjectit to punishment.

Distinction between Strict Liability and AbsoluteLiability

In as much as all criminal and quasi-criminal offencesare creatures of statute, the amenability of the corporationto prosecution necessarily depends upon the terminologyemployed in the statute. In the case of strict liability,the terminology employed by the legislature is such asto reveal an intent that guilt shall not be predicatedupon the automatic breach of the statute but on theestablishment of the actus reus, subject to the defenceof due diligence. The law is primarily based on the termsof the statutes. In the case of absolute liability wherethe legislature by the clearest intendment establishesan offence where liability arises instantly upon the breachof the statutory prohibition, no particular state of mindis a prerequisite to guilt. Corporations and individualpersons stand on the same footing in the face of such astatutory offence. It is a case of automatic primaryresponsibility. Therefore, as regards corporate criminal

liability, there is no doubt that a corporation or companycould be prosecuted for any offence punishable underlaw, whether it is coming under the strict liability orunder absolute liability

The Supreme Court further observed that it is truethat all penal statutes are to be strictly construed in thesense that the court must see that the thing charged asan offence is within the plain meaning of the wordsused and must not strain the words on any notion thatthere has been a slip that the thing is so clearly withinthe mischief that it must have been intended to beincluded and would have been included if thought of.All penal provisions like all other statutes are to be fairlyconstrued according to the legislative intent as expressedin the enactment. See Tolaram Relumal v. State ofBombay, (1955) 1 SCR 158; Giridheri Lal Gupta v. D.H.Mehta, (1971) 3 SCC.

In fact, there are a series of offences under variousstatutes where the accused are also liable to be punishedwith custodial sentence and fine. As per the scheme ofvarious enactments and also the Penal Code, mandatorycustodial sentence is prescribed for graver offences. Ifthe appellants’ plea is accepted, no company or corporatebodies could be prosecuted for the graver offenceswhereas they could be prosecuted for minor offencesas the sentence prescribed therein is custodial sentenceor fine. It could not be the intention of the legislatureto give complete immunity from prosecution to thecorporate bodies for the grave offences.

If the custodial sentence is the only punishmentprescribed for the offence, the company being a juristicperson cannot be prosecuted for the offence for whichcustodial sentence is the mandatory punishment. Butwhen the custodial sentence and fine are the prescribedmode of punishment, the court can impose the sentenceof fine on a company which is found guilty as thesentence of imprisonment is impossible to be carriedout. It is an acceptable legal maxim i.e the impotentiaexcusat legem law does not compel a man to do thatwhich cannot possibly be performed. And “all civilizedsystems of law import the principle that lex non cogitad impossibilia....”. So also “if an enactment requireswhat is legally impossible it will be presumed thatParliament intended it to be modified so as to removethe impossibility element”. As the company cannot besentenced to imprisonment, the court cannot imposethat punishment, but when imprisonment and fine isthe prescribed punishment the court can impose thepunishment of fine which could be enforced againstthe company.



The Supreme Court explained that there is noblanket immunity for any company from any prosecutionfor serious offences merely because the prosecutionwould ultimately entail a sentence of mandatoryimprisonment. The corporate bodies, such as a firm orcompany undertake a series of activities that affect thelife, liberty and property of the citizens. Large-scalefinancial irregularities are done by various corporations.The corporate vehicle now occupies such a large portionof the industrial, commercial and sociological sectorsthat amenability of the corporation to a criminal law isessential to have a peaceful society with stable economy.Therefore, there is no immunity to the companies fromprosecution merely because the prosecution is in respectof offences for which the punishment prescribed ismandatory imprisonment and fine. The Supreme Courtin thus Velliappa Case has given new dimension to thecorporate criminal liability and favoured the new thinkingprevalent in other parts of the world.

In Australia, France (Penal Code of 1992), theNetherlands (the Economic Offences Act,1950 andArticle 51 of the Criminal Code) and Belgium (in 1934Courde Cassation) as citied in Velliappa case, theSupreme Court observed that in all these jurisdictions,the view that prevailed was that, where a statute imposesmandatory imprisonment plus fine, such a provisionwould not enable the punishment of a corporateoffender. If the legislatures of these countries steppedin to resolve the problem by appropriate legislativeenactments giving an option to the courts to imposefine in lieu of imprisonment in the case of a corporateoffender, we see nothing special in the Indian contextas to why such a course cannot be adopted. Merelybecause the situation confronts the courts in a numberof statutes, the court need not feel deterred inconstruing the statute in accordance with reason.”

CONCLUSION

There is an apparent need to adapt the notion offault to the structure and particular modus operandi ofcorporations. The existing mechanisms used to attributecriminal liability to corporations are but a partial solution,and should be improved.

This cannot be achieved in any meaningful wayunless some serious thought is given to a number offundamental questions, including the ability of criminalsanctions to effectively fulfill, in the corporate context,

the objectives of punishment, deterrence andrehabilitation traditionally associated with them. It is oftenargued in opposition to corporate criminal liability thatthe imposition of fines provides no guarantee thatdelinquent conduct will be deterred. The fines imposedon corporations are often minimal in comparison withthe devastating effects of their wrongful acts, andvirtually amount to a cost of doing business. But there isalso a concern that excessive fines can have perverseeffects that may have to be borne by innocentshareholders, creditors, employees or consumers.However, the preceding discussion makes it ample clearthat in view of imposing role of corporations ineconomic, political and social spheres, the jurisdictionaround the world are thinking in harmonious fashion inimposing criminal liability on corporations. As variousjurisdictions have given this a statutory status, in Indiatoo the Government will consider the same in the lightof Reports of Law Commission and the Supreme Courtdecision in Standard Chartered case.

REFERENCES

1. Jennifer Arlen, Evolution of Corporate CriminalLiability : Implications of Managers NYU, Lawand Economics Research Paper No. 04 – 022.

2. Jonanthan Clough, Sentencing the CorporateOffenders: The Neglected Dimension ofCorporate Criminal Liability.

3. C Kennedy, Criminal Sentences forCorporations: Alternative Fining Mechanism(1985) 73 California Law Review 443.

4. B Fisse and J Braithwaite, The Allocation ofResponsibility for Corporate Crime:Individualism, collectivism and Accountability(1988) 11 Syd. L R 468.

5. Anne-Marie Boisvert, Corporate CriminalLiability – A Division Paper, Criminal Law StudyPaper, Uniform Law Conference of Canda.

6. Mar Kus Wagner, Corporate Liability : Nationaland International Perspective Background paperfor International Society for the Reform ofCriminal Law, 13th International Conferenceon Commercial and Financial Fraud : AComparative Perspective, Malta, July 8-12,1999.


Global Marketing and Brand Building of Company Secretaries 15

GLOBAL MARKETING AND BRAND BUILDING OFGLOBAL MARKETING AND BRAND BUILDING OFGLOBAL MARKETING AND BRAND BUILDING OFGLOBAL MARKETING AND BRAND BUILDING OFGLOBAL MARKETING AND BRAND BUILDING OFCOMPCOMPCOMPCOMPCOMPANY SEANY SEANY SEANY SEANY SECRETCRETCRETCRETCRETARIESARIESARIESARIESARIES

BALWANT KULKARNI*

GLOBAL MARKETING

Globalisation of Company Secretaries’ servicesinvolves the commercial aspect of marketing theseservices to clients and companies from abroad establishingtheir presence in India as well as those exist forconducting business in other countries of the world.These companies and business houses need to appreciatethe value of services rendered by Company Secretaries.Although proactive marketing of services is banned asat present under the professional code of conduct,through interaction with such companies and businessesthe result of their dependence on the services ofindependent professionals like Company Secretaries isachieved. A constant touch and continued interactionwith such businesses, Company Secretaries do achieverecognition to and appreciation of the services renderedby them through their public practice activities. Nowthat Company Secretaries will have to compete globallythey would not be able to escape the rules of marketingof professional services and the development of the skillsof marketing of professional services that the multi-national professional firms have perfected over the years.

Service marketing has many subtler nuances ascompared to the marketing of hard products. In fact itis necessary to turn services into and package them asproducts before presenting them as a sales proposition.The packaging should be clear and appealing to thephysical as well as the discerning inner eye of theprospect. The characteristics, the unique sellingproposition, the value-adding propensities, theadvantages offered by the service-product should beclear and palpable in all aspects when the product ispositioned in the service market. The preparation andpresentation of the service-product should be precededby market research, competition research, customer-need research. The after-sale offerings should also beclarified in the presentation. There could also be testmarketing or even better Company Secretaries should

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* Director, The ICSI. The views expressed are personal views of the author and do not necessarily reflect those of the Institute.

recognize the importance of and methodology of co-creation of value with the customer.

Company Secretaries’ firms should also developcustomer-centric culture.

Customer centric culture includes:

— understanding what customers seek;

— mapping competition;

— evolving a positioning strategy;

— bringing the value proposition alive;

— keeping track of changing needs.

They must realize that customers alone pay costsand provide profits. No longer is a product differentiatorfrom a competitor, but it is human touch in the interactionwith customers that matters.

From an organization’s perspective [in connectionwith internal customer culture], it is important to createleadership at every level. Mistakes have to be toleratedand differences [of opinion] within an organization mustbe appreciated. Professional firms also have to managetheir daily processes, as if they [the processes] wereactual villains in creating dissatisfied customers.

Feedback is an integral part of services andcomplaints are like gifts—the option is to effectivelymanage them in order to survive, sustain and grow.

When a professional firm researches the market andthe customers it must bear in mind that research cannottake the place of insights gleaned from observing people.Insights operate at two levels in marketing. The first isas part of the strategy and feeding into the client brief.This is classically the function of the account planner.The insight at this stage is properly a part of the targetaudience understanding in terms of what motivatesthem, and why the service’s selling proposition wouldbe of interest to them.



The second is as part of the creative idea. Theseinsights are sharp and form the core of the approach bywhich the selling proposition is magnified. In greatcreative marketing, the idea is the insight and the insightis the idea. Company Secretaries need to practise‘insightfulness’ which is the habit or observing peoplearound them, what they are upto, what they are talkingabout and what seems to be turning them on. Theseinsights give the service-product idea.

Now if we turn to creation of value that any serviceneeds to offer we may turn to the observations of avery successful service company form India:

Inuagurating the convention on “Beyond CreatingValue” Mr Raju, Chairman, Satyam, said the need ofthe hour was leadership from the manufacturing sectorto create value in the services sector. The concept ofindividuals doing what they have been told to do as aprofessional is losing relevance in the services sector.Satyam has adopted a “full lifecycle value-creationmodel”, which involves three concepts- thinking, doingand communicating.

Knowledge economy demanded that companiesput a premium on their soft assets such as brand valueand goodwill among customers rather than on hard assetslike machines and materials.

Global GDP and wealth creation this century willbe due to the creation of new products and services.This meant that all existing products and servicesavailable will get commoditized, resulting into a fall inprices and reduction in their exchange values.

WTO

Collectively, the profession world-over requires topush for its brand identity. WTO is the right formal forumfor this purpose.

Another aspect of globalisation of companysecretarial services is to have that Head separatelyrecognized as a professional service under the WTOportals. Negotiations through national offers and counter-offers under the four Modes of General Agreement onTrade in Services take place with reference to the variouscategories of services that are rendered across nationalborders. A research through the United Nations CentralProduct Classification adopted by the WTO forclassification of, inter alia, services for negotiations underthe four Modes under the GATS.

An Executive Summary of the Approach Paperpublished by the WTO for securing openness of cross-border trade in services will be an interesting reading

for those who would put in their weight, indirectly ordirectly, in the corridors of the WTO negotiations. TheSummary reads as follows:

(i) Cross-border trade in services is growing rapidly,with India among the most dynamic exporters.Despite the substantial global benefits from suchtrade, it is possible that the adjustmentpressures created in importing countries couldprovoke a protectionist backlash - some signsof which are already visible in procurement andregulatory restrictions. The current negotiationsunder the Doha Development Agenda offer anopportunity to preempt protectionism. This isbest accomplished, not by perpetuating theWTO’s decision on duty-free electroniccommerce, but by ensuring that all WTOMembers make comprehensive commitmentson cross-border trade in services under theGeneral Agreement on Trade in Services(GATS).

(ii) Previous experience of the GATS negotiationsand initial offers of access by Members in thecurrent round suggest, however, thatcomprehensive coverage will not be easy toaccomplish, for two reasons. First, in the currentGATS framework, the market accesscommitments of WTO Members apply only tosectors explicitly listed by them, which placesa heavy burden on the services classificationscheme used by Members. The existingclassification scheme does not cover all theservices in which India has an export interest.Revising it does not offer a durable solutionbecause no classification scheme can keepup with changes in technology, businesspractices and skills, and anticipate the ever-widening range of new services that Indiawil l export. Second, WTO Memberstraditionally negotiate access in servicesthrough the request-and-offer approachwhich involves extracting commitmentstrading partner by trading partner, sector-by-sector. This is a painful task with high costsin terms of negotiating resources, and it willnot be particularly fruitful because India doesnot necessarily have much to offer eachcountry to which it may one day sellservices.

(iii) More innovative approaches are necessary, andshould be possible, since the issue in cross-border trade is not to induce countries toeliminate protection but simply to lock in their



currently open regimes. The paper suggeststwo possibilities. The less ambitious Option 1is for WTO Members to make liberalizingcommitments on the basis of a model scheduledesigned to cover the information technologyand business process outsourcing (BPO) servicesthat are at the heart of the current trade boom.An essential step is to map the IT and BPOservices being traded today into the existingGATS classification scheme, a task this noteundertakes.

(iv) In the more forward looking Option 2, boththe classification and strategic problem may beaddressed through an innovative proposalrequiring that all (or a critical mass of) WTOMembers commit not to impose any restrictionson cross-border trade in any except a mutuallyagreed (narrow) set of services. Such aproposal would combine two elements: anegative list approach for cross-border tradethat finesses the whole classification issue bytreating all services as covered except theexplicitly excluded few; and a “formula”approach that requires all WTO Members (ora critical mass) to undertake a specified levelof commitments.

(v) The paper identifies these concrete options inorder to advance discussion and facilitateconsultations, domestically and with tradingpartners, on how best to secure free cross-border trade in services. It will also benecessary to consider complementary initiativeson regulatory transparency, domestic regulation,and the clarification of issues like applicablejurisdiction, to achieve the aim of unfetteredcross-border trade in services.

Although one way to establish cross-borderrecognition of Company Secretary’s services is for theICSI to enter into Mutual Recognition Agreements withcorresponding Institutes in other countries, this will onlybe a bilateral recognition. The growth in CompanySecretary services at the world or multilateral level willnot take place through this method. The growth that isrequired for the profession to prosper at the global levelcalls for a multilateral recognition. A visible offer orcounter-offer or comprehensive commitment incorporate governance and company secretarial servicesthrough the WTO negotiations would go a long way.

In India, the statute has recognized services of thepractising Company Secretary through section 2 of theCompany Secretaries Act, 1980.

Services of Company Secretary

Section 2(2) of the Company Secretaries Act, 1980has prescribed the following areas of practice for acompany secretary in practice:

(a) to engage himself in the practice of theprofession of company secretaries to, or inrelation to, any company; or

(b) to offer to perform or perform services inrelation to the promotion, formation,incorporation, amalgamation, reconstruction, re-organization or winding-up of companies; or

(c) to offer to perform or perform such services asmay be performed by:(i) an authorized representative of a company

with respect to fil ing, registering,presenting, attesting or verifying anydocuments (including forms, applications,and returns) by or on behalf of thecompany;

(ii) a share transfer agent;(iii) an issue house;(iv) a share and stock broker;(v) a secretarial auditor or consultant;(vi) an adviser to a company on management,

including any legal or procedural matterfalling under the Capital Issues (Control)Act, 1947, the Industries (Developmentand Regulation) Act, 1951; the CompaniesAct, 1956; the Securities Contracts(Regulation) Act, 1956; any of the rules orbye-laws made by a recognized stockexchange, the Monopolies and RestrictiveTrade Practices Act, 1969; the ForeignExchange Regulation Act, 1973; or underany other law for the time being in force.

(vii) to issue certificates on behalf of, or for thepurposes of a company; or

(d) to hold himself out to the public as a companysecretary in practice; or

(e) to render professional services or assistancewith respect to matters of principle or detailrelating to the practice of the profession ofcompany secretaries; or

(f) to render such other services as, in the opinionof the Council are or may be rendered by aCompany Secretary in practice;The words “to be in practice”, with theirgrammatical variations and cognate expressions,shall be construed accordingly.



When India entered into Comprehensive EconomicCooperation Agreement a Joint Study Group wasestablished to study the scope of trade in servicesbetween the two countries. The findings of the studygroup are indicative of the scope for services that canbe rendered by professionals from India and Singaporebilaterally.

FINDINGS OF JOINT STUDY GROUP

(a) Singapore is a labour scarce country andmaintains a policy of being open to foreigntalent. India is a rich source of internationallycompetitive skilled professionals, which can beabsorbed by Singapore’s knowledge-basedsectors. However, the cross-country movementof professionals is restricted by barriers such asregistration requirements, nationality andcitizenship requirements and the lack of mutualrecognition of qualifications.

(b) Singapore’s export of services to India grew by41.7 per cent from S$585 million (US$361million) in 1998 to S$830 million (US$512million) in 2000. India’s export of services toSingapore grew by 34.5 per cent from S$293million (US$181 million) in 1998 to S$394million (US$243.2 million) in 2002.

(c) The Indian economy is expected to grow at arate of around 8 per cent in the next 10–15years. This would require an investment ofUS$429 billion over the same period in theinfrastructure sector alone and India will benefitfrom Singapore’s experience and technicalknow-how in infrastructure services.

(d) Indian companies have shown interest ininvesting in Singapore. Since Singapore isdeveloping as a regional and international hubfor various services, such as IT, finance,education and health, access to the Singaporemarket will widen the global marketing networkof Indian companies.

SERVICE SECTOR STATISTICS

Information about trade in commercial services in2004 points to a faster growth in commercial servicestrade in the Asian Economies than in North American orEuropean Economies.

IMF – BOP Statistics, 2004 reports that the dollarvalue in commercial services increased to $2.10 trillion[16% year on year] in 2004. This was led by strongrecovery in transportation and travel services.

INVESTMENT IN SERVICE SECTOR

World Investment Report, 2004 indicates thatinvestment in services (mode 3) has been on the rise inthe last decade and was an estimated $4 trillion in 2004,60% of world FDI stock.

Services represent 20% of total world trade butaccount for over two-thirds of world GDP.

Yet, inspite of the scope available, a serious, yet,unintended error has crept in when the Annexurerelating to list of professionals was being finalized as apart of the Comprehensive Economic CooperationAgreement with Singapore.

The error has occurred, it may be surmised, becausea general multilateral recognition to the services ofCompany Secretaries was not on the anvil through theUN or the WTO apparatus.

REFERENCE TO CS IN CECA

CECA Between India and Singapore

Annexure 9A – List of Professionals

Item 112 – “Company Secretaries who areAccountants”

A study of the UN Central Product Classificationthat is adopted by the WTO was carried out with specificemphasis on Service Heads that covered services ofPractising Company Secretaries as enunciated in theCompany Secretaries Act, 1980. The results of the studyare as follows:

UNCPC AND WTO CLASSIFICATION

The classification of service sectors in this scheduleis based on the 1991 provisional Central ProductClassification (CPC) of the United Nations StatisticalOffice unless otherwise indicated by the absence of aCPC number. The ordering reflects the Services SectoralClassification list as used in the GATT documentMTN.GNS/W/120 dated 10 July 1991. The schedulingof specific commitments follows the guidelines statedin GATT documents MTN.GNS/W/164 dated 3September 1993 and MTN.GNS/W/164/Add.1 dated30 November 1993.

EXPLANATION TO RELEVANT SUB-CLASSIFICATIONS UNDER PROVISIONAL CPC

Subclass : 86119 - Legal advisory and representationservices in judicial procedures concerning other fieldsof law.



Legal advisory and representation services duringthe litigation process, and drafting services of legaldocumentation in relation to law other than criminallaw. Representation services generally consist of eitheracting as a prosecutor on behalf of the client, ordefending the client from a prosecution.

Subclass: 86120 - Legal advisory and representationservices in statutory procedures of quasi-judicial tribunals,boards, etc.

Legal advisory and representation services duringthe litigation process, and drafting services of legaldocumentation in relation to statutory procedures.Generally, this implies the representation of a client infront of a statutory body (e.g. an administrative tribunal).Included are both the pleading of a case in front ofauthorized bodies other than judicial courts, and therelated legal work. The latter comprises research andother work for the preparation of a non-judicial case(e.g. researching legal documentation, interviewingwitnesses, reviewing reports), and the execution of post-litigation work.

Subclass : 86130 - Legal documentation andcertification services

Preparation, drawing up and certification servicesof legal documents. The services generally comprisethe provision of a number of related legal servicesincluding the provision of advice and the execution ofvarious tasks necessary for the drawing up or certificationof documents. Included are the drawing up of wills,marriage contracts, commercial contracts, businesscharters, etc.

Subclass : 86190 - Other legal advisory andinformation services

Advisory services to clients related to their legalrights and obligations and providing information on legalmatters not elsewhere classified. Services such as escrowservices and estate settlement services are included.

Subclass : 86501 - General management consultingservices

Advisory, guidance and operational assistanceservices concerning business policy and strategy and theoverall planning, structuring and control of anorganization. More specifically, general managementconsulting assignments may deal with one or acombination of the following: policy formulation,determination of the organizational structure that willmost effectively meet the objectives of the organization,legal organization, strategic business plans, defining amanagement information system, development of

management reports and controls, business turnaroundplans, management audits and other matters which areof particular interest to the higher management of anorganization.

Subclass : 86509 - Other management consultingservices

Advisory, guidance and operational assistanceservices concerning other matters. These services includeindustrial development consulting services, tourismdevelopment consulting services, etc.

Subclass : 86602 - Arbitration and conciliationservices

Assistance services through arbitration or mediationfor the settlement of a dispute between labour andmanagement, between businesses or betweenindividuals.

Exclusions : Representation services on behalf ofone of the parties in the dispute and consulting servicesin the field of labour relations are classified in subclass86190 (Other legal advisory and information services),95110 (Services furnished by business and employersorganizations) and 95200 (Services furnished by tradeunions), respectively.

Subclass : 81312 - Financial market regulatoryservices

Monitoring and enforcement services of rules andregulations in the financial markets pertaining to depositand loan services and respective institutions, and tosecurities markets and participants in those markets.

Subclass : 81319 - Other financial marketadministration services

Administrative services to security or commodityholders, brokers or dealers, e.g. security custody services,financial reporting services, and other marketadministration services, not elsewhere classified.

Subclass : 81322 - Securities issue and registrationservices

Administrative services related to the issue andregistration of securities, e.g. provided in issuing stocksor bonds.

Subclass : 81329 - Other services related tosecurities markets

Information services on stock quotations andinformation dissemination services through documentsor electronic means. Other services related to securitiesmarkets, not elsewhere classified.



Cross Border Supply

At present, services negotiations are at a criticaljuncture at the WTO as is well known. Supply of servicesthrough Mode-1 i.e Cross Border Supply is an area ofcore interest for India. Technological developments inthe recent past have made possible commerciallymeaningful trade in a number of sectors and sub-sectorsthat was earlier not possible. Further, the strongeconomic pressures on multinational corporations to cutcosts have also led to outsourcing of a number ofservices.

Under the GATS, trade through Business ProcessOutsourcing is undertaken through the electronic modesof delivery i.e Mode 1. The Services provided throughIT Enabled Services cover a wide range and cut across anumber of service sectors such a professional services,Telecommunication Services, Business Services,Education Services, Distribution service, Tourism Services,Transport Services etc. It would also cover activities suchas back office operations, call centers, medicaltranscription etc. in which India has already developedworld standard abilities.

According to NASSCOM estimates, in 2002, theglobal BPO market was valued at US$ 773 billion. Thisis expected to rise to US$ 1 trillion by 2006. India’sBPO exports in 2003-04 amounted to US$ 3.6 billion,recording a growth of 54% over the previous year. Theprojected BPO exports from India in 2008 are US$ 22billion.

When the Uruguay Round began, Membercountries took commitments in a number of servicesectors, which could be supplied through Cross BorderSupply, which led to a liberal regime through this Modeof supply. However, there are still gaps in commitmentsboth because in the Uruguay Round many of the servicescould not be traded cross border and because theexisting classification does not adequately cover manyservices that are being supplied through this Mode. Ithas been India’s stand that Members should lock incurrent liberal regimes in Cross Border Supply as well asplug the gaps in commitments.

Even the steps above may, however, not be enoughto push forward our agenda in Cross Border Supply. Inparticular, we need to focus on the following:

Whether there are specific services, which have alot of potential for commercial trade even now, but arenot adequately reflected in the current classification.

Assess the commercial potential for trade of theactivities described in the attached classification and

whether India can competitively supply these serviceselectronically.

Assess whether technological developments in thefuture may give rise to new services, which can betraded commercially

It is, therefore, necessary to examine each of theservices in the enclosed list from the point of view ofthe parameters listed above.

In light of the above discussion, it is clear that BPO/ITES and off-shoring are likely to continue as majorthrust areas from India’s point of view. It is, therefore,essential that we negotiate for market access in CrossBorder supply with our major trading partners.Specifically, since it is agreed that both developingand developed countries are likely to benefit, it willbe in everybody ’s interest to el iminate theuncertainties in the business environment and thepolitical backlash that may intensify in the future. Oneway to do this is bind the existing commitments underGATS and make further liberal commitments in CrossBorder Supply as stated above.

COMPANY SECRETARY BRAND

Company Secretaries know their identity; they knowwhat they can do; they know what they can achieve.

But they need to make an effort to reach out to theworld with the Brand ‘Company Secretary’ and its BrandValue.

Sensing this the Council of ICSI in its collectivewisdom took the step forward in May 2004 itself bypassing a Resolution to take up the matter through theMinistry of Commerce, Govt. of India, echelons to movethe WTO corridors in Geneva through the Indian Missionthereby mobilizing support of parallel Institutes in variousother countries.

ICSI COUNCIL RESOLUTION

The Council noted with concern that theCorporate Governance, Compliances and SecretarialAdvisory Services were nowhere recognized as aseparate Head in the Services Sectoral ClassificationList of the WTO.

The Council unanimously resolved that theCompany Secretaries/Chartered Secretaries andAdministrators profession may recommend and pursuethe introduction in the Services Sectoral ClassificationList of the WTO, the following new servicesnamely:



CORPORATE GOVERNANCE, COMPLIANCESAND SECRETARIAL ADVISORY SERVICES

Corporate Secretarial Services

Secretarial Audit and Compliance AuditServices

Certification Services

Corporate Governance Services

Corporate Advisory Services

CORPORATE SECRETARIAL SERVICES

This sub-Services sectoral Classification of the WTOto include promotion, formation and incorporation ofcompanies and matters related therewith; filing,registering any document including forms, returns andapplications by and on behalf of the company as anauthorized representative; maintenance of secretarialrecords, statutory books and registers; arranging board/general meetings and preparing draft minutes thereofand all work relating to shares and their transfer andtransmission.

SECRETARIAL AUDIT AND COMPLIANCE AUDITSERVICES

This sub-Services sectoral Classification of the WTOto include all statutory Secretarial Audits, ComplianceAudits and Compliances under Company, corporate andSecurities Laws including regulations and guidelines, bythe members of the Company Secretaries/CharteredSecretaries and Administrators profession.

CERTIFICATION SERVICES

This sub- Services sectoral Classification of the WTOto include all statutory certification services for whichthe members of the Company Secretaries/CharteredSecretaries and Administrators profession are authorized.

CORPORATE GOVERNANCE SERVICES

This sub-Services sectoral Classification of the WTOto include all services relating to advising on goodgovernance practices and compliance of CorporateGovernance norms as prescribed by the CompaniesLegislations of different countries, Corporate, Securitiesand other legislations of different countries for the timebeing in force.

CORPORATE ADVISORY SERVICES

This sub-Services Sectoral Classification of the WTOto include services relating to:

Advising Companies on management including anylegal and procedural matters falling underCompanies Legislations , Securities Laws andCorporate Laws of different countries.

Appearing as an authorized representative beforequasi-judicial bodies and tribunals

Due diligence

Corporate restructuring

Foreign Collaborations and Joint Ventures

Project Planning

CONCLUSION

Global realities are different. Competition andmarketing at that level require different approach, adifferent attitude, a new work culture and a dynamicwork plan. Establishment as service professionals in othercountries and with foreign clientele will need a retrainingand an inculcation of new skills with a serious studiedapproach. The ICSI has taken a lead; students andmembers have also started catching up. The momentumneeds to be further geared up, polished and speededup if the brand value is to be built up for CompanySecretaries across national borders.



THE INDO-SINGAPORE TREATY ANDTHE INDO-SINGAPORE TREATY ANDTHE INDO-SINGAPORE TREATY ANDTHE INDO-SINGAPORE TREATY ANDTHE INDO-SINGAPORE TREATY ANDGLGLGLGLGLOBALISOBALISOBALISOBALISOBALISAAAAATION OF COMPTION OF COMPTION OF COMPTION OF COMPTION OF COMPANY SEANY SEANY SEANY SEANY SECRETCRETCRETCRETCRETARIES FIRMSARIES FIRMSARIES FIRMSARIES FIRMSARIES FIRMS

BALWANT KULKARNI*

A few thoughts on going multi-disciplinary whilerestructuring professional firms for GATS regime readas follows : Recently in an interview to the EconomicTimes, the CEO of the Boston Consulting Group Mr.Hans-Paul Buerkner remarked that going to and beyondthe boundaries of various disciplines through networkingwill make the future firm happen. In fact, BCG is nowadding scientists, biotech professionals, anthropologists,neurologists, medical doctors, philosophers and eventheologians to its rolls and they are expected to leadchange. It is no use narrowing strategic managementto tools and techniques. Tools may be able to help youtake certain steps but they essentially provide a standardapproach. In giving advice to industry there is no pointrestating the industry logic and following the industrybenchmarks. These, in a way, defeat the very purposeof organizational change in restructuring professionalfirms Company Secretaries need to lead a dynamicorganizational change. Therefore, it is important forthem to go beyond logic, think out of box and try thingsto which people will say “it’s crazy”. Collectingsynergies and ideas from academics and professionalsfrom diverse fields is therefore important to breakboundaries and re-establish the power of ideas.Developing the concept of networked organizations andthe economics of integration will help create a futurefirm that can succeed in the GATS regime. A multi-disciplinary professional firm of the future willshowcase an organization where individuals andgroups act as nodes and links across boundaries inorder to work together for a common purpose. Itwill have multiple leaders, lots of voluntary linksand interacting loops. Such a firm will be a flatterorganization where every person interacts regularlywith others and shares knowledge.

An example can be found in Toyota’s managerialmethods and the open-source traits of its productionsystem analogous to the open- source software Linux.

22

* Director, The ICSI. The views expressed are personal views of the author and do not necessarily reflect those of the Institute. Thispaper was circulated as theme paper at ICSI - SAICSA Joint Conference held on August 1-2, 2005 at Singapore.

The desideratum of building such an organization is“modularity” as opposed to the “re-engineering”cherished in the nineties. Re-engineering was aboutthinking linearly: managing end-to-end processes insteadof discrete functions. That approach fostered focusedefficiency but inhibited variety and adaptability.

Modularity is the reverse: sacrificing static efficiencyfor the recombinant value of options. It is necessary tothink modular teams as well as modular processes. Thefiner, the better.

The thoughts in this Paper ideate a multi-disciplinaryprofessional approach that such a Company Secretaries’firm of the future would venture to model itself on whilegoing global under the GATS regime.

TAKING SHAPE

As the Comprehensive Economic CooperationAgreement [CECA] between India and Singapore isgetting inked the Economic Times of June 17, 2005reports that the Government of India has decided toallow three Singapore Banks free access to Indianmarket, with operational freedom at par with domesticbanks.

Development Bank of Singapore, United OverseasBank and OCBC Bank have been formally listed as partof the overall CECA. The government has also put inplace a mechanism to ensure that Singapore banks thathave access to the Indian market are not used as a proxyby American or European banks to get the sameprivileged market access that India-Singapore CECAallows. The CECA is being signed by June end. TheSingapore banks will also be allowed to acquire privateIndian banks under the existing foreign investment policyframework. These banks will be subject to the overallrestriction imposed on foreign banks. Foreign bankscannot exceed 15% of the total banking sector assets.


The Indo-Singapore Treaty and Globalisation of Company Secretaries Firms 23

However there is enough headroom as the current shareof foreign banks in the total assets is merely 7%. Thiswould ensure that the current regulatory regime for thefinancial sector, under the purview of the RBI and SEBIare not superseded by CECA.

The India-Singapore CECA is a trailblazer for Indiaas the government is planning to sign similar economiccooperation agreements with other countries soon.Under the CECA, the bilateral commitments made byIndia for financial services are within the scope of GATSagreement under WTO. This also addresses the concernof the RBI that the country should not allow de factocapital account convertibility by opening up the windowfor financial services too wide.

The CECA with Singapore is designed to offer anintegrated package governing trade in goods andservices, an agreement on investment, mutualrecognition agreement in services and cooperationagreement in areas such as education, e-commerce,media and intellectual property.

The CECA will take effect from August 1, 2005.

Under the CECA India’s offer contains four lists:

1. the early harvest programme where customsduty will be eliminated immediately on theentry into force of the CECA on 506 lines;

2. the phased elimination of 2,202 lines;

3. the phased reduction of 2,407 lines wherethe tariffs would be eliminated/reduced till2009;

4. negative list of 6,551 tariff lines where noconcessions have been offered.

In all, trade in goods will entail exchange of tariffconcessions under the eight digit harmonized systemcode covering 11,666 lines. But in the 506 items forthe EHP, mostly IT products, which enjoy zero duty entryunder the WTO IT Agreement, are there, apart fromsome commodities that dominate the two-way trade.

Singapore has offered all products made in Indiaentry at zero duty in Singapore. Singapore is a knowntrading hub. Hence the CECA would be helpful infostering supply chains from India.

On investment side, expectations are that FIIinvestment from Singapore will rise to USD 5 billionwith the implementation of the CECA in the very firstfiscal year. FII investment in India’s infrastructure sectorwill add another USD 2 billion.

GLOBAL LEADERSHIP

Reference is invited to the Vision of the Institute ofCompany Secretaries of India adopted in its Vision Plan2010. Taking a position as a global leader by theprofession of company secretaries in corporategovernance calls for a mastery on the mechanisms andworking of international capital markets that providefinance to the corporate sector. International finance isa subject that continues to develop faster as comparedto the other subjects under Economics. Internationalmonetary system also became evermore unstablebecause of the severing of the link between commodityproduction and liquidity creation. Today the degree ofinternational financial integration has increasedenormously. The impact of cross-border flows of moneyand capital to economies that are moving away fromcentral planning and to OECD and developing countrieshas increased complexities of international finance. Thevalue of daily foreign exchange trading is more thanhundreds of times of the value of annual internationaltrade in goods and services. The pace of innovationsthat are taking place in the theory, policy, institutions ofinternational finance is mind-boggling. Vast amount ofempirical research is being developed and published inthis field. The pundits explain new findings in the generalequilibrium theory of exchange rate determination;relative immobility of long-term capital vis-à-vis highlymobile short-term capital; the behaviour of exchangerates within an exchange rate fluctuation band [“targetzone”].

This is a Theme Paper drawn with this background.It seeks to expound some of the theoretical andpragmatic ground for international financial transactionsand risks to enable company secretaries to approachsuch matters with informed abilities. The objective isonly to give a working familiarity with the theoreticaland market behaviour issues that are involved ininternational financial transactions.

FINANCE FUNDAMENTALS

Raising and managing funds from the internationalcapital markets require a working knowledge of somefinancial fundamentals. Prominent amongst these arementioned below.

It becomes necessary to understand why realexchange rates wander away for long periods frompurchasing power parity and disturb real economicactivity and how misinformed speculation and speculativebubbles cause floating exchange rates to be unstableand largely unpredictable. We also need to understandhow best to reform the international monetary system.



The basic tools, exchange rates and balance of paymenttheory, still remain, as they have been to understandinternational finance, although complexities are on therise. The said tools continue to be applied to a numberof issues including money and macroeconomics in anopen economy; the efficiency or inefficiency of foreignexchange markets; the modeling and measuring of shortand long term capital flows; international macroeconomicpolicy coordination; international financial features ofeconomic and financial reform in both transitional anddeveloping economies; the economics of monetaryunion, the functioning of international financialinstitutions, etc.

MONETARY AND FISCAL POLICIES

Opening an economy to international trade andcapital flows changes the nature of constraints on policymakers. Depending upon whether exchange rates arepegged or floating, the effectiveness of monetary orfiscal policy gets compromised as an instrument ofmacroeconomic policy.

International economic cooperation results in gainto cooperating countries because of macroeconomicspillover effects of such cooperation. In the case ofmonetary unions, fiscal policy externalities betweenmember-countries of the union can be managed to thebenefits of the union as a whole. In the context of amonetary union, fiscal policy is known as “fiscalfederalism.” The functions of fiscal federalism remainthe same as those of fiscal policy, viz, allocation,distribution and stabilization. Stabilization function isbetter performed or at least coordinated from the federallevel. A change in a country’s fiscal stance may createexternalities for other members of the union. Ceterisparibus [i.e. all other things remaining equal], anexpansionary fiscal policy by nation “A” may yield anexternal benefit by stimulating growth and employmentor an external diseconomy by increasing inflationarypressures in the union as a whole. These externalitiesare not internalized by nation “A”; it is therefore notdriven to adopt, from the point of view of the monetaryunion, the socially optimal fiscal stance. How then toachieve the most desirable aggregated balance ofnational fiscal policies becomes a moot question. Theunion may actually require, for its overall well-being,dis-inflationary fiscal policies that are economically andpolitically most costly. If they do not find adoption, thesum of dis-inflationary fiscal policies would be insufficient,or the burden of adjustment would fall heavily on a fewcountries, e.g. those in the weakest financial position.An international welfare gain results frominternational policy coordination.

Purchasing Power Parity

The purchasing power parity theory plays a centralrole in the determination of exchange rate and of thebalance of payments. The monetary approach to thebalance of payments gives us an understanding of thecauses and persistence of balance of payments deficits.It holds that the balance of payments is a monetaryphenomenon and not a real phenomenon. BOP shouldbe analyzed using the familiar tools of monetary analysis,namely, the demand for and supply of money. Thedisequilibrium in the BOP is the reflection of thedisequilibrium in money markets. The monetaryapproach teaches us that a devaluation can have only atransitory impact on the BOP; a growing country willhold a BOP surplus; a country can run only a BOP deficituntil it runs out of foreign exchange reserves; importquotas, tariffs, exchange restrictions and otherinterferences to international trade can have onlytransitory effect on the BOP; with pegged exchangerates a country cannot run an independent monetarypolicy; and a rise in domestic interest rates will result ina BOP deficit.

Exchange Rates

Understanding of the mechanisms of exchange ratesis no doubt crucial. Following few paragraphs deal withthe related phenomena.

Predictability of exchange rates is important becausemany economic decisions require knowledge aboutfuture exchange rates, especially, long term realinvestment in traded goods sectors. The unpredictabilityof exchange rates and the deviation of real exchangerates from the level that balances the current accountmay increase if rational speculative bubbles occur. Abubble can push the nominal exchange rate far awayfrom purchasing power parity. The monetary approachto balance of payments also shows how foreignexchange reserves shall eventually be exhausted if therate of domestic credit expansion is excessive.

We also need to examine exchange rate behaviourin a target zone [i.e. a pegged rate fluctuation band].Within the zone, the exchange rate may float, beingdetermined by fundamentals; but at its edgesintervention may be necessary so that foreign exchangereserves may change.

“Dirty floating” is explained by exchange ratepressure model. This model indicates how, in anenvironment of floating, a government may use foreignexchange reserves to nudge the exchange rate in thepreferred direction



Understanding the volatility in exchange rates is akey requirement in modern international finance. Theview is that foreign exchange is an asset. That is pricedin an asset market [rather than in the same manner asstocks or bonds]. An exchange rate is the price of oneasset [currency] in terms of another. It is also necessaryto understand that the reallocation of currencyportfolios by international transactors—such asmultinational corporations—affects the exchangerate. That, as a result, the stability of theinternational monetary system in an era of highlyliquid international money flows is also affectedby multinational corporations.

International finance requires us to study generalequilibrium monetary approach to the exchange rateand exchange rate regime volatility; currency crises andspeculative attack; target zones and dirty floating.

Dissecting Crises

International financial system has been going throughcrisis after crisis. It is necessary to have knowledge ofsuch crises in order to safeguard one’s interests whileoperating in international financial markets. As KarlKaiser, John J Kirton and Joseph P Daniels say in theiredit role of “Shaping a New International FinancialSystem—Challenges of Governance in a GlobalizingWorld”, Ashgate, the G-8 and Global Governance Series,a core issue concerns the causes of the crisis andcontagion and whether it has now been finallyconcluded. Second core issue is how and how well theinternational community has coped with the challengesof crisis response and systems strengthening thus far. Isthe challenging one of calling for incremental reform,deeper reconstruction, or historic replacement with avery new system of principles, practices, processes, andassets of institutions?

Another core issue focuses on critical defects ofthe old system and the best design for the newmechanisms to be added in response. We need thebest weighting and mix of mechanisms for:

— transparency

— surveillance

— precautionary lending

— international standstill or bankruptcy procedures.

We need to choose the best forms, procedures andsequence of introduction and use for each and we doneed to keep on bettering these. We may have toconsider moving into broader domains such as controlof international financial flows and capital flows, greater

exchange rate management, fixity, or even currencyunification, and the rules for international liberalizationor foreign direct investment.

G7 HEGEMONY

We have seen efforts during the last quarter of the20th century to reform the international financial system,the role of the G7 in this effort. As we know, historyrepeats itself [due to our own ignorance and inaction]and hence we must be aware of the recent financialhistory as well. The world and the G7 confronted as acentral challenge the task of altering in basic ways afinancial system under severe stress. There was thecrisis over the global exchange rate regime that servedas very raison d’tre for the birth of the G7 Summit as aneconomic institution – the breakdown of the BrettonWoods System of fixed exchange rates in 1971, thefailure of the IMF and existing processes to construct adurable, widely accepted alternative and the decisionsof the first Summit at Rambouillet, France in 1975 toinstitute a new system of managed floating. The secondwas the commercial bank debt crisis precipitated byMexico’s de facto default at the IMF meetings in Torontoin 1982, and the work of G7 summits from Versailles in1982 to Paris in 1989 to arrive finally, in the form of theBrady Plan, at a solution. The third episode, debt relieffor the world’s poorest countries, began with the“Toronto terms” for relief at the 1998 Summit andcontinued through to the Cologne debt initiative of1999.

In his analysis of the “Asian Crisis and itsImplications”, Takashi Kiuchi [p.37 of Shaping a “NewInternational Financial Systems”, referred earlier] locatesthe ultimate causes of the crisis in capital account ratherthan current account problems, liquidity rather thansolvency problems, and the herding behaviour of theinvestors. He also notes how politicians overriding theirofficials and regulators compounded the problem. Hecalls for universal guidelines and processes for accountingdisclosure, bankruptcy and financial supervision. Japan’sresponse to the Asian crisis came initially in the form ofa proposal for an Asian Monetary Fund that wasabandoned in the face of US opposition, then with a“New Miyazawa Initiative” of US $ 30 billion worth ofbilateral lending guarantees, proposals to reform IMFand new measures to make the yen an internationalcurrency. According to Kiuchi, the crisis taught us theneed for decisive action at the early stages, forenhancing the IMF’s authority to deal with capitalaccount problems, and closer regional policycoordination, beginning with macro economic policy andthe development of an Asian bond market to replace



short-term borrowing from distant bankers. He approvesof short term capital restrictions as a transitional measure,mandatory private sector burden sharing and statebankruptcy codes. Above all, he identifies the role ofthe G7 in moving towards a de facto target zonemechanism and points to the benefits that further movein this direction could bring. During times of crisis,panicked investors do not distinguish one nation fromanother in a region. In other words, professional fundmanagers cannot guide end-investors properly onceliberalized financial markets enable far wider participationby amateur investors in speculative emerging markets.Nations within the region have a common stake inpreserving investors’ confidence. Therefore, the timeis ripe for closer regional policy coordination, a processthat could begin with the task of macroeconomic policyconsultation. Global efforts in this direction deservefurther exploration. G7 surveillance andcoordination, Kiuchi concludes, should thus becontinued, sovereignty over macroeconomicpolicy has to be compromised considerably in anage of a globalised financial market.

Now, what does the exclusive organisation G7 dofor the Newly Industrialized Economies” (NIE’s) or inother words, the developing economies of the world?Durican Wood [in his Paper “The G7, InternationalFinance and Developing Countries” presented at Bonnon June 14, 1999, immediately after the meeting of G7Finance Ministers in Frankfurt, and immediately beforethe opening of the G7 and G8 Summits themselves incologne on 18th June] deals with the issue as follows:

G7 has been an exclusive institution since itsinception in 1975. It is an organ representing theinterests and policy goals of the seven largest economiesin the world. It has a country-club like exclusivity towhich those left on the outside can only aspire. TheG7 has indeed thrived on such a narrow basis for mutualdecision-making! The identification of common interestshas been relatively simple, given the similarities ofeconomic development and political systems and thehigh level of interdependence among its members’economies.

In the 1970’s, the exclusive nature of the G7reflected the dominance of seven states over the globaleconomic system. The same period witnessed a rise inLDC activism with calls for a New International EconomicOrder (NIEO). By the 1990s, the rise to prominence ofseveral developing country economies, shifts in worldtrade and competitiveness and the increasingvulnerability of the global financial system and theseparation of the G7 from the developing world, in

particular from the large emerging markets created, ananachronism.

Witnessing the trebling of the NIE’s share of worldtrade since 1960, the 1988 Toronto G7 Summitconcluded that such countries should match theirincreased economic importance with greaterinternational responsibilities and a strong mutual interestin improved constructive dialogue and cooperativeefforts in the near terms between the industrializedcountries and the Asian NIEs, as well as other outward-oriented countries in the region.

From the 1996 Lyon Summit, G7 forwarded the idealof a new global partnership for development focusingon cooperation, burden sharing, and partnership, of aspirit of common purpose and efficiency.

Such cooperation, however, never materialized.The G7, even taking into account its inclusion of Russiacontinues to be an exclusive club of the rich. Instead,the G7 has attempted to move into the new millenniumwithout the involvement of the largest developingeconomies. This threatens to pose a serious problemfor the Institutions in terms of its effectiveness and itslegitimacy as an organ of global governance.

LDC CONCERNS

The two main areas of interest from an LDCperspective concerned the IMF’s Contigent Credit Line(CCL) and “bailing in” the private sector in crisisresolution. The CCL was hailed by the G7 FinanceMinisters as playing “an important part in crisisprevention”. Its goal is to provide a line of credit tocountries following sound macroeconomic and structuralpolicies and with reasonable debt structures so that theyare protected from contagion during currency andfinancial crisis. While this seems a positive form ofassistance, in the view of some it actually threatensfinancial stability by encouraging moral hazard. Theargument is simple: if a country following sound policiesknows it has access to the CCL, the danger exists that itwill be tempted to adopt more risky practices in theknowledge that a bail-out is already available.

As regards aid to developing countries, Lord Baurreminds, a half-century of aid has been an almostunmitigated disaster. Its politics and psychology areutterly corrupting. It has weaned large, arbitrary andcorrupt governments, while crowding out individualeconomic freedom. A large and sudden increase in aidis a bad idea. It will overwhelm the supply capacities ofweak and dysfunctional governments. For all the talk ofthe good governance criteria, it is bound to provide more



incentives for bigger, wasteful, corrupt and intrusivegovernment. Underlying aid initiatives, is a world-viewthat David Henderson, the former chief economist ofthe OECD, calls Global Salvationism, or Deliverance FromAbove. It afflicts those who call for stronger globalgovernance.

In reforming the international financial architecturea major initiative came from the US. The creation ofthe G22 in 1998 as an ad hoc grouping of developedand developing states constituted an attempt to pulltogether the highly varied experiences of national policymakers. This attached importance to incorporating LDC’sinto the international financial reform. The G22 formedthree working groups that examined the issues ofinternational financial crises, strengthening financialsystems, transparency and accountability. Each workinggroup was co-chaired by officials from one developedcountry and one developing country. Despite thiscooperative atmosphere, the G22 did not survive longenough to make a significant contribution to eitherinternational financial architecture reform or longer termLD – G7 cooperation. The group was dissolved after ithad published its reports, with the US deciding that ithad served its purpose.

Since 1995, one of the central issues forInternational Financial Institutions has been increasingtransparency and disclosure of information, in particularfrom LDC governments. The IMF’s annual Article IVconsultations, developing a core set of accountingstandards, and ensuring that private sector firms engagein transparent practices.

But data gathering, says Durican Wood, andtransparency, are difficult to achieve in LDCs. ManyDC governments have a very real interest (usuallypolitical) in preventing the truth about their economiesfrom being known. It is difficult to develop standardsthat are suitable for such widely varying financial systemsas, for example, the US and Mexico. Developingstandards is one thing, implementing them is yet another.

The overwhelming liberal bias amongst G7 countriesand in the IMF’s management is pushing them towardsthe realisation of a classical liberal assumption: that amarket will work perfectly under conditions of perfectinformation. Whether or not the assumption can everbe realized, or even if it is a correct assumption, remainsto be seen. And in spite of all this reality, the CII venturesto assume well-functioning capital markets.

NEW PERSPECTIVES

It has been India’s traditional wont at annual IMF-

World Bank meetings to advocate substantial SpecialDrawing Rights [SDRs] allocation along with otherdeveloping countries. India had made some proposalsto increase the amount and the use of SDRs, but to noavail. India’s first proposal in the 1970’s, writes Mr AVasudevan, a former Executive Director of the RBI inthe Hindu Business Line of September 16, 2004, didnot get any support. In 1986, India’s Executive Directorproposed that industrialised countries allocate their SDRsfor purposes of development in the form of an overdraftfacility with a condition that the reallocated SDRs shouldbe returned by the users to the creditors within threeyears. In 1999, a senior Indian official proposed thatthe Articles of Agreement be amended to allow theIMF to issue SDRs to itself for use in the lender-of-the-resort operations, subject to a cumulative limit on thetotal volume of SDRs that the IMF could create for thispurpose. But now the global liquidity is sufficient andinternational markets are active. Hence India should notsupport proposals for SDR allocation or distribution.

It is also suggested that India should not go withthe developing countries’ position that industrializedcountries should fulfil the UN target of foreign aid of0.7 per cent of their GNP. The arguments for the increaseof aid have become weak, mainly in view of theexplosive expansion of private capital markets and theweak fiscal positions of many industrialized countries.

It is suggested that India should encouragemovement towards economic convergence in terms ofreal per capita income among nations. This will reducethe relative economic distance amongst groups ofnations. Countries should not be grouped in theconventional manner as industrialized economies anddeveloping economies, but as Industralised Economies;Emerging Market Economies; Transition Economies notcategorized as EMEs; and the Rest Of the Economies.Goldman Sachs have projected that Brazil, Russia, Indiaand China together would overtake six major IEs by2039 going by their economy size, demographicdistribution and patterns of global demand, appreciationof the exchange rates of their currencies,implementation of sound economic policies andexistence of supportive institutions. Convergencerequires economic cooperation, including technical,financial, technological assistance, to equitably shareinternational economic prosperity. Financial assistanceneed not be in the form of loans or grants but couldwell be in terms of debt reduction or swaps for debts oraccess to domestic markets. India also needs to takeinitiatives as to how to utilize without delay thecontingent credit lines at the IMF. She also needs to



thwart the efforts that are currently afoot to allow crisis-hit countries to have access to the IMF resources only iftheir past record is considered appropriate. The basisfor the country’s use of the IMF resources should reston the soundness of adjustment programmes andcommitments to undertake institutional reforms.Convergence leads to balanced expansion ofinternational trade.

INTERNATIONAL BANKING

Moving your corporate in international financialcircles also requires an understanding of how do banksbehave in the context of the cross-border fundoperations.

Following is an example of how banks form thehabit of overwhelming overbidding in response to appealby a Central Bank.

During the period January 1999 to June 2000 theEuropean Central Bank conducted fixed rate tenders.Mr Juan Ayuso and Rafael Repullo in their Paper “WhyDid the Banks Overbid? An Empirical Model of The FixedRate Tenders of the European Central Bank” [publishedby Banco de Espana—Servicio de Estudios] test twohypotheses for the overbidding behaviour of the banksin the fixed rate tenders. One hypothesis attributes theoverbidding to the expectations of a future tighteningof monetary policy, while the other attributes it to theliquidity allotment decisions of the ECB.

The monetary policy instruments used by the ECBare—(i) minimum required reserves, (ii) open marketoperations, and (iii) standing facilities. The minimumreserves help to ensure that the euro area banking systemhas an aggregate liquidity deficit which is covered bytwo main types of open market operations [selling ofsecurities to mop up excess liquidity and buying ofsecurities to release more liquidity in the system] andthe longer term refinancing operations. The refinancingoperations can be conducted via fixed rate or variablerate tenders. In fixed rate tenders, the ECB announcesthe interest rate and the banks bid the amount of liquiditythey borrow at this rate. If the aggregate amount of bidexceeds the amount of liquidity the ECB can provide,each bank receives a pro rata share of this liquidity. Invariable rate tenders the banks bid the amount theywant to borrow and the interest rates they are willing topay. In this case, bids with successively lower interestrates are accepted until the total liquidity to be allottedis exhausted.

From the beginning of the Monetary Union in January1999 until June 2000 the main refinancing operations

were conducted as fixed rate tenders. A striking featureof these tenders was a very high degree of overbiddingby the banks. During May and June 2000 the bankswere bidding on average an amount that was more thaneight times the size of the consolidated balance sheetof the Eurosystem.

The authors of the Paper tested two hypotheses aspointed above to explain the overbidding behaviour bythe banks in the fixed rate tenders. The expectationshypothesis attributes overbidding to the expectationsof a future tightening of monetary policy that led thebanks to increase their current demand for liquidity inorder to reduce the cost of holding reserves over themaintenance period of the reserve requirement. On theother hand, the tight liquidity hypothesis explains theoverbidding by the fact that the ECB kept interbank ratesover the tender rate, which generated a profitopportunity for the banks that was increasing with thequantity bid.

“Our empirical analysis” the authors explain, “ usestwo interest rate spreads as explanatory variables: thespread between the one-week Euribor, and the tenderrate and the spread between the one-month Euriborand the tender rate. The results show that once wecontrol for the first spread, the effect of the second issmall and statistically not different from zero. Hencethe evidence supports the view that the reluctance ofthe ECB to let the interbank rates fall below the tenderrate played a crucial role in explaining why the banksoverbid.

“The main policy implication of our results is thefollowing. To the extent that overbidding is consideredto be a problem, the ECB should decide the quantityallotted in fixed rate tenders in order to keep the one-week Euribor rate close to the tender rate, instead ofcomputing the allotments from the analysis of thebehaviour of the autonomous liquidity creation andabsorption factors. However, in the presence ofexpectations of interest rate changes this alternativepolicy would probably introduce large variability in thesequence of allotments, which may also be regarded asundesirable.”

SECURITISATION

Securitisation is a financing option that involvescherry-picking assets from the seller’s book , buildingin adequate credit enhancements and then selling themoff to a Special Purpose Vehicle or Trust. The SPV or theTrust then issues debt instruments on the strength ofthe underlying assets utilizing the credit rating to obtaincompetitive market price. As a financial tool, it has been



used to finance further assets by analyzing/scrutinizingthe past assets. The company raises money by issuingdebt securities, which are backed by specific asset pool.The assets are the loans, auto loans, future receivables,etc. The cash flow from the underlying assets is thesource of funds for the issuer to make payments on thesecurities. When compared with the traditional secureddebts, securitisation provides lenders/investors withgreater protection against the credit risk of borrower/issuer.

In a securitisation transaction, lender/investor is likea ‘super-secured creditor’ with rights that surpass thoseof a secured lender. The subject assets are as if ‘sold’by the borrower/issuer to the lender. Therefore theassets do not get entangled with bankruptcy. Bankruptcycourt will not characterize the assets as merely pledgedto secure a loan. To securitize, the borrower/issuertransfers the subject assets to a SPV/Trust to constitutea true sale. Then the SPV/Trust issues securities backedby those assets. It uses the sale proceeds of the securitiesto pay the borrower/issuer for the assets.

Banks or finance companies may use securitisatiionto improve the volume of funds for capital deficientsectors by transferring resources from surplus sectors.They many also use securitisation to take somecustomers’ loans off balance sheet in order to be ableto lend new funds to those customers and still maintaininternal credit limits.

A company can diversify its funding resourcesreducing its dependence on bank loans, corporate bondsand commercial paper by resorting to securitisation. Itcan improve liquidity. Further, securitisation can bedeployed by a company to place its securitised assetsbeyond the reach of the bankruptcy system. Thesecuritised assets are excluded from the bankruptcyestate of the company that has filed for bankruptcyprotection. Securitisation investors are regarded as aspecial class creditors who can satisfy their claims evenwithout going to bankruptcy court although this is acontroversial issue as this causes injustice to othercreditors of the company and there is no provision tothat effect in the bankruptcy code.

Global Funds

Hindu Business Line of August 22, 2004 reportsabout feeder funds that may be the next big thing forIndian investors looking for opportunities abroad. TheChairman AMFI is strongly pushing the idea, supportedby a few local players of the Mutual Funds industry. Theplayers have already expressed willingness to explorethe possibility of developing the right products. Feeder

funds will be structured in the domestic market anddomiciled in India. Feeder funds will be instrumental inchanneling retail investments in to overseas funds. TheIndian Union Government had recently opened up theretail investment limit in overseas market to the tune of$ 25,000. Feeder funds will tap these resources androute retail investments in overseas markets. Thesefunds will take exposure to other investment products,subject to prescribed limits. Feeder funds will whet theappetite of investors who are keen to check out newer,smarter options.. The first is a vehicle, managed byFranklin Templeton, which invests in a US fund dedicatedto government securities. The second is an equity fund,offered by IDBI Principal that invests in European,Japanese and US stocks.

It is essential to address the challenge to raise theIndian savings rate from 23-24 per cent to 28-30 percent range to sustain seven-eight per cent growth rate.Mutual Funds is the way for doing this. The returnsfrom the traditional products provided by banks and postoffices have reduced considerably. At the same time,in India, only 6.7 per cent of households own mutualfunds as compared to the US where over 49.6 per centhouseholds own mutual funds. In UK around 17 percent of households own mutual funds. Unlessperformance of mutual funds becomes more stable andpopular and easy-to-understand mutual fund productsare made available to rural and retail households, raisingof savings rate in India may not be possible. CompanySecretaries need to devise strategies for advising mutualfunds in India to do this so that efficiencies in the financialsector in India rise to enable Indian corporates meetthe competition from MNC giants.

India, however, is yet to have real estate andcommodity funds which local players must provide inthe long run.

Company Secretaries who would be renderingprofessional services to mutual fund industry andcommodity exchanges must therefore develop skills inglobal finance and global financial markets in order tobe able to add value to such mutual fund products.Meeting the MNC giants will also require understandingof domestic mutual funds that invest in equities of suchgiants from abroad.

Company secretaries need to look also at the factthat Indians, and Indian corporates pay about 1.2 percent more for bank loans and advances than internationalrates because of the government controls over State-owned banking entities which raise cost of funds andinefficiencies. [ Former Planning Commission Member,Mr N K Singh quoted in Hindu Business Line of



August 22, 2004]. Company Secretaries can developskills to help in further reforms in the financial sector toenable Indian companies enhance their competitivenessin order to be able to meet the giants.

Hedge Funds

MNC finances are also propelled by hedge fundsknown as ‘rich man’s mutual funds’. Other unregisteredinvestment pools, such as venture capital funds, privateequity funds and commodity pools are also known ashedge funds. Usually, hedge funds;

— are organized as private investment partnershipsor offshore investment corporations;

— use a wide variety of trading strategies involvingposition-taking in a range of markets;

— employ an assortment of trading techniques andinstruments, often including short-selling,derivatives and leverage;

— pay performance fees to their managers; and

— have an investor base comprising wealthyindividuals and institutions and relatively highindividual investment limit.

Learning to use and advising on hedge fund activityat the international level is another area in whichcompany secretaries need to nurture skills for helpingcorporates face global competition.

As reported in the Hindu Business Line of October13, 2004, the participation by global hedge funds inthe Indian market might finally be a very restricted one.Only those entities may be registered as fall under theregulatory framework of their country of origin. Thiswould lead to an automatic disqualification of a largenumber of global hedge funds from registering withSEBI since, by their very nature, such funds are entitiesthat are not regulated in their own countries. There isno definition of a ‘hedge fund’ under any law. It hasbeen pointed out that these funds could loosely betermed as unregistered private investment partnerships,funds or pools that may invest and trade in differentmarkets and are not subject to the regulatoryrequirement in their home country. The SEBI task forcepoints out the registration dilemma arising out of theunregulated nature of the hedge funds. Under thepresent FII regulations, hedge funds cannot approachSEBI for registration since the norms explicitly providethat only entities regulated in their place of incorporationor origin can be registered as FIIs. On the other hand,though these funds can enter through the FII sponsoredsub-account route, such an entry has to be in a

surreptitious manner. This is because, any mention ofthe fund having characteristic of a hedge fundautomatically results in the application being withheld.The Government and SEBI have been trying to work outways to allow foreign hedge funds to register directlywith the regulator instead of through the participatorynote [PN] route. PNs are offshore derivative instrumentsin the form of contract notes issued by registered FIIsagainst underlying securities to overseas investors. ThePN route allows foreign funds to flow in without theactual overseas investor showing up in SEBI’s regulatoryradar.

Helen Avery reports in Euromoney July 2004 issuethat until three years ago, high net-worth individualswere almost the sole investors in hedge funds. Theirrelative sophistication, risk appetite and flexibilitycompared with institutional counterparts resulted in anaffinity with hedge funds. Now, however, high-net-worthindividuals account for less than 75% of hedge fundassets and in three years time their share could be below60%.

It is not that the wealthy are removing money fromhedge funds—indeed, their inflows are increasing.Rather institutional investors such as pension funds andendowments, have steadily been introducing hedgefunds to their portfolios. They now hold about 25% ofthe 800 billion dollar assets in the sector. It is estimatedthat hedge fund industry could double the assets in thenext three years. Institutional investors hold an estimated$ 40 trillion in assets under management. Even if theInstitutes move just 5% allocation to hedge funds, theinstitutional assets in hedge funds would increase tentimes over. Hedge funds managers may then desertrelationships with high-net-worth individuals in favourof the large lumpsums promised by the institutions.Fewer clients with more money is a better situation tobe in. Theorertically, looking at historical relationship,private banks should continue to enjoy a privilegedposition with hedge fund managers. But institutionalmoney would be more stable than private clients’ money.Hedge fund managers might feel more comfortable withinstitutional clients. .Decisions of pension funds andendowments to allocate to hedge funds are not takenlightly. Asset allocation reviews tend to take place everythree years, and after pension fund decides to allocateto hedge funds, the trustees will usually have sometraining, receive professional advice, and then go aboutdeciding how much they want to allocate.

There are some problems, although, in the way ofinstitutional investors allocating funds to hedge funds.Some hedge funds open and close within six months,



and institutional investors will be too slow to react,particularly if they are not familiar with the managementteam. Rigid demands on track records and size will alsohinder the opportunities available to them. They willface risk of being excluded from hedge funds throughnot investing soon after launch.

These constraints are leading some hedge fundmanagers to ensure that their investor base is a mix ofprivate clients and institutional money. There are prosand cons to both so it pays to have a mix. Lager investorscome with a lump sum but that can have a big effect ifthey were to change their allocations. The two investorbases will be attracted to different strategies. Individualshave the advantage of tailoring their investmentobjectives to their own risk profile, whereas institutionalinvestors are often saddled with the worries of thedownside, so are typically attracted to strategies andstructures with lower volatility than individuals.

Mastering Mutual Funds

Consider that the financial press has chosen to dub2003 as a remarkable year for the way the mask fell offthe face of the American mutual fund industry {BusinessStandard Fund Manager, Volume VI, No1, August 2004.Regulators in America clamped down hard on leadingUS funds for rampant violations and unethical practices.Many heads rolled. Violators had to pay heavy penalties,apart from reimbursing common investors for the lossesthat accrued to them on account of dubious dealings.The American mutual funds industry has been longconsidered to be role model for the rest of the world.Funds around the world are now introspecting moreabout the way they do business and taking correctiveaction. Back home, one of the biggest ills plaguing thefund industry is called late trading. The deal is to offerpreferential treatment to large investors by offering themback-dated Net Asset Values. The offering of theprevious day’s NAV is bad because, for instance, if theRBI cuts repo rates unexpectedly after close of businesshours, it is almost certain that the bond markets wouldrally the next day. A savvy investor could, thus, negotiatewith a mutual fund to accept his application at a staleNAV, so that he gets a share in profits the next daywhen the market surges. Even though the new applicant’smoney is not deployed in the markets, and hence doesnot earn anything consequent to the market rally, theinvestor gets a share in the gains. Existing investors loseto the extent that their share of gains will come downas the gain is shared by a larger number of investors. In2003, all income funds recorded daily gains of morethan 0.5 per cent. Birla Income Plus –six times, HDFCIncome Fund —seven times, Templeton Income Fund

– seven times. Medium and long term gilt fundsobviously exhibited at least double that figure. The costto existing investors could have been to the tune of Rs30 crore if about Rs 1,000 crore of assets were giventhe benefit of stale NAVs on six crucial days when theNAV gains had been in excess of 0.5 per cent. If oneconsiders the fact that in 2003 the gyrations in gilt fundswere sharper than in income funds, a similar amountinvested in funds that gained around one per cent, theloss would be Rs 60 crore for the common investors.

One more ill that afflicts the fund industry is unfairallocation of trades. Most mutual funds do not haveadequate systems and processes to ensure fair tradeallocations. There are no specific regulations governingtrade allocations among various trade allocation schemes,although mutual funds are required to maintain recordsfor portfolio transactions relating to each fund scheme.It is not mandatory for funds to mention at the time ofpurchase or sale of a security the name of the schemefor which the purchase or sale is made. If a fund managerwho is responsible to manage three fund schemes wantsto place an order with a dealer to buy shares, of, sayPower Finance Corporation, he can do so withoutmentioning the names of the schemes for which hewants to purchase. Dealers effect transactions after theinvestment officer or fund manager places the order.The latter enjoys the luxury of allocating trades at theend of the day. This leaves scope for manipulation. Hecan, for example, allocate trades in a manner profitablefor the fund schemes that hold promise in terms of assetmobilization.

Mutual fund industry in India is facing crisis ofconfidence because of over-dependence on corporatefunds for building scale. The Fixed Maturity Plans thatthe funds use for corporates are not made available bythem to retail investors. An FMP tries to match theinvestment horizon of the investor with that of the fundportfolio such that all securities in the portfolio are heldto maturity. Since mutual fund investments attractconcessional tax rates as against direct investments insecurities, these products became hot favourites amongcorporate investors. The product is custom made to passthe benefit of tax arbitrage to preferred customers. Thiscontinues in spite of the fact that there is over-dependence on corporate customers in India. While, inIndia, only 2 per cent of the households invest in mutualfunds as compared to one out of every two householdsin the USA investing in mutual funds, the catch-the-corporate mindset of Indian mutual fund industrycontinues. The early strategy was that mutual fundsshould achieve critical mass by first tapping corporateand institutional funds, raising the required volumes in



terms of Assets Under Management and then move onto retail customers. The private sector funds thereforestarted wooing corporate money. Although institutionalmoney accounts for 75 to 80 percent of some funds’assets, most funds in India are coy about admitting it.Marketing job thus has been easy. The time expendedon getting Rs 1 lakh out of a retail investor is far greaterthan getting a few crores from an institution. There hasbeen truth in the harsh criticism that mutual funds wereindulging in unethical practices and launching schemesthat benefited the institutional investors at the cost ofthe retail investor. Ten years after the entry of privatesector mutual funds in India in 1994, industry leadersare in a mood for introspection. The industry has beena witness to a whole lot of unethical practices, includingmindless incentivising of distributors, promising assuredreturns to poorly informed investors and, in someextreme cases, switching investments from scheme toscheme. The culture of numbers has created a rapaciousrelationship between AMCs and their distributors whereone feeds off the other.

Regulatory efforts by SEBI have not helped improvethe situation either. During 2002-03, for example, SEBIdevised detailed guidelines on corporate governancepractices for asset management companies. One of thesewas the introduction of compulsory benchmarking of afund’s performance against any chosen index. Thetrustees of funds were also entrusted with theresponsibility of reviewing the performance of variousschemes against the benchmark index. Everyoneincluding the trustees have been brought under theinsider trading regulations. Trustees have now to holdmeetings at least once in two months. SEBI has alsomade it mandatory for the board of trustees to havetwo-thirds of its strength as independent directors—thatis those who are not associates of the sponsors. At theoperational level, AMCs have also been asked to put inplace risk management systems for fund management,operations and so on.

SEBI has issued guidelines for valuing bondinstruments, non-performing assets, and illiquid andunlisted securities. AMFI has mandated funds to followuniform sector classifications making productcomparisons easy for investors. SEBI has also prescribeda code of conduct for mutual fund distributors. But theonus is on fund managements to ensure that their agentsand distributors follow the practices laid down in thecode of conduct. Yet to hardsell a fund scheme,distributors often share a part of their distributioncommission with brokers and retail investors as anincentive. This amounts to promoting and sellingschemes for wrong reasons that ends up in misleading

the investor. SEBI has put the onus on the fund housesto monitor their distributors and stop incentivisinginvestors.

Convergence between Securities and Commodities

Again, while late trading has been rampant forseveral years, SEBI took corrective action only recentlyby introducing uniform cut-off timings for equity anddebt funds. It also asked AMCs to set up time stampingmachines that would keep track of the date and timewhen applications were received to curb late trading.

Commodities markets are witnessing exponentialgrowth. Soft interest rates and weak dollar havecontributed to this. Commodity prices are soaring forcrude oil, silver, soyabean, gold, corn, wheat, copper,unleaded gasoline, and natural gas. Price discovery andrisk management are propelled as functions ofcommodity markets in their futures segment. Thenotional value for the OTC commodity futures marketalone has reached the level of 1.5 trillion dollars.

Around mid-September 2004, a top executive of abank in Chennai earned a little over Rs 20,000 by tradingin commodity futures market in Florida—at the sametime as Hurricane Ivan hit Florida. He made the moneyby buying December wheat contract at $3.21 a busheland selling it at $3.30. The executive had invested witha US broking firm and sought a portfolio manager totake care of the investment. The amount was investedin wheat futures which is less risky. As Hurricane Ivanneared the US shores, the panic of destruction pushedthe wheat market higher. It was possible to book profiton the trade. High net worth individuals such as bankexecutives have begun to invest in commodity futuresin the US. The permission was given by Indiangovernment to individuals to remit upto $ 25,000 a yearabroad for any purpose. Earlier, NRIs used to invest incommodity futures in Chicago and New York. Nowresident Indians have also begun to invest.

To trade in commodity futures in the US one has toapproach a Foreign Introducing Broker. Then a clientaccount agreement and a risk disclosure statement haveto be signed by the applicant and sent across to the USFutures Commission Merchant [FCM] for opening anaccount in the client’s own name.

Once the account is set up, the client wires fundsto his Customer Segregated Account.

No deposits are collected from the client by ForeignIntroducing Brokers. They may act solely in the capacityof a portfolio manager if the client so wishes. Theminimum amount to be invested is $ 5,000 and the



client himself has control over the deposit and withdrawalof the funds. There is no lock-in period for the margindeposit. The investment is only towards the marginmoney for the futures contract the client enters into.Investors can also take part in options in the futureswhich are perceived to be less risky. To handle theinvestment by nominating the latter as a third partycontroller of the account. The brokerage chargeddepends on the investment made, its size and numberof trades done. While nominating a portfolio manager,the client indicates the percentage of the risk that canbe taken. Most of the clients start by offering a ten percent risk. As they gain confidence, they permit the riskup to twenty per cent. In case the portfolio managerexceeds the limit of risk allowed by the client, then it isthe client’s discretion to withdraw his funds.

A keen investor can follow the traded prices onlinefrom various sites on the futures market.

The investment managed by the portfolio manageris fully transparent and the FCM sends statements on adaily basis to the client. The client is also free to withdrawhis profits every month. With a 3 trillion dollar a dayturnover a commodities market is better organized andis a mature ground for investors.

In India, after the World Bank and UNCTAD reportsin 1996, futures markets in agricultural commoditieswere opened. Today, trading in commodities derivativesin India is restricted to futures contracts only. This hasbeen made easier and more reliable with the introductionof exchanges with state of the art technology, prudentialnorms, sophisticated risk management practices, andinvestor friendly trading platforms. A price discoveryprocess in the spot markets and effective hedgingmechanisms and referral pricing have made it possiblefor traders to deal in the commodities market. Peopleexposed to commodity price risk also have access tothe market to hedge against that risk.

There is a clear convergence between thefunctioning of trading in securities markets will findseveral similarities in commodities futures trading. Thefundamentals of trading in commodity futures are thesame as those followed in the F&O segment of theequity market. As in the case of any other financialinstrument, predicting price movements accurately isnot possible. Trading in commodities has similar inherentrisks comparable with other financial markets. It isessential that retail investors understand these risksbefore venturing into commodities trading.

The retail investor should first choose the

commodities exchange on which he will trade. For thispurpose he will study the parameters like

— the background of the exchange;

— risk management systems;

— margining approach;

— size of settlement guarantee fund;

— liquidity of the contracts for ease of entry andexit.

Then the retail investor should approach a memberof the exchange in order to access the commoditiesfutures market. By paying a brokerage and upfrontmargin, one can take positions in the futures market.Retail investors can also widely trade in the commoditiesmarket through web-based trading systems. Throughmutual funds also investments can be made asprofessional investment management service is availablethere. Commodity prices are influenced by global macrofactors. This requires domain expertise in commodities,understanding of market dynamics and price forecastingskills. Commodity funds with qualified analysts and fundmanagers boost confidence of retail investors. Mutualfunds have started believing that they should enter intocommodities in order to diversify their portfolio and todeliver better returns. Commodities will prove an idealportfolio diversifier as there exists a low correlationamong commodity, debt and equity returns. This pointsto a convergence of securities and commodities marketsand will usher in changes in the regulatory system.There are also certain other advantages of the commoditymarkets to the investors and traders. The margin requiredfor taking a position is normally much lower than the marginon the stock markets. The margins vary between 5 to 10%on an average as compared to 20 to 30% in the equitysegment. Again, unlike equity futures where the contractsize for all underlying is fixed at Rs 2 lakh, commodityfutures have flexible contract sizes for differentcommodities. Therefore the ability to leverage is muchhigher. This reduces the trading cost substantially.

Further the recently introduced securities transactiontax is not applicable in commodity futures trading. Thatgives an added incentive to retail investor to diversifyinvestible funds to commodities from equity or debtmarkets. The retail investors would of course have tohave an internet connection and would incur relatedcosts apart from margins and mark to market pay outcosts, as in the case of stock market futures.

Hedging through Derivatives

A derivative is commonly defined as a financialinstrument whose value depends in some way on the



values of other more basic underlying securities.Examples are futures on the long Treasury bond and acall option on IBM stock. Originally, these derivativesplayed a secondary role in finance. They were usedmainly or hedging [e.g., the short sale of a future orpurchase of a put option to hedge a long position in theunderlying security]. Derivatives were also used by someinvestment managers to enhance returns, perhaps byselling covered call options on an existing portfolio. Butin early 1990’s there was an explosion in the use ofderivative products, especially the over-the-countervariety. [A Konichi and Ravi E Dattatrya in “The Handbookof Derivative Instruments, IRWIN ProfessionalPublishing, 1996]. Most of the growth came from theinvestment community rather than the corporations, thetraditional users. They trace this phenomenal growth toseveral factors that influenced investors. Interest ratesin the United States fell to historically low levels acrossall maturities. Suddenly, many factors found that thereturns on their fixed income portfolios were barelynoticeable. The traditionally high quality, high-yield areaof mortgaged backed securities was also affectedseverely. As mortgage lenders began to offer low-costor no-cost refinancing, home owners began to prepaytheir loans at rates much higher than levels assumed byinvestors: junk bonds. However, astute investors arealways cautious of subjecting the entire capital to creditrisk in return for a few basis points of extra yield. Afterall, credit risk is difficult to measure and manage.

Derivatives provided an alternative. Derivative-embedded securities, called structured notes, allowedinvestors to achieve high yields in most foreseeablescenarios. Credit risk was replaced by market risk. Inaddition, investors could select their type and leverage[i.e. degree] of market risk. Most often, any risk waslimited to the size of coupon received. Clearly, thetechnical advancement in theoretical modeling andcomputer implementation, and the level of comfort andconfidence that dealers had in such models and systemsfueled the use of such derivatives.

Hedging

Hedge is a kind of derivative instrument. Thepurpose of hedging contract is to guard oneself againstlikely future loss on account of fluctuations in the valueof some asset or liability a person has.

Certain derivative instruments qualify under thedefinition of hedging instruments. Those that qualifywill be accounted for using hedge accounting. Hedgeaccounting generally provides for matching therecognition of the gains and losses of the hedgeinstrument and the hedged asset or liability.

There are three kinds of hedges one of which is aforeign currency hedge. The foreign currency hedgeand its accounting is the topic of this discussion. To ensuremore clarity we go by the Statement on FinancialAccounting Standards (SFAS 133) issued by AmericanInstitute of Certified Public Accountants [AICPA]. Thethree types of hedge are discussed to have a clearperspective. They are -

1. Fair value hedge;

2. Cash flow hedge;

3. Foreign currency hedge.

A hedge of foreign currency is exposure of

(a) an unrecognized firm commitment,

(b) an available-for-sale security,

(c) a forecasted transaction, or

(d) a net investment in a foreign operation.

If a derivative instrument does not qualify as a hedgeinstrument under one of the three categories shownabove, then its gains or losses must be reported andrecognized in current earnings.

Hedging Instruments

Two primary criteria must be met in order for aderivative instrument to qualify as a hedging instrument.

(a) Sufficient documentation must be provided atthe beginning of the process to identify at aminimum

(1) the objective and strategy of the hedge;

(2) the hedging instrument and the hedgeditem;

(3) and how the effectiveness of the hedgewill be assessed on an ongoing basis.

(b) The hedge must be highly effective throughoutits life. Effectiveness is measured by analyzingthe hedging instrument’s (derivative instrument)ability to generate changes in fair value thatoffset the changes in value of the hedgedinstrument.

At a minimum, its effectiveness will be measuredevery three months and whenever earnings or financialstatements are reported. A highly effective hedge issuch that “ the cumulative change in the value of thehedge instrument should be between 80 and 125 % ofthe inverse cumulative changes in the fair value of cashflows of the hedged item.” SFAS 133 does not provideany specific definition for “highly effective”, hence this



definition may be used as a surrogate. The method usedto assess the effectiveness must be used through thehedge period and must be consistent with the approachused for managing the risk. Similar hedges should usuallybe assessed for effectiveness in a similar manner unlessa different method can be justified. Eventhough ahedging item may meet the definition for being highlyeffective, it may not eliminate variations in reportedearnings, because to the extent that a hedging item isnot 100% effective, the difference in net loss or gain ineach period must be reported in current earnings.

FAIR VALUE HEDGES

(a) Specific Criteria of a fair value hedge

The hedged item must be either all or a specificportion (e g a percentage, a contractual cash flow) of arecognized asset/liability or an unrecognized firmcommitment. Both of these situations arise frequentlyin foreign currency transactions.

For example, a company may enter into a firmcommitment with a foreign supplier to purchase a pieceof equipment, the price of which is denominated in aforeign currency and both the delivery date and thepayment date are in the future. The company maydecide to hedge the commitment to pay for theequipment in foreign currency in order to protect itselffrom foreign currency fluctuations between the firmcommitment date and the payment date. For the periodbetween the firm commitment date and the deliverydate, the company will be hedging against anunrecognized firm time commitment. For the periodbetween the delivery date and the payment date, thecompany is hedging against a recognized liability.

(b) Accounting for fair value hedge

Current earnings will recognize gains and losses onthe hedged asset and liability and on the hedginginstrument.

CASH FLOW HEDGES

(a) Specific criteria

There are additional criteria that must be met toqualify as a cash flow hedge. The primary criterion isthat the hedged asset/liability and the hedginginstrument must be “linked”. Linking exists if the basis(the specified rate or index ) for the change in cashflows do not have to be identical, but they must meetthe “highly effective” threshold.

Again, it must be considered probable, based onappropriate facts and circumstances (ie past history). In

addition, if the forecasted-hedged asset/liability is aseries of transactions, they must share the same riskexposure. Purchases of a particular product from thesame supplier over a period of time is, for example,sufficient.

(b) Accounting for cash flow hedges

For the hedging instrument,

(1) effective portion is reported in other“comprehensive income”, and

(2) ineffective portion and/or excludedcomponents are reported on a cumulative basisto reflect the lesser of

(i) the cumulative gain/loss on the derivativesince the creation of the hedge, or (ii) thecumulative gain or loss from the change inexpected cash flow from the hedgedinstrument since the creation of the hedge.

The above amounts need to be adjusted to reflectany reclassification of other comprehensive income tocurrent earnings. This will occur when three hedgedasset/liability affects earnings (e.g. when hedgedinventory is sold and the cost of inventory passes throughto the cost of goods sold).

Comprehensive Income is an accounting conceptin the US. Under Statement of Financial AccountingConcepts No 6 issued by AICPA it includes all changersin equity during the period from transactions, eventsand circumstances other than investments, by ownersand distributions to owners.

FOREIGN CURRENCY HEDGES

When one works on exchange risk control function,he many times encounters volatility in forward premiain foreign exchange markets. Meaty part of the volatilitycomes from “expectations” in central bank decisions ofcountries occupying centrality in exchange ratedetermination process.

On November 5, 2001, for example, forex marketswere led to expect that US Federal Reserve ChairmanMr. Alan Greenspan will announce a bolder interest ratecut for the tenth time in 2001. Forward premium— thesix month forward annualized premium—on dollarended sharply higher at 6.27 per cent that day fromprevious Friday’s close of 5.94 per cent. The longerterm —the 12 month premium ended at 6 per cent.This was a 22 basis points increase from previous closeof 5.78 per cent.

The renowned news agency Reuters took a pollamong 24 primary dealers of US Government securities



on Friday 2nd November. Fifteen out of those 24 primarydealers predicted the FED will cut rates by a half pointon November 6.

The FED funds rate influences borrowing costacross the US economy. The predicted reduction byhalf point would bring the rate down to 2 per cent.This would be the lowest level of the federal fundsrate (which is like our bank rate) to its lowest level infour decades.

Such a rate cut, the forward markets expected,would widen the interest rate differentials.between Indiaand U.S. That was the reason why the forward premiarose. Interest rates in India are still stronger in spite ofthe recent cuts in the bank rate by the Reserve Bank ofIndia.

Such volatility in forward exchange rates makes itnecessary to hedge foreign exchange transactions. It isnecessary to understand the accounting of the hedgingtransactions after understanding their nature and reasonfor their existence.

Foreign currency denominated assets/liabilities thatarise in the course of normal business are often hedgedwith offsetting forward exchange contracts. This process,in effect, creates a natural hedge. Normal accountingrules apply. The Financial Accounting Standards Boarddecided not to change normal accounting treatment inthe implementation of SFAS133. The four foreigncurrency hedges under SFAS 133 are as follows :

1. Unrecognized firm commitment

Either a derivative instrument or a non-derivativefinancial instrument like a receivable in foreign currencycan be designated as a hedge of an unrecognized firmcommitment attributable to changes in foreign currencyexchange rates. If the requirements for a fair value hedgeare to be met, this hedging arrangement can beaccounted for as a fair value hedge.

2. Available-for-sale securities

A firm commitment to purchase a trading securityand several transactions related to held-to-maturitysecurities were, prior to SFAS133, permitted to usehedging accounting under certain conditions. Now theuse of hedging accounting is eliminated. This eliminationapplies to both trading and held-to-maturity securities.SFAS 133 limits hedge accounting to TRANSACTIONSIN SECURITIES DESIGNATED AS AVAILABLE FOR SALE.Derivative instruments can be used to hedge debt orequity available-for sale securities. However, equitysecurities must need two additional criteria, viz,

(i) They cannot be traded on an exchangedenominated in investor’s functional currency.

(ii) Dividends must be denominated in the sameforeign currency as is expected to be receivedon the sale of the security.

If the above criteria are met hedging instrumentsrelated to available for sale securities can be accountedfor as fair value hedges.

3. Foreign currency denominated forecastedtransactions

This is an exception in the permitted use of hedgeaccounting. Only derivative instruments can bedesignated as hedges of foreign currency denominatedforecasted transactions. A forecasted export sale withthe price denominated in a foreign currency might qualifyfor this type of hedge treatment. Forecasted transactionsare distinguished from firm commitments because thetiming and the cash flows remain uncertain. Thisadditional complexity result in hedging instruments inforeign currency denominated forecasted transactionsbeing accounted for as cash flow hedges. Hedgeaccounting is permissible for transactions betweenunrelated parties, and under special circumstances forinter-company transactions.

4. Net investments in foreign operations

Here the hedging instrument has to meet the new“effective” criterion under the SFAS 133. The changein the fair value of the hedging derivative is recorded inthe other comprehensive income account in the equitysection of the balance sheet.

Thus it will be seen that in case of fair valuederivatives, cash flow derivatives, and foreign currencyderivatives or nonderivatives the balance sheet valuationof hedging instruments is “fair value”.

In the case of fair value derivatives, the recognitionof gain or loss on changes in value of hedging instrumentis done in current earnings. In the case of cash flowderivatives, the effective portion of the gain or loss (Onchanges in value of hedging instrument is treatedcurrently as a component of other comprehensiveincome and reclassified to earnings in future periods)that forecasted transaction affects earnings. Theineffective portion of the gain or loss is accounted for inthe current earnings.

In the case of the foreign currency instruments,where it is a foreign currency denominated firmcommitment, the gain or loss on changes in value of



hedging instrument is done in current earnings. If it isavailable-for-sale security also the gain or loss isrecognized currently in earnings. Where it is a forecastedforeign currency transaction, the treatment of the gainor loss is the same as in cash flow hedge. That is tosay,-the effective portion of the gain or loss is recognizedcurrently in other comprehensive income and reclassifiedto earnings in future period(s) that forecasted transactionaffects earnings. The ineffective portion of the gain orloss is recognized currently in earnings.

In the case of the net investment in foreignoperation, the recognition of the gain or loss on changesin value of hedging instrument in othercomprehensive income as part of the cumulativetransaction adjustment to the extent it is effective as ahedge.

In the case of fair value derivative instrument,recognition of the gain or loss on changes in the fairvalue of the hedged item is done currently inearnings. Since, in the case of cash flow hedges, asthey are not associated with recognized assets orliabilities, recognition of such gain or loss doesnot arise.

In the case of foreign currency derivatives ornonderivatives, the recognition of gain or loss onchanges in fair value of hedged item is doneas follows:

Where it is a foreign currency denominated firmcommitment, the gain or loss is recognized currently inearnings. If it is available-for-sale security also the gainor loss is recognized currently in earnings. For aforecasted foreign currency transaction, this gain or lossis not applicable as such assets are not associated withrecognized assets or liabilities.

Forward Exchange Contracts

Foreign currency transaction gains and losses onassets and liabilities, which are denominated in a currencyother than the functional currency, can be hedged if aUS company enters into a forward exchange contract.The following example shows how a forward exchangecontract can be used as hedge, first against a firmcommitment and then, following delivery date, as ahedge against a recognized liability. The general rulefor estimating the fair value of forward exchangecontracts is to use the forward exchange rate for theremaining term of the contract.

The hedging as a derivative instrument willl be betterunderstood by following its accounting in the books of

account supported by the explanatory narration for eachjournal entry:

Example : B.S.Inc. enters into a firm commitmentwith D.I.,AG of Germany on October 1999, to purchasea computerized robotic system for DM 6,000,000. Thesystem will be delivered on March 1,2000, with paymentdue 60 days after delivery (April 30,2000). BSI decidesto hedge this foreign currency firm commitment andenters into a forward exchange contract on the firmcommitment date to receive DM 6,00,000 on paymentdate. The applicable exchange rates are shown in thetable below :

Date Spot rates Forward ratesfor April 30

October 1,1999 DM1 = $.55 Dm1 = $.57

December 31,1999 DM1 = $.58 Dm1 = $.59

March 1, 2000 DM1 = $.58 Dm1 = $.585

April 30,2000 DM1 = $.60

The following example separately presents both theforward contract receivable and the dollars payableliability in order to show all aspects of the forwardcontract. For financial reporting purposes, mostcompanies present just the net fair value of the forwardcontract, which would be the difference between thecurrent value of the forward contract receivable and thedollars payable amounts.

The transactions which reflect the forward exchangecontract, the firm commitment and the acquisition ofthe asset and retirement of the related liability appearas follows :

Forward Contract Entries Hedge against firmcommitment entries

(1) 10/1/99 (forward rate for4/3/00 DM 1 = $.57)

Forward contractreceivable 3,420,000

Dollars payable3,420,000

This entry recognizes theexistence of the forwardexchange contract usingthe gross method. Underthe net method, thisentry would not appearat all, since the fair valueof the forward contract is



zero when the contract isinitiated. The amount iscalculated using the10.1.99 forward rate for4/30/00 (DM 6,00,000 x$.57 = $3,420,000).Note that the net fairvalue of the forwardexchange contract is zeroon 10/1/99 becausethere is an exact amountoffset of the forwardcontract receivable withthe dollars payableliability.

(2) 12/31/99 (forward ratefor 4/30/00 DM 1 =.589) Forward contractreceivable 114000

Gain on hedge activity114000

The dollar values for thisentry reflect, amongother things, the changein the forward rate from10/1/99 to 12/31/99.However, the actualamount recorded as gainwill be determined by allmarket factor

(3) 12/31/99

Loss on hedgeactivity

114,000

Firm commit114,000

The dollar values forthis entry identical tothe previous entry,reflecting the factthat the hedge ishighly effective(100%) and also thefact that the marketrecognizes the samefactors in thistransaction as the

previous one. Thisentry reflects the firstuse of the firmc o m m i t m e n taccount, a temporaryliability accountpending the receiptof the asset againstwhich the firmcommitment hasbeen hedged.

(4) 3/1/00 (forwarded rate for (5) 3/1/004/30/00 DM1 = $.585) Firm commitmentLoss on hedge activity 2400024,000

Forward contract receivable Gain on hedge

24000 activity 24000

These entries again will bedriven by market factors,and they are calculated thesame way as entries (2) and(3). Notice that the declinein the forward rate from 12/31/99 to 3/1/00 resulted ina loss against the forwardcontract receivable and again against firmcommitment.‘

(6) 3/1/00 (spotrate DM 1 = .58)

E q u i p m e n t3,390,000

Firm Commitment90,000

Accounts3,480,000

This entry recordsreceipt of thee q u i p m e n t(recorded at fairvalue determined ona discounted netpresent value basis),the elimination of thetemporary liabilityaccount (firmcommitment), and





the recognition ofthe payable,calculated at the spotrate on the date ofreceipt (DM6,000,000 x $.58 =$3,480,000)

(7) 4/30/00 (spot rate DM 1 (8) 4/30/00= $.60)

Forward contract receivable Transaction loss

90,000 120,000

Gain on forward contract Accounts payable90000 (DM) 120,000

The gain on the forward The transaction losscontract is calculated related to accountsusing the change in the payable reflects onlyforward to the spot rate the change in spotfrom 3/1/00 to 4/30/00 rates and ignores the[(DM 6,000,000 x accrual of interest.($.60-$.585)] DM 6000,000

(9) 4/30/00 (10) AccountsDollars payable 3420000 payable 3,600,000Cash 3420000 (DM)

Foreign currency units Foreign currency3,600,000 (DM) units 3,600,000

This entry reflects the This entry reflectssettlement of the forward the use of thecontract of the 10/1/99 foreign currencycontracted forward rate units to retire the(DM 600000 x $.57 = accounts payable.$3420000 and the receipt


of foreign currency unitsvalued at the spot rate(DM 6,000,000 x $.60 =$3600,000)

In the case of using a forward exchange contract tospeculate in a specific foreign currency, the general rateto estimate the fair value of the forward contract is touse the forward exchange rate for the remainder of theterm of the forward contract.

CONCLUSION

When facing a globalised professional servicesmarket growing by virtue of global or regional multi-lateralism through RTAs and CECAs apart from the WTO,Company Secretaries need to come to grips with themechanics and operations of international financialmarket. The Theme Paper delineates some theoreticaland practical aspects of international financial transactionsand markets. It is necessary to understand thefundamentals, behavioural patterns, different financialindustries working cross-border, and inter-countryfinancial markets and transactions in order to raise fundsinternationally and to mange risks of cross-borderactivities. This Paper seeks to address these issues.Although the scope of the topics extends far beyondthe counters of a single Paper’s dimensions, the widerange of glimpse provided hereunder should generatebasic understanding and necessary inquisitiveness thata Company Secretary specializing in corporategovernance would need to keep at the back of his mindwhile countenancing international financial transactionsfor the corporate sector.




GLOBAL CONVERGENCE IN GOVERNINGGLOBAL CONVERGENCE IN GOVERNINGGLOBAL CONVERGENCE IN GOVERNINGGLOBAL CONVERGENCE IN GOVERNINGGLOBAL CONVERGENCE IN GOVERNINGBANKING AND FINBANKING AND FINBANKING AND FINBANKING AND FINBANKING AND FINANCIAL SEANCIAL SEANCIAL SEANCIAL SEANCIAL SECTORCTORCTORCTORCTOR

V P SHARMA* & M A JOSEPH**

INTRODUCTION

The financial system in any economy plays animportant role in promoting economic growth anddevelopment by improving the efficiency of resourcemobilization, pooling of savings and allocating thesesavings to investment outlets. It provides both liquidityand capital to firms in their production processes orservices and facilitates a reliable payment system, therebyproviding a veritable platform for an effective monetarypolicy management. For a financial system to achievethese objectives, it must be developed through thecollaborative efforts of the government, the monetaryauthorities, the financial institutions, the regulators andthe general public. The monetary authorities musttherefore improve on their supervisory processes andpursue policies and standards that would enhance thesafety, soundness and efficiency of the financial systemin a country.

Financial institutions including banks, the majoroperators in the financial system, provide theinstitutional mechanism for financial intermediation inthe system by managing the financial assets and liabilitiesof other economic units. They mobilize deposits,provide credits and in the process create money, offerprofessional advise to investors and act as agents of thegovernment in the implementation of various monetaryand macroeconomic policies.

Given the overall importance of banks in theeconomy, their supervision, control and regulationbecome imperative for ensuring a stable and healthyfinancial system. Supervision and controls entail, notonly the enforcement of rules and regulations, but alsosome judgment regarding the quality of financialinstitutions’ assets, capital adequacy and management,while regulation involves the specific rules governingexpected behaviors that limit or control the activitiesand operations of financial institutions. Often, these

40

* Joint Director, The ICSI. The views expressed are personal views of the author and do not necessarily reflect those of the Institute.** Assistant Director, The ICSI. The views expressed are personal views of the author and do not necessarily reflect those of the

Institute.

concepts are used interchangeably because of theirclose associations.

Banking Supervision, as part of public infrastructure,has the major role in ensuring financial sector stabilityand sustainable economic growth and development.Effective economic policy management requires arobust, efficient and sound financial sector. Supervisorsmust therefore ensure that banks and other financialinstitutions are operated in a safe and effective mannerthat would guarantee sustainable economic growth.Instability and poor performance in the banking sectorcould lead to bank failures, loss of public confidence aswell as adverse macroeconomic environment withnegative impact on real incomes, employment andoutput.

Banks’ capital is only a small part of their sources offunds, the major source of their funding being depositsfrom investors. Hence, depositors need protection,primarily because they do not have the means todetermine the extent of risks taken by banks in using oftheir money. The supervisory and regulatory frameworkmust ensure that banks operate within the prescribedprudential limits and standards, in a safe manner whichuphold high standards of professional conduct that wouldsustain continuing confidence in the banking system.

As a result of the growing volume of internationaltrade, financial institutions have adopted more effectiveand efficient ways to facilitate and finance cross bordertransactions and at the same time manage the relatedrisks. The resultant close linkage between financialinstitutions and financial markets has in turn necessitated,among other things the development of financialderivatives, strong support for reducing counter partycredit risk and a growing need to clarify laws andregulations regarding cross-border financial contracts.Supervisors in financial institutions/banks world over,have consequently realized and recognized the need to


Global Convergence in Governing Banking and Financial Sector 41

harmonize laws, regulations, codes and standards in orderto promote economic growth and international financialsecurity and stability. This has created the need ofconvergence of regulatory bodies, institutions etc. withreference to financial market in order to achieve theoptimum results in global competitive environment.

At present , financial markets are globally intransition. Traditional business models, when businesseswere clearly differentiated (Banks conduct banking,insurance companies offer risk covers and securitiescompanies offer investment opportunities), havebecome the footnotes of the finance literature.Nowadays , insurance companies are exploringopportunities in the banking and investment productsand vice versa. It is no more a bank competing withanother bank and insurance company competing withanother insurance company, but insurance companiescompeting with banks and banking companies stand againstinsurance companies. Hence, the most talked about wordtoday is the “convergence” of the opportunity zones infinancial markets from concept to culmination.

Regulatory convergence in this context refers tothe process by which regulators of a nation’s financialinstitutions establish common principles andhomogenous norms to be followed by all supervisedfinancial intermediaries, such as commercial banks,insurance companies, and securities firms, among others.The principal aim of regulatory convergence goes beyondensuring the soundness of individual intermediaries andsectors of the financial industry, for securing overall financialsystem stability in a country. Structuring of financialsupervisory systems to meet this objective also serves toenhance protection of depositors, investors andpolicyholders and to support economic stability and viability.

Regulatory convergence may be viewed as a directresponse to the convergence in the products and servicesoffered by the different types of financial intermediaries.It has been observed that the competitive dynamics ofmarket has changed phenomenally. Nowadays, marketplayers compete in one segment and co-operate in othersegment. Strategic alliance of the competing banks onthe ATM infrastructure is a live example. Today, mutualfunds also compete with the banks on deposits, as theytoo provide liquidity and cheque facility with certainlimitations. Revolutionary waves have gone to theextent of providing the ATM facility to even the mutualfunds investors. It is very interesting to observe thecompetition mounting across the opportunity zonesbecause that encourages institutions to improve anddeliver better values to the market leading to growth ofoverall productivity of the nation.

As stated earlier insurance products are otherexamples. One would observe that the buyer of theinsurance products also looks at them as the investmentproducts. This is an issue conditioning over the periodof time and therefore, the buyers of the insuranceproducts are both the customers of the risk protectionand the investment products. This leads to the insurancesector competing with the other avenues of theinvestment including banks, financial institutions andinvestment companies. The structure of the players indifferent opportunity zones is also changing oncontinuous basis. Corporate marriages, exchange’smergers, clearing corporation’s alliances, regulator’sintegration, etc. at global level bear testimony to it.Convergence of the financial products is also apparent,everywhere.

On regulators side, deeper co-ordination hasbecome the need of the hour. Creation of the FinancialServices Authority by merger of all the regulators in U.K.has set a precedent in itself. Now, a number of countries,across the globe, are thinking on these lines. Recently,Germany has joined the U.K. through creation of theFinancial Services Supervisor, a combined regulatoryauthority for the banking, securities and insurance. Thelogic behind is simple – integration of the opportunitieszone demands a flexible, efficient and effectivesupervisory regime. This can be accomplished eitherthrough the effective co-ordination among the regulatorsor the creation of single regulatory body. Someeconomies are choosing the former and others the later.

MANIFESTATION AND CHALLENGES OFMARKET CONVERGENCE

Market convergence arises from the increasedblurring of the lines of demarcation between differenttypes of financial institutions and the various productsthey offer to the customers and the resulting increasein competition for market share and survival. One impactof this competition has been disinter- mediation, wherecompanies that don’t operate as banking licensees,structure products which result in traditional bankingproducts such as loans, being effected through non-banking means. An illustration was the introduction ofcommercial paper, which saw deposits actually carvingout of the system. Similar banking products are beingoffered by non-banking entities. For example:

— Deposit-like products marketed by insurancecompanies which have “just a little insurance”;

— Products being offered by securities houseswhich not only allow clients to invest insecurities but also allow access to funds,



through cheque facilities owned and operatedby the securities as in the case of commercialbanks.

These types of products greatly resemble depositsand have given some concern to the Bank Supervisor/regulators. This highlights the need for recognition thatalthough not truly deposits, such activities must takeplace under similar prudential requirements as fordeposit-taking entities.

Another impact of this competitive pressure hasbeen the formation and increasing dominance ofdiversified financial group-conglomerates – that providea range of financial services across traditional jurisdictions.These cross-sector groups carry a unique risk profile,which relates to the following:

— Contagion whereby financial problems aretransmitted from one group member to another.Here, one entity within a group can be at riskof a loss of confidence arising from negativepublicity about the activities of a fellow groupmember or affiliate. This may also result inone group entity being drawn into the adversecircumstances of a problem of an affiliate if it ispressured by the group’s management to offerliquidity and other support to that affiliate.

— Conflicts of interest where decisions taken bythe management of a financial group to benefitthe group as a whole, may not be in the bestinterest of a particular entity or the specificgroup entity which is charged with carrying outthe activity leading from the decision.

— Complex and opaque corporate structures,which may obscure the real governance andmanagement structure of a financial institutionthat forms part of a group. This may alsocomplicate the assessment of the group’s andthe individual institutions’ true risk profile andthe adequacy of their capital, which specifiesthe ground conditions for the unhealthyphenomenon better known as regulatoryarbitrage.

The resulting challenges to the different authoritiesthat regulate and supervise financial institutions andconglomerates include the following :

— Similar activities across financial sectors are oftentreated inconsistently due to differentialprudential requirements of the varyingSupervisors. This encourages migration ofactivities from areas where there is stringent

prudential requirement to other sectors wherethe market has assessed as being less rigorouslyregulated and with less prudential requirementsto meet for essentially the same activity. Thiscan again lead to regulatory arbitrage thatthwarts the intent of regulation.

— Blurring of supervisory responsibilities, whichmay result in overlap, conflicts and evensupervisory gaps as between banking,insurance, securities and other financial sectorsupervisors.

— Obscuring of the limits of deposit protection,which de facto results in public perception ofan increase in the government safety net acrossbroad classes of financial sector liabilities;

— The need to quickly respond to the anomaliesin regulation and supervision in an environmentthat includes complex and diverse organizationswhile continuing to pursue the objective ofpromoting financial stability.

Regulatory convergence therefore is directed toaddress these challenges, in a situation where financialsector regulators, must continuously evaluate theeffectiveness of the regulatory framework, in light ofthe dynamic nature of financial markets.

INSTITUTING REGULATORY CONVERGENCE

Regulatory convergence may be instituted throughany of the following or the both basic supervisorystructures :

— Institutional convergence, which refers to theconsolidation of regulatory and supervisoryfunctions into one agency to supervise allfinancial sectors; banking, securities, insurance,pensions, housing societies and so on.

— Retaining specific sector regulatory agencies,while strengthening co-ordination andexchange of information between relevantagencies.

In order to ensure effective regulatory convergencethe following five essentials are considered irrespectiveof the type of supervisory structure to be adopted :

— Firstly, streamlining of the laws and regulationsgoverning the functioning of banks, securitiesfirms, insurers, etc. and convergence of relevantsupervisory methodology to ensure consistencyin regulation and prudential standards for similaractivities across different institutions.



— Secondly, close co-operation and co-ordinationbetween financial system supervisors; whetherdomestically or internationally. This approachis most effective where formal agreements thatcodify policies and strategies to be adopted tofacilitate greater co-ordination on issues suchas information sharing, lead regulator and theconduct of coordinated examinations for duallysupervised entities that have been established.

— The third essential is comprehensiveconsolidated (conglomerate) supervision thatseeks to minimize potential contagion withingroups, promote transparency of groupstructures and finances, and to promoteaccountability of directors and managers ofindividual regulated entities.

— Fourthly, effective market discipline which, afterensuring good governance and management,is the best line of defence against excessiverisk taking by financial groups. In this regard,disclosure is essential for the market to be ableto make decisions on an informed basis.

— And lastly, well-defined and coordinatedsupervisory responses and contingency plansto deal with problems which may arise inindividual entities or sectors or present systemicthreats.

CONVERGENCE FACTORS

In the past years, financial markets and institutionsworld over, have become larger, more complex and moretightly integrated. As a result of this process ofconvergence that has been shaping the global financialindustry has been powerful and broad based. Thedevelopments have been propelled by a number ofdriving forces which include the following :

Deregulation and Liberalization. Deregulationinvolves the relaxation of controls usually designed tooverride market forces. Countries are rapidly shiftingtowards market forces and private enterprises for themanagement of economies. These have manifested inthe steady retreat of the State from administrative andquantitative controls. Deregulation has contributed tothe increasingly intense competition and the blurring oftraditional distinctions between different types offinancial institutions. On the other hand, liberalization,entails the removal of impediments to world-wideexpansion of trade in goods and services, flows of capitaland foreign investment. Liberalization has also led tothe tremendous growth in the number and variety of

financial institutions, the volume and complexity ofoperations, as well as the number of products andservices offered due to the increased competitivenessin financial intermediation.

The respective role of capital markets and of financialinstitutions have been converging. Markets have mademajor inroads as mechanisms for allocating both fundsand risks within the economy that were once primarilythe domain of banking institutions or other regulatedfinancial intermediaries. Now financial markets are notonly a key supplier of credit but also a provider oftraditional insurance services. For instance, rapid growthof catastrophy bonds. In addition, they transfer risksacross segments of the financial system, not leastthrough derivatives. Initially, derivatives addressed marketrisk; now, by the unfolding revolution is an instrumentto manage credit risk. Crucially, in the process, thedividing line between market-traded and non-tradedfinancial instruments and that between insurance andother types of financial instruments that provideprotection from specific risks have become increasinglyblurred. Credit risk insurance can, in fact, be thoughtof as one such example.

Globalization : The increasing awareness of thepotential advantages of opening national financialmarkets to international competition has led toglobalization, a process of integrating national economiesinto a global market place in which all nations can freelyparticipate. The process also involves the creation ofharmonized trade policies, rules and practices across theglobe. Globalization is increasingly fuelled byinternational financial institutions and regional groupings,which promote similar policies across the world. Differenttypes of financial institutions have been converging. Thishas been true even as the financial landscape has becomemore diverse. In insurance, for instance, companies havebeen providing products with an increased financialcomponent. Thus, through products such as singlepremium unit-linked insurance policies, insuranceproviders now compete directly with mutual funds. Andthe growth of conglomerates that encompass bothinsurance and banking has eroded the long-standing barriersthat had kept these two lines of business apart. Financialarrangements across different national jurisdictions havebeen converging - a process that most of us know as“financial globalization”. As obstacles to capital flows,foreign establishment and the cross-border provision offinancial services have come down, resulting which thepressure to adopt similar arrangements across countrieshas grown. In insurance sector, for instance, cross-borderownership of companies has increased considerably.



Technology : A rapid technological change inInformation Technology (IT), communication andtransport has given rise to new products and services,methods of management and organization of production.Similarly, innovations in technology have provided a freshstimulus for capital. For enterprises some forms ofspecialization and consolidation have made possible anentirely new and much cheaper means of deliveringfinancial services. Additionally, it has facilitated thedevelopment of new financial instruments andinvestment strategies and radically changed tradingmechanisms. Furthermore, technology has made iteasier for both financial institutions and their regulatorsto measure, monitor and manage risks.

Within the framework of these driving forces, theglobal financial market has been subject to increasingvolatility and vulnerability such that there have beencurrency, banking and financial crisis in some regions.Thus, the needs for fair, sound, stable and consistentpolicies, standards, procedures and practices havebecome imperative. Indeed, the global growth offinancial markets and institutions have provided theimpetus for cooperation, coordination and harmonizationamong different countries’ supervisory and regulatorysystems.

AREAS OF COMMON INTEREST ANDINTERNATIONAL AGENCIES

There are essentially two reasons that necessitatemost international efforts to coordinate banking issues:Firstly, to maintain a healthy, responsive and financiallystrong banking and financial system that will facilitatethe growing needs of domestic economies. Secondly,to build and maintain adequate legal and regulatorystructures that will permit institutions to compete safelyon an equal and non-discriminatory basis, bothdomestically and internationally.

The promotion of sound risk management hasbecome of common interest and the regulatory andsupervisory authorities continue to build on “best” or“sound” banking practices in designing rules andregulations, working towards such a common end willbe achieved. Apart from risk management, other areasof common interest in banking supervision and regulationinclude issues relating to accounting standards,auditing practices, corporate governance, informationdissemination, transparency, cross-border securitiestransactions and insurance. These areas havecontinued to be addressed by relevant agencies acrossthe globe.

The agencies established to address these commonareas of interest include the International Accounting

Standards Board [IASB], International Federation ofAccountants [IFAC], Organization for EconomicCooperation and Development [OECD], InternationalMonetary Fund [IMF], The World Bank, United NationsCommission on International Trade Law [UNCITRAL],International Bar Association [IBA], InternationalAssociation of Insurance Supervisors [IAIS], Committeeon Payments and Settlements Systems [CPSS] andInternational Organization of Securities Commissions(IOSCO], etc.

These international agencies have issued standards,guidelines and codes along the areas of common interestto supervisory and regulatory authorities worldwide.However, in implementing the standards, guidelines andcodes, supervisors are never unmindful of theirenvironment and the structure of the financial institutionsin their jurisdiction. Such consideration should howevernot impair their oversight responsibilities because in theglobal market, weak or ineffective supervision in eitherlarge/developed or small/developing countries can haveadverse and far-reaching consequences. It is thereforeimportant for supervisors to relate and cooperate withtheir counterparts in other countries in implementingthe agreed standards for the safety and soundness oftheir financial institutions and the global financial system.

INTERNATIONAL STANDARDS AND CODES

International financial standards have been developedto help financial authorities for fashion prudent policies,increase transparency and improve institutional andmarket infrastructure. These, in turn, are expected toreinforce the stability of the international financial system.It is, therefore, in the overall self-interest of any countrynot only to adopt these standards but also to adhere tothem as much as possible. The basic responsibility forensuring the implementation and monitoring of thestandards rests with the relevant financial sectorsupervisory/regulatory agencies in each country. Manyproposals have been made for strengthening theinternational financial system. These proposals havebroadly focused on the indicators of financialvulnerability, the development of sound internationalcodes, standards and best practices, the introduction ofpre-emptive measures and safety nets, and thedesigning of a framework for crisis management.

As part of the effort to strengthen financial systemsand improve coordination among the agenciesresponsible for them, the Financial Stability Forum [FSF]was established in April 1999. Its mandate was topromote international financial stability by improving thefunctioning of markets and thereby reducing systemicrisk through information exchange and international



cooperation in the supervision and surveillance offinancial markets. The FSF has drawn together variousstandard setting bodies, which were constituted bymeans of cooperation among central banks, internationalfinancial institutions, national authorities and internationalsupervisory and regulatory bodies.

The FSF has produced a compendium of standards,which serve as a common reference. Currently, thereare 69 standards in the compendium. A set of 12standards has been highlighted by the FSF as key, forsound financial systems and deserving consideration forpriority implementation. These 12 key standards, whichare organized under three broad headings, are acceptedas representing minimum requirements for good practiceas listed hereunder.

A. Macro-Economic Policy and Data Transparency:

1. Code of Good Practices on Transparency inMonetary and Financial Policies;

2. Code of Good Practices on Fiscal Transparency;and

3. Special Data Dissemination Standard.

B. Institutional and Market Infrastructure:

4. Principles and Guidelines for EffectiveInsolvency and Creditor Rights Systems;

5. Principles of Corporate Governance;

6. International Accounting Standards;

7. International Standards on Auditing;

8. Core Principles for Systematically ImportantPayment Systems; and

9. The Forty Recommendations of the FinancialAction Task Force on Money Laundering.

C. Financial Regulation and Supervision:

10. Core Principles for Effective BankingSupervision;

11. Objectives and Principles of SecuritiesRegulation and Disclosure Standards to FacilitateCross-Border Offerings and Initial Listings byMultinational Issuers; and

12. Insurance Supervisory Principles.

Perhaps, among the above, we should focus on oneof the standards that seem to be most relevant tobanking supervision. The Core Principles for EffectiveBanking Supervision was developed by the BasleCommittee on Banking Supervision to provide theinternational financial community with benchmarksagainst which the effectiveness of bank supervisory

regimes can be assessed. The need for strengtheningthe supervision of banks has been stressed as a majorpriority since it is now widely recognized thatweaknesses in banking systems have been the cause offinancial crisis in many countries over the last decade.Thus, the Core Principles, which have been endorsedand are being implemented by a vast majority ofcountries, have become the most important globalstandard for prudential regulation and supervision.

The Basle Core Principles comprise 25 basicprinciples, which are regarded as minimum standardsthat need to be in place for any supervisory system tobe effective. They relate to 7 main areas of supervisionnamely: pre-condition for effective banking supervision;licensing and structure; prudential regulations andrequirements; methods of on-going supervision;information requirement; formal powers of supervisors;and cross-border banking. The Basle Committeecontinues to take the lead in coordinating bankingsupervisory policies and practices globally.

Another area the Basle Committee has also excelledso much is on the setting of capital standards.Recognizing that adequate capital is essential forfostering the safety and soundness of banks, theCommittee issued the first Capital Accord in 1988. Sincethen, it has continued to develop and refine the standardin an effort to keep pace with banking practices and tomaintain adequate levels of bank capital throughout theworld. From the start, it was observed that the 1988Accord was not perfect in several respects. Althoughthe Accord incorporated some differentiations in creditrisk, it was limited. Moreover, it did not explicitly addressinterest rate risk, market risk, operational risk, and otherrisks that could be significant in some banks. In orderto address the initial and inherent imperfections, theCommittee in 1996, reviewed the 1988 accord toincorporate market risks in the determination of theadequacy of banks’ capital. It also recently issued theNew Capital Accord that is more comprehensive andrisk sensitive in approach and consists of three mutuallyreinforcing pillars.

Pillar I is the minimum capital standard whichessentially is the Existing Accord with some additionalrequirements. Pillar II is supervisory oversight of capitaladequacy at individual banks while Pillar III is marketdiscipline, involving adequate public disclosures bybanks. The addition of Pillar II and III emphasise theimportance of ongoing review by supervisors of thecapital adequacy at individual banks and the criticalrole of market discipline in controlling risk-taking bybanks.



The Committee expects the implementation of theNew Accord to commence by the end of year 2006.This is to allow time for necessary amendments to thelegislative framework and for effecting any changes thatmight be necessary in the various countries’ processes,procedures and information systems. Also, time isrequired to build up the required data bank for theextensive statistical records that most aspects of the newpackage would require. Supervisors and operators wouldalso require time for training.

The several interrelated standards and codesrepresent the collaborative efforts of developed countriesand emerging economies, international institutions,public and private sector regulators and marketparticipants. In addition, the current initiative providesfor assessment methodologies involving externalassessment and incentives for internal assessment ofthe degree of compliance of a country with the keystandards and codes. Furthermore, the entire exerciseis undertaken on the premise that its implementationwould not only help to promote sound financial systemswithin the different countries but also would ensuresmooth integration into the global market, therebycontributing to finance stability in the global system.The adoption and implementation of internationalstandards and codes are also fostered by regionalgroupings in order to optimally derive the inherentbenefits and also move towards a better assimilationinto the global financial market.

INDIAN SCENARIO

The principles and vision of supervision in Basel IIare valuable for supervisors and banks not only acrossthe developed markets , but even the developing ones.Unique feature of the Indian financial system is thediversity of its composition. Major chunk of bankingsector business goes to public sector banks. The processof providing financial services is changing very rapidlyfrom traditional banking to a one stop shop of variedfinancial services and the old institutional demarcationsare getting increasingly vanished.

In recent years, there has been a considerablewidening and deepening of the Indian financial system,coupled with the increasing globalization of financialservices. India is fast approaching to an era of financialconglomerisation and ‘bundling’ in the provision of financialservices. These developments are opportunities for themarket participants but nevertheless pose serious challengesto regulation and supervision of the banking system.

In India, the pursuit of financial and macroeconomicstability has emerged as the central plank of financial

sector reforms. Stability of the financial system has acritical influence on price stability and sustained growth,which constitute the principal objectives of monetarypolicy. A stable financial system facilitates efficienttransmission of monetary policy initiatives and thesmooth operation of payment systems. From theperspective of regulation and supervision, safeguardingdepositors’ interest, and ensuring strong riskmanagement within payment, clearing and settlementsystems, are the mandates of the Reserve Bank of India(RBI). The RBI has put in place Prudential SupervisoryReporting System, covering all vital aspects and a widerange of indicators, which serves as an early warningsignal as well. Macro-Prudential Indicators (MPIs) havebeen compiled since March 2000, collating data fromvarious reports that are received in the regulatory andsupervisory wings of the Bank. The review of MPIscovers the areas of capital adequacy, asset quality, riskmanagement, management soundness, earnings andprofitability, liquidity, interest rate, maturity structure ofassets and liabilities, and various indicators pertaining tomajor segments of financial markets such as debts, forex,capital market segments, besides macroeconomicindicators such as growth, inflation, interest rate andexchange rate. The MPI review is accompanied by areview of developments in the global environment. Aspart of the efforts to disseminate these FinancialSoundness Indicators (FSIs), the Reserve Bank of Indiahas started publishing the core set of indicators in itsvarious publications.

Financial sector reforms adopted in the 1990s haveenhanced the strength of banks and financial institutionsin India. A striking feature of these institutions has beentheir improved resilience to the domestic and theexternal environment. The reform process has changedthe relationship between the RBI and commercial banksfrom one of micro regulation to that of macromanagement. Aided by the robust macroeconomicenvironment, banks’ bottom lines have improvedsignificantly over the last two years. The aggregatecapital adequacy ratios of scheduled commercial banksstood at 12.83 per cent as at end March 2005 havebeen well above the stipulated level of 9 per cent.

The Reserve Bank of India along with theGovernment, has initiated several institutional measuresto contain the levels of Non-Performing Assets(NPAs).Notable among these include establishment of DebtRecovery Tribunals, Lok Adalats (people’s courts), AssetReconstruction Companies (ARCs) and Corporate DebtRestructuring (CDR) mechanism. Settlement AdvisoryCommittees have been formed at regional and headoffice level of commercial banks. Enactment of the



Securitisation and Reconstruction of Financial Assets andEnforcement of Security Interest (SARFAESI) Act, 2002has helped in improving the recovery climate in thecountry. The Government amended the relevantprovisions of the Act to address the concerns expressedby the Supreme Court regarding a fair deal to borrowersthrough an ordinance dated November 11,2004. Thedeclining trend in gross and net NPLs for scheduledcommercial banks has continued despite the adoptionof 90-days delinquency norm and unprecedented surgein growth of advances.

Legislation has since been enacted to facilitate thecompilation and dissemination of credit informationincluding data on defaults to the financial system by theCredit Information Bureau of India Ltd. (CIBIL). The legalprovisions and practice in bankruptcy of the real sectorare however still inadequate and need further reform.

The Reserve Bank is also making efforts to formulatepolicies to deal with risks arising on account of operationsof large and complex financial institutions as these posea systemic risk. As a first step in this direction, in June2004, an inter-agency Working Group on FinancialConglomerates (FC) comprising three supervisory bodies,viz., the Reserve Bank, the Securities and ExchangeBoard of India and Insurance Regulatory andDevelopment Authority, identified 23 FCs and a pilotprocess for obtaining information from theseconglomerates has been initiated.

The year 2004-05 has witnessed a surge in creditoff-take leading to a sizeable decline in the liquid assetsof the bank. Consistent with the shift to functioning ina competitive economy and to the adoption of prudentialbest practices, the major challenges facing the bankingsector are the deployment of funds in quality assets andthe management of revenues and costs.

BASEL II

Unlike Basel I, which is simple, Basel II is complex.Therefore, the Basel Committee on Banking Supervision(BCBS) does not expect Basel II to be adopted widelyor quickly. They believe that countries should adopt theoptions and approaches that are most appropriate forthe state of their markets, their banking systems, andtheir supervisory structures. Supervisors can adopt theframework on an evolutionary basis and use elementsof national discretion to adapt it to their needs.

INDIAN APPROACH TO BASEL II

With the commencement of the banking sectorreforms in the early 1990s, the RBI has been consistently

upgrading the Indian banking sector by adoptinginternational best practices. The approach to reforms isone of having clarity about the destination as alsodeciding on the sequence and pace of reforms to suitIndian conditions. This has helped us in moving aheadwith the reforms without disruption. With the successfulimplementation of banking sector reforms over the pastdecade, the Indian banking system has shown substantialimprovement on various parameters. It has becomerobust and displayed significant resilience to nationaland international shocks. There is ample evidence ofthe capacity of the Indian banking system to migratesmoothly to Basel II norms.

The policy approach to Basel II in India is such thatexternal perception about India conforming to bestinternational standards is positive and is in our favour.Commercial banks in India will start implementing BaselII with effect from March 31, 2007. They will initiallyadopt the Standardised Approach for credit risk and theBasic Indicator Approach for operational risk. Afteradequate skills are developed, both by the banks andalso by the supervisors, some banks may be allowed tomigrate to the Internal Rating Based (IRB) Approach.

Some of the regulatory initiatives taken by theReserve Bank of India, relevant for Basel II are as follows:

Firstly, it has tried to ensure that the banks havesuitable risk management frameworks oriented towardstheir requirements dictated by the size and complexityof business, risk philosophy, market perceptions and theexpected level of capital.

Secondly, Risk Based Supervision (RBS) in 23 bankshas been introduced on a pilot basis.

Thirdly, RBI has been encouraging banks toformalize their Capital Adequacy Assessment Process(CAAP) in alignment with their business plans andperformance budgeting systems. This, together with theadoption of RBS, would enable factoring in of the PillarII requirements under Basel II.

Fourthly, RBI has been expanding the area ofdisclosures (Pillar III), so as to have greater transparencyin the financial position and risk profile of banks.

Finally, RBI is also trying to build capacity for ensuringthe regulator’s ability for identifying and permitting eligiblebanks to adopt IRB / Advanced Measurement approaches.

As per normal practice, and with a view to ensuringa smooth migration to Basel II, a consultative andparticipative approach has been adopted for bothdesigning and implementing Basel II. A SteeringCommittee comprising senior officials from 14 banks



(public, private and foreign) has been constituted withrepresentation from the Indian Banks’ Association andthe RBI. The Steering Committee had formed sub-groupsto address specific issues. On the basis ofrecommendations of the Steering Committee, draftguidelines to the banks on implementation of the NewCapital Adequacy Framework have been issued.

Implementation of Basel II will require more capitalfor banks in India due to the fact that operational risk isnot captured under Basel I, and the capital charge formarket risk was not prescribed until recently. Thoughthe cushion available in the system, which at presenthas a CRAR of over 12 per cent, is comforting, banksare exploring various avenues for meeting the capitalrequirements under Basel II.

Even while RBI has decided to take the Indianbanking system on to the simple approaches under BaselII, it has taken some initiatives which would clearlydemonstrate that it has no intentions of either dilutingthe standards or picking on the less stringent optionslaid down in Basel II. Through these initiatives, RBI hasprescribed stringent prudential requirements for banksin India e.g. with regard to adoption of risk weights forclaims on State Governments, Public Sector Enterprises,banks and for capital market and real estate exposures.Further even though banks can be allowed to useunsolicited ratings under the Standardised Approach, RBIwould not allow the use of unsolicited ratings.

RBI also has been expanding the area of disclosuresso as to have greater transparency with regard to thefinancial position and risk profile of banks. Illustratively,with a view to enhancing further transparency, all casesof penalty imposed by the RBI on the banks as alsodirections issued on specific matters, including thosearising out of inspection, are to be placed in the publicdomain. Such proactive disclosures by the Regulator areexpected to have a salutary effect on the functioning ofthe banking system. In addition to the above, any penalaction taken against any foreign bank branches in Indiaare also shared with the Home country regulator with aview to enhance the quality of consolidated supervision.These initiatives will be an important supplement to thePillar III disclosures prescribed under Basel II, whichwill further facilitate the cause of a stable banking system.

Banking will remain a highly dynamic industry.Supervisors will have to be especially attentive tochanging best practices and ensure that Basel II does

not inhibit adoption of new banking practices andfinancial instruments. Maintaining financial stability inglobal banking and financial markets continues to be animportant objective of regulators, bankers, and othermarket participants, particularly because of the negativeimpact that financial instability has on economies as awhole. Basel II, will help to improve financial stability,even though minimum regulatory capital ratios are likelyto be more volatile under Basel II, this reflects greaterrisk sensitivity.

REFERENCES

1. O.I. Imala, International Convergence inSupervision and Regulation.

2. Gayon Hosin,Regulatory Convergence-A mustfor Financial Sector Safety, Banking on SafetySeminar, Bank of Jamaica, Kingston, Jamaica,6thOctober, 2004.

3. Malcom D Knight,( Manager BIS), Regulationand Supervision in Banking : GreaterConvergence, Shared Challenges; IAIS 11THAnnual Conference in Amman, Jordan, 6thOctober, 2004.

4. Malcom D Knight,( Manager BIS), Regulationand Supervision in Banking and Insurance :Greater Convergence, Common Challenges;International Conference of Banking Supervisorsin Madrid, 22-23 September, 2004.

5. G N Bajpai, Banking, Insurance and FinancialSector- A Vision of the Future; 15th All IndiaConference of Chartered Accountants –2003 ,New Delhi.

6. Kishori Udeshi (Deputy Governor, RBI), FinancialSystem Stability and Basel lI-Way Forward; AnnualConference of the Association of ProfessionalBankers-Sri Lanka, 26th August, 2005.

7. Dr. Y V Reddy,(Governor RBI), Monetary Policyin Asia, Inaugural Address at the 8th Meetingof the BIS Working Party at Mumbai , 6-7June,2005

8. Enhancing International Financial MarketIntegration; Joint Statement of the Asian,European ,Japanese, Latin American and theUS Shadow Financial Regulatory Committee,Washington, DC, November15,2004;American Enterprise Institute of Public PolicyResearch-Short Publication.


Attuning to Global Governance Norms — Indian Perspective 49

AAAAATTUNING TO GLTTUNING TO GLTTUNING TO GLTTUNING TO GLTTUNING TO GLOBAL GOOBAL GOOBAL GOOBAL GOOBAL GOVERNVERNVERNVERNVERNANCE NORMS —ANCE NORMS —ANCE NORMS —ANCE NORMS —ANCE NORMS —INDIAN PERSPECTIVEINDIAN PERSPECTIVEINDIAN PERSPECTIVEINDIAN PERSPECTIVEINDIAN PERSPECTIVE

DR. S K DIXIT*

49

* Joint Director, The ICSI. The views expressed are personal views of the author and do not necessarily reflect those of the Institute.

INTRODUCTION

The transformation from command economies tomarket-oriented economies, the rapid development andglobal proliferation of information and communicationstechnologies, the growth of knowledge-based industriesand services sector and the continuing integration ofthe world economy through trade and investment - allthese have created the foundation for a new age ofsustainable human development. Changes in the world’seconomic, political and social systems have indeedbrought unprecedented improvements in human livingconditions in both developed and developing countries.Here the trend towards globalisation deserves specialattention as it has profound implications for governance,putting the government under greater scrutiny, leadingto improved state conduct and more responsibleeconomic policies.

In this article an attempt has been made to highlightthe need for participation of State, private sector andcivil society in the governance process. The article alsohighlights the initiatives taken by the governmentparticularly in the context of regulatory governance forbusinesses.

CONCEPT OF GOVERNANCE

The concept of governance is not new. However, ithas assumed the present prominence in the light ofunprecedented changes that are taking place all aroundthe world. The World Bank has defined that the goodgovernance is epitomized by predictable, open andenlightened policy-making, a bureaucracy imbued witha professional ethos acting in furtherance of the publicgood, the rule of law, transparent processes, and a strongcivil society participating in public affairs.

United Nations Development Programme (UNDP)views Governance as the exercise of political, economicand administrative authority in the management of a

country’s affairs at all levels. It comprises mechanisms,processes and institutions through which citizens andgroups articulate their interests, exercise their legalrights, meet their obligations, and mediate theirdifferences.

Organisation for Economic Cooperation andDevelopment (OECD) defines governance, as the useof political authority and exercise of control in a societyin relation to the management of its resources for socialand economic development. This broad definitionencompasses the role of public authorities in establishingthe environment in which economic operators functionand in determining the distribution of benefits.

It is, therefore, clear that the term governanceencompasses political, social and economic governanceincluding corporate governance, which has over theyears gained momentum and a wider meaning. Apartfrom being an instrument of public affairs management,or a gauge of political development, governance hasbecome a pre-requisite for competitive advantage forsustainable growth of business.

Major Constituents of Governance

Governance encompasses the state, but ittranscends the state by including the private sector andcivil society organisations. The private sector coversprivate enterprises (manufacturing, trade, banking,cooperatives and so on) and the informal sector in themarketplace.

Civil society, lying between the individual and thestate, comprises individuals and groups (organised orunorganised) interacting socially, politically andeconomically - regulated by formal and informal rulesand laws. Therefore, the institutions of governance inthe three domains - state, civil society and the privatesector must be designed to contribute to sustainablegrowth and development of the country.



Efficient governance requires effective institutions.The efficiency and effectiveness of institutions, in turn,depends on their adopted delivery mechanism and thesupportive framework of rules and procedures. Each ofthese has to work in harmony with the other to dischargethe functions and roles for which the institutions havebeen created. More importantly, with changingcontext– domestic as well as global – a change in theprofile and requirement of the society and withdevelopment, there has to be a capacity for evolution,the continuous adaptation in each of these elements.In the absence of such a capacity, governance invariablysuffers. If institutions fail to keep up with the changingcontext and the supportive framework of rules andprocedures become out of tune with the prevalentdelivery mechanism, the institutions, may fail to deliveron their objectives satisfactorily.

Elements of Good Governance

— Participation - All men and women should havea voice in decision-making, either directly orthrough legitimate intermediate institutionsthat represent their interests. Such broadparticipation is built on freedom of associationand speech, as well as capacities to participateconstructively.

— Rule of law - Legal framework should befair and enforced impartially.

— Transparency - Transparency is built on thefree flow of information. Processes, institutionsand information should be directly accessibleto those concerned with them, and enoughinformation is provided to understand andmonitor them.

— Responsiveness - Institutions and processesshould serve all stakeholders.

— Consensus - Good governance mediatesbetween differing interests to reach a broadconsensus on what is in the best interests ofthe group or where possible, on policies andprocedures.

— Equity - All men and women have opportunitiesto improve or maintain their well-being.

— Effectiveness and efficiency - Processes andinstitutions produce results that meet needswhile making the best use of resources.

— Accountability - Decision-makers ingovernment, the private sector and civil societyorganisations are accountable to the public, aswell as to institutional stakeholders.

— Strategic vision - Leaders and the public have abroad and long-term perspective on goodgovernance and human development, alongwith a sense of what is needed for suchdevelopment.

CONCEPT OF CORPORATE GOVERNANCE

As we have seen above, corporate governance is aspecies of a larger genus - the governance. Corporategovernance is the system by which companies are run.It relates to the set of incentives, safeguards and disputeresolution process that are used to control and co-ordinate the actions of the agents on behalf of theshareholders by the Board of Directors. At the centerof the corporate governance system is therefore, theBoard of Directors, the composition of which isdetermined by shareholders. Their responsibilities aredefined by statutes and their position.

Corporate governance today is a strategic necessitywhere focus is on quality of governance. Capital andinvestments from international investors are availableto corporates demonstrating good governance practicesand thus helping them both in procuring capital atcompetitive rates and also in employing and retainingthe intellectual capital. Research studies have establishedthat shareholders and stakeholders reward corporatesconforming to norms of corporate governance in letterand spirit as they respond positively to them.

There is no universal definition of corporategovernance. In the narrowest sense, Noble laureateMilton Friedman defined corporate governance as “theconduct of business in accordance with shareholders’desires, which generally is to make as much money aspossible, while conforming to the basic rules of thesociety embodied in law and local customs.” In a broadersense, James Wolfensohn, president of the World Bank,defined corporate governance as the “promotion ofcorporate fairness, transparency, and accountability.”

Sir Adrian Cadbury while defining corporategovernance said that it is a system by which companiesare directed and controlled and thus brought into sharpfocus the role of board, shareholders and management.Corporate governance extends far beyond the confinesof corporate law. The quality, quantity and frequency offinancial disclosures, the extent of exercise of fiduciaryresponsibilities and duties by the boards towardsshareholders and stakeholders, accountability andtransparency in corporate functioning for maximizingshareholders’ wealth are the progressive elements andindeed, the underlying spirit of corporate governance.



Effective corporate governance mechanism providesfor corporate ombudsmen and encourages whistleblowers to dissent when the interests of the Companyare potentially in jeopardy. It is believed that corporategovernance is limited to the highest levels of thecompany - perhaps the Chairman or the Board ofDirectors alone, but it indeed is the responsibility andprivilege of each and every stakeholder.

While corporate governance is an importantelement affecting the long-term financial health ofcompanies, it is only part of the larger economic contextin which firms operate. Corporate governance frameworkdepends on the legal, regulatory and institutionalenvironment. Business ethics and corporate awarenessof the environmental and societal interests of thecommunities in which it operates also impact thereputation and long-term success of a company. Ifcompanies are to reap the full benefit of the global capitalmarket, capture efficiency gains, reap the economiesof scale and attract long term capital, corporategovernance standards must be credible,consistentcoherent and inspiring.

Value Addition through Good CorporateGovernance

— Good governance provides a competitiveadvantage in the global marketplace.

— Well-governed companies raise capital widely,easily, and cheaply.

— Good governance leads to improved employeemorale and higher productivity.

— Well-governed companies last longer.

— Good governance provides stability and growthto the enterprise.

— Good governance system, demonstrated byadoption of good corporate practices, buildsconfidence.

— Effective governance reduces perceived risks,consequently reducing cost of capital.

— Good corporate practices promote stability andlong-term sustenance of stakeholders’relationship.

— A good corporate citizen becomes an icon andenjoys a position of pride.

— Potential stakeholders aspire to enter into arelationship with enterprises whose governancecredentials are exemplary.

GOVERNMENT INITIATIVES TOWARDSREGULATORY GOVERNANCE FOR CORPORATES

As a consequence of increasing interconnectednessand interdependence the structures of nationalgovernance are all for change in the course ofglobalisation. The quest for more mobility and efficiencyhave compelled the nations to open up their bordersand allow globalisation to expand and grow, however,within the national governance system. As globalisationrequires a national governance system to conform toglobal norms, the agenda for market oriented reformsprocess encompassed legislative reforms,complementing and supplementing the policyorientations to meet the desired objectives of the wholeprocess.

With the initiation of economic reforms process inJuly 1991, the Government has initiated the process ofRegulatory Reforms to suit the changing policyorientation and to fulfill its obligations under WTO. Inthe process, the Government enacted various new laws,amended existing legislations to provide a conduciveeconomic and corporate legal environment. Some ofthe important initiatives towards attuning the governancenorms conforming to requirements of globalisationincludes reforms in corporate and economic legislationsencompassing company law, securities laws, foreignexchange law, intellectual property law and competitionlaw. This is an ongoing process.

New Governance Norms for Companies

The governance framework dealing withincorporation, management and even liquidation of thecompanies contained in the Companies Act, 1956. TheCompany Law, an ever-evolving subject, has undergonemajor transformation in the last decade. The impetusfor such transformation germinated partially from theworldwide move for market oriented polices and partiallyby disquieting features of globalisation, resulting intofocused attention on need for Good CorporateGovernance. The advancements in informationtechnology and influence of faster means ofcommunications over corporate operations have alsoprovided impetus for such transformation. In otherwords, the paradigm shift witnessed in the globaleconomy and corporate sector the world over, havecumulatively presented various issues that havetriggered debate and become important factors forinitiating changes in Company Law in India and abroad.

With the initiation of market-oriented policies inJuly 1991, the Government has expedited the processto modify the company law in line with policy objectives



and to harmonise it with the international standards. Inthis direction a Working Group was constituted in theyear 1996 to re-write the Companies Act, to facilitatehealthy growth of Indian corporate sector under aliberalised, fast changing and highly competitivebusiness environment. Based on the recommendationsof Working Group Companies Bill, 1997 was introducedto replace the Companies Act, 1956. Since the Bill of1997 was under consideration and an urgent need wasfelt to amend the Companies Act, the President of Indiapromulgated the Companies (Amendment) Ordinance,1998 which was later replaced by the Companies(Amendment) Act, 1999 to surge the capital market byboosting morale of national business houses besidesencouraging FIIs as well as FDI in the country, and totailor the Companies Act in consonance with the thenprevailing economic environment and to furtherGovernment policy of deregulation and globalisation ofeconomy.

To expedite the harmonization process, theCompanies Act was further amended in the year 2000to provide certain measures of good corporategovernance and for ensuring meaningful shareholders’democracy in the working of companies.

Two years later, the Companies (Amendment) Act,2002 was enacted with the main objective of facilitatingformation of cooperative business as companies and alsoto convert existing cooperatives into companies.Similarly, the Companies (Second Amendment) Act,2002 provided for setting up of a National CompanyLaw Tribunal having powers and jurisdiction, presentlyvested with Company Law Board/BIFR or AppellateAuthority for Industrial and Financial Reconstruction orHigh Court. The Amendment Act aimed at reducingthe entire process which was taking several years inwinding up of the companies to about two years. Theamendment Act is yet to come into force. In the meantime, consequent to the Enron debacle, which hadshaken the whole world and brought the corporategovernance in sharp focus, the Surbans Oxley Act wasenacted, providing for stringent corporate governancerequirements. Accordingly, as part of the process ofattuning governance norms with global standards, thegovernment constituted a Committee on CorporateAudit and Governance (The Naresh ChandraCommittee).

Based on the recommendations of Naresh ChandraCommittee, joint parliamentary Committee on StockMarket Scam and R D Joshi Committee on remainingprovisions of the Companies Bill, 1997, the Government

introduced the Companies (Amendment) Bill, 2003 inthe Parliament on 7.5.2003.

Recently the Government has initiated a freshexercise for bringing a new Company Law on the basisof a broad based consultative process by releasing aConcept Paper for public debate. To put the variousproposals contained in the Concept Paper and thesuggestions received thereon to a merited evaluation,to address the changes taking place in the national andinternational scenario and to enable timely adoption ofinternationally accepted best practices, the Ministry ofCompany Affairs constituted an Expert Committeeunder the Chairmanship of Dr. J J Irani. The Committeeworked on the underlined philosophy that in acompetitive and technology driven businessenvironment, great autonomy of operations and self-regulation must be matched with enhanced responsibilityon the part of the corporate sector. The Committeehas submitted it’s Report to the Ministry of CompanyAffairs on 31.5.2005.

Governance Norms for Capital Market

Today, the legislative framework dealing withsecurities markets comprises of Securities Contracts(Regulation) Act, 1956, Depositories Act, 1996 andvarious regulations and guidelines issued by Securitiesand Exchange Board of India (SEBI) under the SEBI Act,1992 including listing agreement of the StockExchanges. The government and the SEBI as capitalmarket regulator has taken various steps towardsstrengthening governance mechanism in capital market.The government amended the Securities ContractRegulation Act and Depositories Act to provide fordemutualisation and corporatisation of stock exchanges,delisting of securities, permission to brokers of oneexchange to trade with that of another so as toconsolidate the market of the small exchanges andstrengthen the penal framework for violation of securitieslaw. Similarly, SEBI Act was also amended empoweringSEBI to check cases of insider trading, fraudulent andunfair trade practices and market manipulation in orderto protect the investors and to levy stringent penalties.To ensure that all constituents of governance process,the private sector and civil society participate in theevolution of governance norms, SEBI established aconsultative mechanism by placing reports of theCommittee and draft regulations on its website for publiccomments and views.

In order to strengthen the Corporate Governanceof listed companies SEBI constituted a Committee onCorporate Governance under the Chairmanship of Kumar



Mangalam Birla. Based on the recommendations of theCommittee, the SEBI had specified CorporateGovernance norms for listed companies and introduceda new clause 49 in the Listing agreement of the StockExchanges in the year 2000. Later, as part of constantefforts to benchmark the standards of corporategovernance SEBI constituted another Committee onCorporate Governance under the Chairmanship of ShriN. R. Narayana Murthy. The Committee in its Reportobserved that “the effectiveness of a system ofCorporate Governance cannot be legislated by law, norcan any system of Corporate Governance be static. In adynamic environment, system of Corporate Governanceneeds to be continually evolved.” Based on therecommendations of the Committee, SEBI revisedclause 49 of the Listing agreement in August 26, 2003,the implementation of which was deferred later. TheSecurities and Exchange Board of India on October 29,2004 again revised the Clause 49 of the ListingAgreement, w.e.f. March 31, 2005. However, SEBIextended the date for ensuring compliance with therevised clause 49 of the listing agreement to December31, 2005, keeping in view the fact that large number ofcompanies were not in the state of preparedness tocomply with revised governance norms.

Governance Norms for Management of ForeignExchange

Exchange control regime was introduced in Indiaimmediately after the outburst of the Second World War.Control was administered under the emergency powersderived from Defence of India Rules, which were laterplaced on a statutory pedestal through enactment ofthe Foreign Exchange Regulation Act, 1947. The ForeignExchange Regulation Act, 1973 (FERA) was subsequentlyenacted to consolidate and amend the law in severalrespects, encompassing the experience gained over twodecades of implementation of control through the earlierenactment of 1947, and considering the report of theStudy Group on the question of leakage of foreignexchange through invoice manipulation and the LawCommission report on the Trial and Punishment of Socialand Economic offences.

Experience gained over the years in theadministration of the Foreign Exchange Regulation Act,1973 had shown that certain provisions, meant to dealwith emergencies of different kinds, are no longerrelevant and are required to be removed for improvingthe climate for foreign investment in India. Hence, theForeign Exchange Regulation Act, 1973 was reviewedin 1993 and several amendments were enacted as partof the on-going process of economic liberalisation

relating to foreign investment and foreign trade for closerinteraction with the world economy.

However, in view of the significant developmentsthat had taken place since 1993 such as substantialincrease in foreign exchange reserves, growth in foreigntrade, rationalisation of tariffs, liberalisation of Indianinvestments abroad, increased access to externalcommercial borrowings by Indian corporates andparticipation of foreign institutional investors in stockmarkets in India, a Bill to repeal and replace the ForeignExchange Regulation Act, 1973 was introduced in LokSabha on 4th August, 1998. The said Bill was referredto the Standing Committee on Finance, which submittedits report to the Parliament on 23rd December, 1998with certain modifications and suggestions. Afterincorporating certain modifications and suggestions ofthe Standing Committee on Finance, the CentralGovernment introduced the Foreign ExchangeManagement Bill 1999 in the Parliament to repeal theForeign Exchange Regulation Act, 1973. TheGovernment notified the Foreign Exchange ManagementAct (FEMA) w.e.f. June 1, 2000 putting to end the eraof control and ushering in the era of foreign exchangemanagement. Thus the governance norms for foreignexchange and currency have been designed to meetthe requirements of globalisation process initiated bythe Government in the year 1991.

It may be said that the present law is an attempt tomove from control regime to flexible managementapproach and regulation by the guidelines issued by theRBI and the Central Government from time to time.

Governance through Enhanced Competition

Governance in market framework dealing withcompetition in India spread over various legislations,besides the Monopolies and Restrictive Trade PracticesAct, 1969 (MRTP Act) which is the principal legislationdealing with Monopolistic and Unfair Trade Practicessince 1969. Other legislations include ConsumerProtection Act, 1986, Prevention of Food AdulterationAct, 1954, Standards of Weights & Measures Act, 1976,Packaged Commodities Rules, 1977, Patents Act, 1970,the Customs Tariff (Amendment) Act, 1995 and SEBI(Substantial Acquisition of Shares and Takeover)Regulations, 1997.

With the growing complexity of industrial structureand the need for achieving economies of scale forensuring higher productivity and competitive advantagein the international market, and a shift in the thrust ofthe industrial policy to control and regulate themonopolistic, restrictive and unfair trade practices rather



than making it necessary for certain undertakings toobtain prior approval of the Central Government forexpansion, establishment of new undertakings, merger,amalgamation, take over and appointment of directors,the MRTP Act was amended in 1991.

However, the governance norms contained in MRTPAct were found to be outdated in terms of Governmentpolicies and international developments, therefore thegovernment constituted a Committee to examine theprovisions of the MRTP Act, in the light of internationaleconomic development relating to competition law tosuit Indian conditions and to propose a moderncompetition law suitable to the needs of the country.The Committee in its report recommended the repealof MRTP Act and enactment of new Indian CompetitionLaw and establishment of Competition Commission ofIndia to implement the new Act and to take up theMonopolistic and Restrictive Trade Practices casespending before the MRTP Commission. Committee alsorecommended the abolition of MRTP Commission andsuggested transfer of cases of Unfair Trade Practices tothe concerned consumer Courts. Thus, based on therecommendations of the Committee, the Governmentintroduced in the Parliament the Competition Billcontaining new governance norms for fair competition.The major provisions of the Bill include :

— to ensure fair competition in India by prohibitingtrade practices which cause appreciable adverseeffect on competition in markets within India;

— establishment of a quasi-judicial body to becalled the Competition Commission of India(CCI) to undertake competition advocacy forcreating awareness and imparting training oncompetition issues;

— to curb negative aspects of competition;

— investigation by the Director-General for theCommission;

— to empower CCI to levy penalty forcontravention of its orders, failure to complywith its directions, making of false statementsor omission to furnish material information, etc.

— to create a fund to be called the CompetitionFund;

— repeal the Monopolies and Restrictive TradePractices Act, 1969 and the dissolution of theMonopolies and Restrictive Trade PracticesCommission.

The Competition Act, 2002 has since been passedby the Parliament to provide, keeping in view of the

economic development of the country, for theestablishment of a Commission to prevent practiceshaving adverse effect on competition, to promote andsustain competition in markets, to protect the interestsof consumers and to ensure freedom of trade carriedon by other participants in markets, in India.

ERNST & YOUNG CORPORATE GOVERNANCEWEB SURVEY (2005)

The Ernst & Yong Corporate Governance Web Surveyconducted in May and June, 2005 indicates that thecorporate governance, while already a critical issuefacing large corporations, is becoming more importantas companies operate in an increasing complexregulatory environment. The summary of the findingsof the survey is given below :

1. Differing Perspectives of the CEO/CFO andthe Board

— The survey suggests a clear demarcation in theviews of management including CEOs/ CFOsand the Board. In most cases, managementswere found less positive than Board ongovernance issues.

— CEOs and CFOs and other management peoplewere found to be generally less positive thanboard members about the capacity of theirorganisation to address corporate governanceissues and the extent to which clear businesspolicies exist.

— Board members see a greater role forthemselves in debating company strategy ratherthan setting the broad strategic objectives. Incontrast, CEOs and CFOs believe that theprimary role of the Board is in setting strategyand reviewing management performance.

— Management was found more skeptical thanthe Board about Board effectiveness. 43% ofmanagement (vs 27% Board members) do notbelieve that the Board is especially effective atproviding an independent overview andassessment of management performance. Inaddition, 40% of management (vs. 29% Board)do not believe that the Board is effective inensuring that the principles of corporategovernance are being implemented.

2. Communication and Support of GoodCorporate Governance

— There is room for improvement incommunicating the principles of corporate



governance. Only a third of managementbelieves that these are widely disseminatedthroughout their organisation. Similarly, 59%of investors indicate that they are not wellinformed about the policies of the companiesin which they invest.

— The governance is not yet central to the dailyoperation of companies; only 35% of boardmembers and 36% of management stronglyagree that the culture of their organisation issupportive of good corporate governance.

3. Audit Committee and Internal AuditFunction

— While the majority of respondents report thattheir company has a Board audit committee(80%), in most cases, there are less than fivemembers. The survey highlighted that thegreater the revenue, the higher the percentageof respondents who have an audit committeeof board members.

— The difference in management and boardmember points of view applies to perceptionsof how effective the Audit Committee is inproviding oversight of independent financialreporting. While 62% of board membersstrongly agree that the audit committee providesan appropriate level of oversight, only 23% ofsenior management (CEO/CFO) stronglyagree. 37% of CEO/CFOs rate the auditcommittee as adequate or less than adequatein its central responsibility.

— Over two thirds of respondents were fromorganisations that have an internal audit function.Interestingly, more than 50% saw this functionas reporting to the Audit Committee - indeedalmost 60% saw this as Board responsibility ifthe “reporting to the Board” responses areadded. In a further 20% of companies, theinternal audit function reported to the CFO.

— Nearly half of each group (Board members 44%and CEO/ CFO/other management 47%) feelthat a balance exists between risk managementand management for growth within theircompany.

4. Risk Management Policy & Responsibility

— While Board members are generally morepositive about governance and risk issues in theirorganisations, they are slightly less

knowledgeable about the policies in place,perhaps reflecting their distance from concreteimplementation. CEOs and CFOs are morelikely than Board members to say that thecompany has a clear policy in place to identifyand to assess risk.

— Board members see the CEO as the person withprimary risk management responsibility and maysee this as an aspect of the leadership role thatcannot be delegated.

— The CFO is most likely to be seen as the“owner” of risk management in the US (40%US vs. 24% UK), whereas it is more likely tobe the CEO in the UK (39% UK vs. 12% US).

— Overall, fewer respondents see the Chief RiskOfficer as the primary owner of risk within thecompany; the highest percentage, (32%) beingother management, the group most likely totake on the role.

— Only a very small number of respondents sawrisk management as primarily the responsibilityof the Board.

5. Risk Management Committee

— Most companies (72%) have not established aseparate Risk Management Committee. A third(32%) of UK companies, in comparison with14% of US companies have a risk managementcommittee.

6. Shareholder / Investor Opinions

— Most shareholders report that they have limitedinformation about corporate governancepolicies. Even when prompted, investors didn’treport a high level awareness of any of theprinciples of good corporate governance.

BENCHMARKING GOVERNANCE NORMS BYCOMPANIES

As mentioned in preceding paragraphs andhighlighted in the corporate governance web survey itbecomes clear that the term governance is different fordifferent people. It indeed is a way of thinking,philosophy and attitude. It encompasses thephilosophies and processes in an organisation that enableits people to weigh competing objectives, challenges,and opportunities and consistently find the appropriatebalance and direction. Thus, companies intent onimproving governance need to start by enhancingprocesses, and changing attitude. Governance is really



about creating trust which cannot be legislated. It hasto come through principles based approach. Companiesmust have fundamental internal controls and processesin place to implement the principles and concepts andto ensure that they are followed consistently. Finally, itshould be understood that corporate governance is allabout people. The best intentions and the most carefullydesigned processes will serve no purpose unless peopleat all levels have the intelligence, skills and, the strengthof character to make the right and sometimes difficultdecisions. Berry F. Kroeger in his article “StrengtheningCorporate Governance” has suggested some areas offocus for boards and management to consider as theyassess their governance norms and practices.

1. The Board

— In addition to reexamining its fundamentalcharter in the light of the current environment,the board should take a fresh look at committeestructures, mandates, membership, and howcommittees are communicating about issuesof mutual interest.

— Most Boards understand that the so called Tonefrom the top, must emanate from Boardroomas well as from the top management. TheBoard members need to seriously consider howits role is defined and the optimum balance ofpower between the Board and management.

— Meaningful continuing education for the boardmembers is essential, so that they possess theadequate knowledge to probe and ask thenecessary questions to adequately dischargetheir responsibilities.

2. Audit committees

— Audit committees should examine in greaterdetail the nature and extent of both internaland external audit and the interaction betweenthe two. The audit Committee should ensurethat it understands the basis for management’sconclusion about the quality of internal audit,including management’s priorities. It shouldalso explore how audit scopes are sharedbetween the two and whether there is goodcommunication and knowledge sharingbetween them.

— In respect of quality of external audit, the AuditCommittee should understand the judgementsmade in setting audit scopes and in evaluatingthe results of audit procedures.

3. Management

— Companies must find a way to properly balancethe need to address the competitive forces withthe need to consistently do the right thing. TheCEO should play a critical role in achieving andmaintaining this balance.

— As the business is becoming more competitivethan ever before, this is a time to address issuessuch as:

(a) How open and candid is communicationthroughout the company both verticallyand horizontally ?

(b) How are different points of view resolved?

(c) How does the company deal with failureof initiatives or missed financial oroperating results ?

(d) Do incentives reward all of the rightbehaviors of employees ? and

(e) Are the messages from the top - bothformal and informal- appropriatelybalanced?

— The management together with the Boardshould reevaluate the completeness andappropriateness of their governance policies andpractices. In this direction, the companiesshould address whether necessary mechanismsare in place to provide employees at all levelswith access to senior management

— Companies should evaluate systems andpractices, especially those with implications tofinancial reporting and governance issues.

— In the light of sharp focus on expanded financialdisclosure requirements, it is important forcompanies to identify and challenge who isresponsible for determining asset valuations andother critical estimates;the quality of underlinedata; and the process for reviewing the initialdeterminations

The defining difference between companies withgreat governance and others is not whether they addressgovernance-related issues but the depth and rigor withwhich they do so and their willingness to make the toughdecisions. Like strategy, success of a company inbenchmarking governance norms, lies in its willingnessand effective execution.



CONCLUSION

Clearly, Governance has occupied the Centre-stagein today’s efforts to improve the quality of life, efficiencyof an organisation, and ensuring the best value formoney. To govern is to rule or control with authorityand conduct the policy and affairs of an organisation.The process involves influencing and determining thecourse of action.

The issue of improving governance in the countryhas to be addressed at multiple levels. The relevanceand the operations of institutions concerning the social,economic and political processes towards the goals ofdevelopment will have to be re-examined, particularlyin view of the current context, which, in many cases, isvastly different from the context that may have led totheir creation.

Elimination of unnecessary procedural controls andregulations that stifle entrepreneurial energy, breedcorruption and affect the common man has to be apriority area of improving governance. Rationalisationof rules, notifying them in a comprehensive andtransparent manner, assigning accountability of eachfunctionary and providing administrative and legalrecourse in case of malafide dilatoriness are necessaryto address the problem of crisis of Governance. Theseare issues in governance that have to be addressed on apriority as they impinge on the success of economicreforms.

Despite the diversity of corporate governancesystem, the globalization of markets is producing adegree of convergence in actual operations andgovernance practices. The global market pressures areproviding the impetus for private sector to harmonizecorporate governance practice – to reduce risks toinvestors and hold down the cost of capital tocorporations. It is well recognised that the Corporategovernance cannot be regulated as its fundamentalobjective is not mere fulfillment of the requirements oflaw but in ensuring commitment of the board inmanaging the company in transparent manner formaximising long-term shareholder value. It is aboutestablishing a climate of trust and confidence.

Benchmarking governance norms is fundamentallya political, social and economic process in whichgovernment, the private sector and civil society have tojoin hands. Like democratic governments, business mustbe governed by a set of rules that reflect the interestsof their shareholders and the public at large. Theserules of the game for businesses are an importantdimension of reform efforts in developed and transition

economies alike. Countries that ignore or lag behind inimproving corporate governance norms will rapidly findthemselves at a competitive disadvantage in attractinglong-term capital for development. Therefore, there isan imperative need to undertake efforts to push forstronger governance institutions. Public education effortsare needed to promote better understanding of essentialgovernance principles and their relationships todemocratic development; and Companies need toundertake voluntary reforms by developing codes ofconduct and best practices guidelines as suggested inthe preceding paragraphs.

As the globalisation takes place and CorporateGovernance becomes increasingly important indetermining the perception of international investor,managerial structures and credibility of business, thereis need for corporates in India to heed this tide ofchange. They must proactively design their culturespecific codes and effectively implement, instead sit andwait for rules to be imposed from the Government andregulatory agencies.

REFERENCES

1. Report of Sir Adrian Cadbury Committee onFinancial Aspects of Corporate Governance(1992)

2. Report on Blue Ribbon Committee onImproving the Effectiveness of Corporate AuditCommittees (1999)

3. CACG Principles for Corporate Governance inCommon Wealth (1999)

4. CII Code – Desirable Corporate Governance(1998)

5. Kumar Mangalam Birla Committee onCorporate Governance (2000)

6. Corporate Governance: A Framework forImplementation – Overview (1999, World BankGroup).

7. Corporate Governance in CommonwealthAuthorities and Companies – Principles & BetterPractices (Discussion paper) (1999, AustralianNational Audit Office).

8. S L Rao, Competition, Ethics and Governance,Economic & Political Weekly, pp. 3015 to 19(August 19, 2000).

9. B N Vittal, Bureaucracy, Media and Corruption,(Talk delivered in the B D Goenka AwardsFunction on November 9, 2000).

10. Report on the Human Development in South



Asia, published by the Mahbub-ul-Haq HumanDevelopment Centre, 1999.

11. Corporate Vision – 21st Century,Commemorative Lecture Delivered by Mr.Justice M N Venkatachaliah, (Formerly, ChiefJustice of India and Chairperson, NationalHuman Rights Commission) at New Delhi onGolden Jubilee Celebrations of India’sIndependence, organised by the Institute ofCompany Secretaries of India, onAugust 5,1998.

12. Dr. P L Sanjeev Reddy, Corporate GovernanceEmerging Trends (2000).

13. Ernst & Young Corporate Governance WebSurvey, 2005.

14. Barry F. Kroeger, Strengthening CorporateGovernance. (ey.com). This article alsoappeared in the winter 2002-2003 issue ofCross Currents, Ernst & Young's financial servicesmagazine.

15. Report of Naresh Chandra Committee onCorporate Audit and Governance.

16. Report of Dr. J J Irani Committee on NewCompany Law (2005).


Securities Laws and Capital Market — Global Benchmarking 59

SESESESESECURITIES LACURITIES LACURITIES LACURITIES LACURITIES LAWS AND CWS AND CWS AND CWS AND CWS AND CAPITAPITAPITAPITAPITAL MARKET —AL MARKET —AL MARKET —AL MARKET —AL MARKET —GLOBAL BENCHMARKINGGLOBAL BENCHMARKINGGLOBAL BENCHMARKINGGLOBAL BENCHMARKINGGLOBAL BENCHMARKING

SONIA BAIJAL*

INTRODUCTION

The sensex crossed the 8000 mark achieving historichigh and growing. There is strong view suggesting thata vibrant securities market is a vehicle for disseminatingopportunities and mitigating economic deprivation. TheIndian securities market which has undergonerevolutionary changes over a period of time, is said tobe not only at par with global standards on manyparameters, in some, it is ahead of the global standards.So when one benchmark with best in the world, whatcould be the future road map? This indeed is a complextask particularly when the future looks non linear,discontinuous and unpredictable. Therefore, the future,road map for benchmarking rest in the innovation,creativity and capability to deal with future.

This article is an attempt to discuss the operational,systemic and regulatory developments in capital marketin India. The article beginning with the structure andspread of capital market discuss in detail the continuousefforts being made by SEBI – the capital marketregulator– towards further refining the governancesystem and suggested areas for further benchmarking.

CAPITAL MARKET STRUCTURE AND SPREAD

Capital market performs four functions namely,making available variety of opportunities to investors topark their disposable wealth; formation of capital bothrisk capital and debt capital; allocation of capital; andcorporate governance. The performance of capitalmarket and SEBI on these four counts has beenexemplary, as it has achieved several milestones inmaking Indian capital market comparable to itscounterparts in developed and emerging economies.

As per independent estimates by the Society forCapital Market Research & Development and SEBI-NCAER Survey, the population of shareowning individualsin India is around 2 crore. SEBI’s registered market

59

* Assistant Director, The ICSI. The views expressed are personal views of the author and do not necessarily reflect those of theInstitute.

intermediaries include 2 National level exchanges(Bombay Stock Exchange – BSE and National StockExchange – NSE) and 21 regional exchanges with fullyelectronic trading platforms. A 9359 companies wereavailable for trading on stock exchanges at the end ofMarch, 2004. The trading platform of the stockexchanges was accessible to 9368 brokers, 1829derivative brokers and 12815 sub brokers from over 400cities in the same period. The number of foreigninstitutional investor is 540, custodians 11, depositories2, depository participants 431, Merchant Brokers 123,Bankers to an issue 55, Underwriters 47, DebentureTrustee 34, Credit Rating Agencies 4, Venture CapitalFunds 45, Foreign Venture Capital Investors 9, Registrarto an Issue and Share Transfer Agents 78, PortfolioManagers 60 and Mutual Funds 37. The Mutual Fundswith 396 schemes manages an asset base of nearly 22US Billion dollars. During 2005-06 (April-August), thenet resource mobilization by mutual funds was higherat Rs. 35,087 crore as compared to Rs, 12,014 croreduring 2004 - 05 (April - August) - an increase ofRs. 23,073 crore. At the end of August 31, 2005, thenet assets under management by mutual funds wereRs. 1,95,784 crore as compared to Rs. 1,55,686 crorein August 2004, an increase of 25.8%.

In terms of regulatory framework, there are strictdisclosure and accounting norms for the listed companiesand facility of book building in public offerings througha transparent price discovery mechanism is available tothe issuers.

SEBI’S STRATEGIC ACTION PLAN

SEBI from its very inception has been continuouslyendeavouring to make the Indian Capital Marketeffective, transparent and investor friendly. In thisdirection, SEBI has undertaken several initiatives of far-reaching consequences, which have not only radicallyreformed but totally transformed Indian Capital Market.



In fact SEBI’s approach to the regulation has beendevelopmental in nature with a long-term perspectiveon sustaining confidence of the stakeholders in themarket. SEBI is persistently striving to ensure thatobjectivity and pragmatism is maintained in all itsdecisions and accordingly, the regulatory process is madeextremely transparent, interactive and consultative vis-a-vis the stakeholders.

The SEBI has chalked out a vision of becoming the“Most Dynamic and Respected Regulator-Globally” and in order to realise the vision, SEBI hasdrawn a Comprehensive Strategic Action Plan aiming atinvestors, corporates, markets and regulatory regime.

Operationalisation of Strategic Action Plan

SEBI has taken following initiatives to operationalisethe strategic Action Plan :

1. Investors

(i) Electronic Data Filing and Retrieval System(EDIFAR), an automated web based system forfiling, retrieval and dissemination of informationpertaining to corporates have been madeoperational.

(ii) In the case of debt oriented and balanced fundsbenchmarking has been made compulsory forproviding objective analysis of the performanceof the mutual fund schemes.

(iii) A Code of conduct and Guidelines for RiskManagement System for the valuation ofunlisted equity shares and due diligence havebeen issued.

(iv) Nomination facility for the unit holders has beenintroduced and Mutual Funds have beenadvised to follow a uniform method to calculatethe sale and repurchase price to avoid confusionin the minds of the investors.

(v) Rebating and discounting by the Mutual Fundshas been prohibited for ensuring that allinvestors get fair treatment.

2. Markets And Intermediaries

(i) The exchanges have been directed to followcompulsorily rolling settlement for all listedsecurities.

(ii) Inter – depository transfer through on-lineconnectivity was established between CDSL andNSDL.

(iii) Straight Through Processing (STP) on thesecurities market has been made operational.

(iv) Exchanges have been directed to establish acomprehensive surveillance mechanism fortracking the derivative markets.

(v) Disclosure of the fair value of the ESOPs (i.e.using Black Scholes or similar models), theimpact on profits and on EPS of the company,had the company expensed the ESOPs on fairvalue basis and also lock in requirements subjectto certain disclosures in the offer documents incase company is going for IPO after the grantof options, have been made mandatory.

(vi) Half yearly audited consolidated results andquarterly audit review.

(vii) Credit Rating Agencies have been asked todevelop models for rating corporate governanceon the principles of wealth creation, wealthmanagement and wealth sharing.

(viii) A code of conduct has been specified for listedentities for regulated firms under the InsiderTrading Regulations.

Strengthening Regulatory Regime

The Strategic Action Plan aims to achieve anappropriate, proportionate and effective regulatoryregime to ensure the confidence of all the stakeholders.In this direction, the SEBI Act, 1992 was amended inempowering SEBI to check cases of insider trading,fraudulent and unfair trading practices in securitiesmarkets and market manipulation in order to protectthe investors and to levy deterrent penalties againstcorporates and individuals in such matters. The SEBIBoard was enlarged with the provision of three full timeBoard members. The Securities Appellate Tribunal wasconverted into a three-member body with a sitting orretired judge of Supreme Court or a sitting or retiredChief Justice of High Court as the presiding officer.All the orders passed by the Securities AppellateTribunal and Chairman, SEBI are being posted on theSEBI website, as an effort to enhance regulatorytransparency.

Also, with a view to ensure that participation ofregulates as also the nation at large in the process ofdesigning the regulation will improve the efficacy ofregulations, SEBI established a consultative mechanismby placing reports of committees and draft regulationson the SEBI website and seeking comments, suggestionsand opinions. Besides the involvement of the regulateein this process, the consultative mechanism has alsoensured that the regulatee are aware of the changes inthe regulatory framework in advance.



As a measure of proactive regulatory approach SEBIhas been enacting new regulations and regulatoryamendments in the existing areas. SEBI has enactedfollowing new regulations and guidelines and amendedthe existing ones in the year 2004-05.

(i) SEBI (Substantial Acquisition of Shares andTakeovers) Regulations 1997 last amended onDecember 30, 2004

(ii) SEBI (Portfolio Managers) Regulations, 1993 lastamended on May 27, 2004

(iii) SEBI (Procedure for Holding Enquiry by EnquiryOfficer and Imposing Penalty) Regulations,2002 last amended on June 6, 2005

(iv) SEBI (Foreign Institutional Investors)Regulations, 1995 last amended on February19, 2004

(v) SEBI (Mutual Fund) Regulations, 1996 lastamended on January 12, 2004

(vi) SEBI (Depositories and Participants) Regulations,2004 last amended on June 10, 2004.

(vii) SEBI(Self Regulatory Organisations) Regulations,2004 (notified on February 19, 2004)

(viii) SEBI (Criteria for Fit and Proper Person)Regulations, 2004 (notified on March 10, 2004)

(ix) SEBI (Interest Liability Regularisation) Scheme.2004 (notified on July 15, 2004)

(x) Notification under sub Regulation (1) ofRegulation 6 of SEBI (Central Database ofMarket Participants) Regulations, 2003 (issuedon March 31, 2005)

(xi) SEBI (Venture Capital Funds) Regulations, 1996last amended on April 5, 2004

(xii) SEBI (Foreign Venture Capital Investors)Regulations, 2000 last amended on April 5,2004)

(xiii) SEBI (Buy back of Securities) Regulations lastamended on June 18, 2004

(xiv) SEBI (Informal Guidance) Scheme, 2003 lastamended on January 21, 2004

(xv) SEBI (Employee Stock Option Scheme andEmployee Stock Purchase Scheme) Guidelines,1999, last amended on July 22, 2004

(xvi) SEBI (Disclousre & Investor Protection)Guidelines, 2000, last amended onSeptember 19, 2005.

DEVELOPMENTS IN SECURITIES LAWS

I. Securities Laws (Amendment) Act, 2004

The Securities Laws (Amendment) Act, 2004 wasenacted to insert/ amend provisions in the SCRA andthe Depositories Act to enable demutualization andcorporatisation of the stock exchanges, fill up certainidentified regulatory gaps such as units of MFs, delistingof securities, clearing corporation, for which there wereno statutory provisions, allow a broker of one exchangeto trade with that of another so as to consolidate themarket of the small exchanges, and strengthen the penalframework for violation of securities laws.

Demutualisation of Exchanges

The Act makes it mandatory for all stock exchanges,if not corporatised and demutualised, to be corporatisedand demutualised on and from the appointed date asnotified in the official gazette by SEBI. The stockexchanges may submit within prescribed time, a schemefor corporatisation and demutualization to SEBI for itsapproval.

Definition of Securities

The Act expanded the definition of ‘securities’ toinclude units or any other such instrument issued to theinvestors under any Mutual Fund Scheme.

Delisting of Securities

The Act, incorporates a new provision to allowdelisting of securities. A stock exchange may delistsecurities, after recording reasons, on any of the groundsas may be prescribed in the rules, after giving thecompany concerned an opportunity of hearing. A listedcompany or an aggrieved investor can file an appealbefore SAT against the decision of the exchange to delistthe securities.

Clearing Corporation

The Act inserted a new section in the SCRA toprovide that an exchange may, with the approval of SEBI,transfer the duties and functions of a clearing house toa clearing corporation for the purpose of periodicalsettlement of contracts and differences thereunder, anddelivery of and payment for securities. The variousprovisions in the SCRA such as grant and withdrawal ofrecognition, supersession of management, suspensionof business etc. applicable to stock exchanges have beenmade applicable to clearing corporations mutatismutandis.



Scheme of Penalty

The amendment makes all the offences listed insection 23 of the SCRA cognizable. It provided thatthese offences and all offences listed in section 23M(1)of the SCRA and section 20 (1) of the Depositories Act,on conviction, shall attract punishment in terms ofimprisonment and/or fine, without prejudice to anyaward of penalty by the adjudicating officer.

The Amendment Act empowers SEBI to appointadjudicating officers to adjudicate a wide range ofoffences, as listed under sections 23A to 23H in theSCRA and 19A to 19G in the Depositories Act andimpose monetary penalties for such offences.

The Act provides that all sums realised by way ofpenalties imposed by the adjudicating officers wouldbe credited to the Consolidated Fund of India. It furtherprovides that non-payment of penalty imposed by anadjudicating officer or non-compliance with any of hisorders or directions would be an offence punishablewith imprisonment for a term between one month andten years, or with fine up to Rs. 25 crore or with both.

Powers of SEBI

The Act has inserted a new section 12A in the SCRAto empower SEBI to issue appropriate directions in theinterest of investors and the securities market to anystock exchange, clearing corporation and such otherperson or agency providing trading, clearing orsettlement facility in respect of securities or to anycompany whose securities are listed or proposed to belisted in a stock exchange.

REPORT OF THE EXPERT GROUP FORSUGGESTING AMENDMENTS TO SECURITIESAND EXCHANGE BOARD OF INDIA ACT, 1992

SEBI constituted an Expert Group headed by JusticeM H Kania, Former Chief Justice of India on August2004 to identify the deficiencies/inconsistencies in theexisting provisions of the SEBI Act and also to suggestnew provisions that can be incorporated in the SEBI Actto make it more effective and investor friendly, takinginto account recommendations of the Joint ParliamentaryCommittee (2002) as also recommendations of otherexpert groups constituted by SEBI from time to time inthis regard.

The Group after deliberating on the proposals maderegarding amendments to SEBI Act in the light ofcomments thereon received from the stakeholderssubmitted its report in June 2005 recommendingincorporation of new provisions in the SEBI Act;

amendments for changes in the existing provisions; andconsequential and related amendments in other Acts.The major recommendations of the Group aresummarized below :

1. Recommendations for incorporating newprovisions in the SEBI Act

(i) Investor Protection Fund

The Group recommended that a separateInvestor Protection Fund under the SEBI Act,on the lines of Subscriber Education andProtection Fund under Pension Fund Regulatoryand Development Authority (PFRDA) Ordinance2004 may be established for the purpose ofinvestor education and awareness and forcompensation to the small investors in respectof fraud or mispresentations or misstatementsby companies or intermediaries. The Groupfurther recommended that the said fund beadministered by SEBI to protect the investorsand take measures for investor education andawareness and for compensation to the smallinvestors in accordance with the establishedguidelines or parameters specified by SEBI onthe lines of the guidelines in respect of stockexchanges. As to the composition of Fund,the Group recommended that there shall becredited to the said fund the following amountsnamely:

(a) Unclaimed dividend or interest under anymutual fund or Collective InvestmentScheme (CIS) or venture capital andscheme for more than 7 years.

(b) Any unclaimed money or securities of aclient lying with an intermediary insecurities market for more than 7 years;

(c) Monies lying unutilized in the InvestorProtection Funds of the stock exchanges.

(d) All sums realized by way of monetarypenalty under Chapter VIA of SEBI Act.

(ii) Nomination Facility

The Group recommended for a suitableamendment in the SEBI Act for incorporationof a provision to provide nomination facility tothe unit holders of Mutual Funds and CollectiveInvestment Schemes.

(iii) Winding up of intermediaries

The Group recommended that suitable provisionin the SEBI Act may be made to enable SEBI to



file winding up petition in respect of theintermediary companies on the lines ofSection 45MC of the Reserve Bank of IndiaAct and Section 43A of the Banking RegulationAct.

(iv) Non attachment of assets of clients withintermediaries

The Group recommended that there should bea specific provision in the SEBI Act to the effectthat the monies or securities of the clientsshould be held in the form of a trust byintermediaries and no authority shall attach orseize such assets of investors which are inpossession of the intermediary.

2. Recommendations for amendment in theexisting provisions of the SEBI Act

(i) Registration and Regulation of AssetManagement Company, Research Analyst,Clearing Corporation, STP Provider etc.

The Group recommended that the SEBI Act maybe amended to include Asset ManagementCompany, stock lender and STP Service Providerin section 12 of SEBI Act. Section 12 of SEBIAct deals with the registration of stock brokers,sub-brokers, share transfer agents etc.

(ii) Monetary Penalty for false information

The Group recommended that SEBI Act, maybe amended so as to empower SEBI to initiateadjudication proceedings for furnishing falseinformation knowingly.

(iii) Power to share information with overseasregulators

The Group recommended that Section 11(2)(1a)may be amended to authorize SEBI to shareinformation on reciprocal basis with overseasregulators on the lines of Sections 169 and 354of the Financial Services and Markets Act, 2000of UK.

(iv) Inspection and Investigation

The group recommended that sections 11(2A),11C(9) and 11D be amended to bring them inharmony with Section 12A of the SEBI Act.

(v) Attachment of Bank accounts ofintermediaries

The group recommended that Section 11(4) ofSEBI Act may be amended so as to increasethe period of attachment from one month tothree months subject to further extension by

another three months upon the order of aJudicial Magistrate of First Class in writing.

(vi) Maximum Penalty

The group recommended that in Sections 15Ato 15H of SEBI Act, the words “one lac rupeesfor each day during which such failure continuesor one crore rupees, whichever is less” maybe replaced by the words “not exceeding onelac rupees for each day during which such failurecontinues subject to a maximum of one crorerupees”, for the sake of clarity.

(vii) Failure to comply with the order of SEBI

The group recommended that Section 15HBof SEBI Act, may be amended to provide formonetary penalty for the failure to comply withthe orders of SEBI and to amend Section 24(2)to make non-compliance of SEBI order anoffence under the provisions of the said section.

(viii) Monetary Penalty to be transferred to InvestorProtection Fund

The group recommended that the SEBI Act maybe amended on the lines of PFRDA Ordinanceso that all the penalty amounts realized underChapter VIA of the SEBI Act, are utilized forinvestors protection and education. The Groupfurther recommended that suitableamendments in Section 15JA of the SEBI Actshould also be made.

(ix) Composition of Securities Appellate Tribunal

The group recommended that an amendmentin the SEBI Act be made so as to empower thePresiding Officer to constitute benchesconsisting of one or two members for hearingany appeal or interim application. It has alsobeen provided that atleast one of the memberof such bench is a judicial member.

(x) Filing of complaint by SEBI-Deemed PublicProsecutor for prosecution

The group recommended that a suitableamendment in section 26 of the SEBI Act, maybe made to provide that the person conductingprosecution on behalf of SEBI, under SEBI Actbefore the Sessions Court shall be deemed tobe a public prosecutor.

(xi) Office of Single Enquiry and AdjudicatingAuthority

The group recommended that SEBI Act maybe amended to provide that an Enquiry andAdjudicating Officer appointed by the



Chairman/Whole-time Member may decidethe matter of imposition of any type of penaltynamely, suspension or cancellation ofcertificates of registration to be imposed by SEBIor monetary penalty under SEBI Act and Rules/Regulations made thereunder.

The Group further recommended for theAmendment of SEBI Act to provide forconstitution of a three member standingcommittee to review all the orders passed bythe Enquiry and Adjudicating Officers.

3. Recommendations for consequential andrelated amendments in other Acts

The group recommended that SEBI may in exerciseof its powers under Section 11A of the SEBI Act, specifyadditional disclosures to be made by the companies andthe power to amend Schedule II of the Companies Actmay remain with the Central Government.

II. SEBI (DISCLOSURE & INVESTORPROTECTION) GUIDELINES

SEBI had issued a compendium containingconsolidated guidelines, instructions relating to issue ofcapital effective from January 27, 2000. Thecompendium titled SEBI (Disclosure and InvestorProtection) Guidelines, 2000 replaced the originalguidelines issued in June, 1992 and clarifications thereof.It also abandoned the issue related RMB GeneralInstructions (GI) Series, circulars and other guidelinesrelating to preferential issue, advertisement, bookbuilding etc. Since the issue of consolidated guidelinesin 2000, various changes have been made in theguidelines latest amendment being issued onSeptember 19, 2005.

A. The amendments to the DIP Guidelines as notifiedin January, 2005 may be classified under the fourcategories :

(i) Order of presentation of disclosures inprospectus;

(ii) Requirements relating to abridged prospectus;

(iii) Requirements relating to issue advertisements;

(iv) Appointment of co-managers, advisors, etc.

Order of presentation of disclosures in prospectus

1. Section I dealing with contents of theprospectus of Chapter VI of the guidelines i.e.Contents of the Offer Document has beenamended. Clauses of Section I have been

rearranged in the same order in whichdisclosures should appear in the prospectus.

2. All the disclosure requirements specified underSchedule II of the Companies Act, 1956 havebeen retained either under the same headingor under new headings.

3. Few requirements / sections have been addedto make the prospectus more effective likesummary, table of contents, industry review,etc.

4. Repetitive disclosures are required to beavoided by giving cross references to the extentpossible.

5. An annexure indicating order of presentationof disclosures in the prospectus has beeninserted in the guidelines for easyunderstanding.

6. Issuers are free to make additional disclosures,so long as they are not inconsistent with theguidelines. Further, the said disclosures havebeen, to the extent possible, brought withinthe broad headings as specified in Section I ofthe guidelines i.e. ‘Contents of the OfferDocument’.

Requirements relating to abridged prospectus

In order to achieve the objective of making theabridged prospectus more readable, the guidelines haveamended Section II of Chapter VI of the guidelineswhich lays down the disclosure requirements in theabridged prospectus providing for :

1. increased readability/visual impact of thecontents of the abridged prospectus.

2. deleting the repetitive disclosures, etc.

3. sequencing of items followed shall be the sameas appearing in the prospectus.

4. supplementing the disclosures in abridgedprospectus (As per Form 2A of the CompaniesAct, 1956) by such information as is consideredmost relevant for the prospective retail investors.

Requirements relating to issue advertisements

In view of the high cost involved in publishing theabridged prospectus and also to make available theabridged prospectuses along with the application form,SEBI guidelines have been amended to provide for thefollowing:

1. Pre-issue advertisement has been mademandatory for all public issues.



2. The issue advertisements (pre-issueadvertisements, issue opening or closingadvertisements) have been required to containthe minimum details prescribed in the formatsas specified in the guidelines.

3. The issue advertisements like issue closing oropening advertisement, continue to beoptional.

4. The issuer company has an option of includingadditional disclosures in these advertisementsso long as they are not inconsistent with theguidelines and subject to the same being incompliance with the principles and code ofadvertisements laid down in Chapter IX of theguidelines.

5. Any bill Board Advertisement in regard to anissue shall not contain information other thanas stipulated in the formats specified in theguidelines.

Appointment of co-managers, advisors, etc.

The restriction on the number of co-managers andadvisors which can be appointed in an issue has beenremoved. The disclosure(s) pertaining to issue expenseshave also been enhanced.

B. Amendments to the SEBI (Disclosure and InvestorProtection) Guidelines, 2000 vide circular datedMarch 29,2005 relate mainly to the book buildingprocess. Highlights of the amendments are asunder:

Retail Individual Investors(RIIs)

The RII, till date was defined in value terms as onewho can apply for shares upto a maximum amount ofRs.50,000/-. SEBI has redefined the RII as one who canapply up to Rs.1,00,000/-.

Allocation category for retail individual investors

In a book built issue allocation to Retail IndividualInvestors,Non Institutional Investors (NIIs) and QualifiedInstitutional Buyers (QIBs) used to be in the ratio of 25:25: 50 respectively. SEBI increased the allocation to RIIsfrom the existing 25% to 35% and correspondinglyreduced the allocation to NIIs from the existing 25% to15%.

Further, in case the book built issues are madepursuant to the requirement of mandatory allocation of60% to QIBs in terms of Rule 19(2)(b) of SCRR, therespective figures are 30% for RIIs and 10% for NIIs.

Bidding period

Earlier, SEBI guidelines provided for a maximumbidding period of 10 days extendable by three moredays, if there is a revision in price band. Through theamendment, SEBI has reduced the bidding period from5 – 10 days (including holidays) to 3 -7 working days.

Timing of disclosure of Price Band/Floor Price

SEBI guidelines required all issuers (whether listedor unlisted), making a public issue through book buildingprocess to disclose the price band/ floor price in theRed Herring Prospectus (RHP)/application form. SEBIvide this amendment has given an option to listedissuers to either (a) disclose price band in RHP /application form/abridged prospectus (current practice)or (b) to disclose the price band /floor price atleast oneday before bid opening.

Data reporting at website of stock exchanges

In order to ensure dissemination of relevantinformation in public domain, SEBI guidelines have beenamended inter alia to improve the contents of and toensure uniformity in data display on the websites of theconcerned stock exchanges and to ensure availability ofdata for a further period of 3 days after the closure ofthe bids/issue.

C. The DIP Guidelines as amended in August 2005revised the provisions related to minimum publicshareholding as follows:

(1) All listed companies are required to maintainatleast 25% shareholding with public for thepurpose of continuous listing.

(2) This is, however, not applicable to companieswhich are permitted to make an Initial PublicOffer (IPO) of atleast 10% to public in termsof Rule 19(2)(b) of Securities Contracts(Regulation) Rules, 1957 (SCRR). Suchcompanies are required to maintain atleast 10%public shareholding for the purpose ofcontinuous listing.

(3) The aforesaid minimum public shareholdingrequirement is not applicable to Governmentcompanies, infrastructure companies andcompanies registered with Board for IndustrialFinancial Restructuring (BIFR).

(4) Listed companies, which are not presentlycomplying with the minimum public holdingrequirement as mentioned above, have beengiven a period of two years, for compliance,



from the date of issuance of circular in thisregard.

(5) Listed companies which may in future fall shortof the requisite minimum level as mentionedabove on account of reasons like CorporateDebt Restructuring (CDR) packages etc. havebeen given a period of one year , forcompliance, from the date of non - compliance.

The objective is to ultimately reach a single level ofminimum public shareholding requirement for listedcompanies, in course of time. However, no time framehas been envisaged at this stage.

D. SEBI DIP guidelines have been further amendedvide circular dated September 19, 2005 issued toall Registered Merchant Bankers/ Stock Exchanges.These amendments are applicable to the publicissues through book building route, draft offerdocuments which, are filed with SEBI on or afterthe date of this circular.

Provision for specific allocation for mutual fundswithin the QIB category

Mutual funds registered with SEBI in terms of SEBI(Mutual Funds) Regulations, were not given any specificallocation within the QIB category in book-built issues.It has now been decided to provide 5% of the 50% or60% {in case of issues in terms of Rule 19(2)(b) ofSCRR} of net offer to public available for allocation toQIBs, for mutual funds.

Effectively, out of the portion available for allocationto QIBs, 5% will be available for allocation to mutualfunds. All eligible bids by mutual funds will beconsidered for allocation in the afore mentioned 5% aswell as in the balance available for QIBs. An illustrationexplaining the method of allocation to mutual funds hasalso been incorporated in the guidelines. In the eventof inadequate response from the mutual funds, theshares may be made available to QIBs other than mutualfunds.

Proportionate allotment to QIBs

Earlier, the allotment to QIBs was decided by IssuerCompany in consultation with Book Running LeadManagers (BRLMs). Now the existing provisions ofproportionate allotment as applicable for Retail individualinvestors (RIIs) and Non Institutional Investors (NIIs) havebeen extended to the QIB category. It has also beendecided that where BRLMs have reasons not to accepta QIB bid, the same should be done at the time ofreceipt of the bids and the reasons therefor should be

disclosed to the bidders. Necessary disclosures in thisregard are also required to be made in the offerdocument.

Margin requirements for QIBs

So far the guidelines did not mandate any specificmargin for any of the categories eligible for applying inpublic issues, whether RIIs, NIIs or QIBs. However, inpractice, in all the book built issues, there has invariablybeen 100% margin for RIIs and NIIs, but no margin forQIBs. It has now been decided to bring in margin of10% in QIB category.

III. BENCHMARKING OPERATIONAL ANDSYSTEMIC ENVIRONMENT

Innovations in the Securities Market

With a view to ensure that markets remaininnovative in meeting the interests of all stakeholdersand in furtherance of its consultative process, SEBIprepared and issued for public comments, a DiscussionPaper on Innovations in the Securities Market, containing-

(i) trading of rights on stock exchanges inelectronic form;

(ii) Strategic use of put options in the fixed pricebuy back and takeover cases;

(iii) Buy-back of shares for other than the cash;

(iv) Insurance and trading of third party warrants;put options and event risk in bonds; and

(v) professional rating of the intermediaries.

Tracking Stocks

Dr. J J Irani Expert Committee constituted by theGovernment to make recommendation on the ConceptPaper on Company Law has recommended in its reportfor the introduction of ‘Tracking Stocks’ in the IndianCapital market.

A tracking stock is a type of common stock that“tracks” or depends on the financial performance of aspecific business unit or operating division of a company,rather than the operations of the company as a whole.As a result, if the unit or division performs well, thevalue of the tracking stocks may increase, even if thecompany’s performance as a whole is not up to mark orsatisfactory. The opposite may also be true.

A tracking stock is a special type of stock issued bya publicly held company to track the value of onesegment of that company. By issuing a tracking stock,the different segments of the company can be valued



differently by investors. Tracking stocks are generallyissued by a parent company in order to create a financialvehicle that tracks the performance of a particular divisionor subsidiary. When a parent company issues a trackingstock, all revenues and expenses of the applicabledivision are separated from the parent company’sfinancial statements and bound to the tracking stock.Often this is done to separate a high-growth divisionfrom large losses shown by the financial statements ofthe parent company. The parent company and itsshareholders, however, still control operations of thesubsidiary.

Tracking stock carries dividend rights tied to theperformance of a targeted division without transferringownership or control over divisional assets. In contrastto a spin-off or an equity carve-out, the parent retainsfull control, allowing it to enjoy any operating synergies,or economies of scale in administration or finance.

Shareholders of tracking stocks have a financialinterest only in that unit or division of the company.Unlike the common stock of the company itself, atracking stock usually has limited or no voting rights. Inthe event of a company’s liquidation, tracking stockshareholders typically do not have a legal claim on thecompany’s assets. If a tracking stock pays dividends,the amounts paid depends on the performance of thebusiness unit or division. But not all tracking stocks paydividends.

A company has many good reasons to issue atracking stock for one of its subsidiaries (as opposed tospinning it off to shareholders).

(i) First, the company keeps control over thesubsidiary (although they don’t get all the profit),but all revenues and expenses of the divisionare separated from the parent company’sfinancial statements and attributed to trackingstock. This is often done to separate a highgrowth division with large losses from thefinancial statements of the parent company.

(ii) Second, they might be able to lower their costsof obtaining capital by getting a better creditrating.

(iii) Third, the businesses can share marketing,administrative support functions, etc.

(iv) Finally, if the tracking stock shoots up, the parentcompany can make acquisitions and pay in stockof subsidiary instead of cash.

When a tracking stock is issued, the company canchoose to sell it to the markets (i.e., via an initial public

offering) or to distribute new shares to existingshareholders. Either way, the newly tracked businesssegment gets a longer lease, but can still run back tothe parent company in tough times.

Advantages of Tracking Stock

A key advantage of tracking stock is that it offersdivisional managers a degree of decision-makingauthority that might otherwise be unattainable, giventop management’s reluctance to dilute its control overthe division’s assets. The practical effect should be toenhance job satisfaction for divisional managers, thusreducing retention risk and also increasing the company’sresponsiveness to changing market conditions. Also,investors have more direct access to the specificbusinesses of the parent, which can be highly useful inthe case of a diversified company. Another possiblereason for the growing popularity of trackers is thattrackers allow mainstream companies to exploit the dualstock market pricing between conventional and high-tech or Internet businesses. By creating tracked businessunits, conventional businesses too can benefit from thepricing frenzy.

Disadvantages of Tracking Stock

For investors, tracking stocks can be of a mixed bag.Like regular stocks, tracking stockholders are entitled todividends paid out by the subsidiaries issuing the trackingstock. Yet the holders of tracking stocks do not haveownership in the company, instead, at-times trackingstock shareholders vote on issues affecting thecorporate parent, not the subsidiary whose stocks theyown. Another downside is the fact that the board ofdirectors of the tracking-stock subsidiary is often putin place by the parent company and is not elected bytracking stock shareholders, which would causeconflicts of interests.

The tracking stocks are highly skeptical also.Shareholders have limited voting rights, if any, and theycannot elect their own boards. Moreover, if the parentcompany falls on hard times, conflict could developbetween the shareholders of a tracked division,especially if it continues to do well, and the shareholdersof the parent company. The potential for such conflictcould affect the performance of the tracking stock.

Another important drawback with tracking stock isthat it can dramatically increase the potential for conflictand litigation over accounting policy. It is because theowners of the tracking stock have rights only overdividends, and dividend payouts are driven by therecognition of divisional profits, the arguments over profit



recognition are almost sure to arise whenever trackingstock investors are disappointed in their returns. Theywill surely be tempted to accuse corporate managementof adopting policies that deliberately understate theirprofits.

MARKET PARTICIPANTS AND INVESTORSIDENTIFICATION NUMBER (MAPIN)

Convergence of identity in India continues to be adream. Several bodies in the past have gone ahead andissued multiple and independent IDs, without anyintegration, and many more are in the offing. Even inthe capital market, two efforts have been made in thepast to allot an ID to the investors -DP Client ID andUCC (which is in addition to the folio numbers assignedto investors by mutual funds and by companies).However, for a variety of reasons, an investor waspermitted to obtain multiple IDs both times -while hecould obtain multiple IDs from a particular depositoryand also from the second depository, he could obtainmultiple UCCs with different brokers of an exchange oracross multiple exchanges. A unique ID for investorswas once again considered essential and MAPIN wasconceived.

The Central Database of Securities MarketParticipants’ and Investors’ Identification Numbers(MAPIN) was set up by SEBI under the SEBI (CentralDatabase of Market Participants) Regulations, 2003 andwas notified by SEBI on November 20, 2003.

Objectives of MAPIN

The main objectives of MAPIN are :

(a) To create a unique non-duplicable ID for allinvestors in order to establish an audit trail forany specific transaction.

(b) To cover public disclosure of actions taken bySEBI against entities/individuals.

(c) To develop an inventory of all marketparticipants (issuers/intermediaries/investors).

However, there exists confusion regarding manyaspects of usage/applicability of MAPIN and in order toaddress various issues and concerns, SEBI set up aCommittee under the Chairmanship of Shri JagdishCapoor, Former Deputy Governor of RBI and Chairmanof HDFC Bank Ltd. The Report of the Committee wasput up for public comments on SEBI Website and SEBIalso suspended all fresh registeration for UIN fromJuly 1, 2005 following the Committee recommendationseeking to move away from the biometric system forgenerating UINs. The Report of the Committee to

Examine Issues Relating To MAPIN has rightly recognisedthat the convergence of identity in India continues tobe a dream. Presently, there are multiple andindependent IDs issued by several bodies for differentpurposes like PAN Card, Voter ID Card etc. It is,therefore believed that it would be in the public interestto integrate all such IDs for creating a truly uniquemultipurpose identification number. This will save onthe national resources and be also userfriendly andconvenient. It is, therefore desired that a MultipurposeSingle Unique Identification Number on the lines of theSocial Security Number system prevalent in the US maybe introduced. Thus, Instead of creating a new numbersystem, the possibilities of enlarging the scope of PANand converting that into a universal identification numbermay be explored. As it requires tremendous efforts andcoordination among the regulatory authorities, it maynot be possible to achieve this in the short run, howeverthis should be goal that should be set up in the largerpublic interest.

V. DEVELOPMENTS IN CORPORATEGOVERNANCE

With a view to strengthen the CorporateGovernance, SEBI constituted a Committee on CorporateGovernance under the Chairmanship of Shri KumarMangalam Birla. The Committee in its report observedthat “the strong Corporate Governance is indispensableto resilient and vibrant capital markets and is animportant instrument of investor protection. It is theblood that fills the veins of transparent corporatedisclosure and high quality accounting practices. It isthe muscle that moves a viable and accessible financialreporting structure.”

Based on the recommendations of the Committee,the SEBI had specified principles of CorporateGovernance and introduced a new clause 49 in theListing agreement of the Stock Exchanges in the year2000. These principles of Corporate Governance weremade applicable in a phased manner and all the listedcompanies with the paid up capital of Rs 3 crores andabove or net worth of Rs 25 crores or more at any timein the history of the company, were covered.

SEBI, as part of its endeavour to continuously improvethe standards of corporate governance in line with theneeds of a dynamic market, constituted anotherCommittee on Corporate Governance under theChairmanship of Shri N. R. Narayana Murthy to reviewthe performance of Corporate Governance and todetermine the role of companies in responding to rumourand other price sensitive information circulating in the



market in order to enhance the transparency and integrityof the market. The Committee in its Report observedthat “the effectiveness of a system of CorporateGovernance cannot be legislated by law, nor can anysystem of Corporate Governance be static. In a dynamicenvironment, system of Corporate Governance need tobe continually evolved.”

Based on the recommendations of the Committeeand also with a view to promote and raise the standardsof Corporate Governance, SEBI revised clause 49 of theListing agreement vide its circular dated August 26,2003, the implementation of which was deffered later.The Securities and Exchange Board of India onOctober 29, 2004 again revised the Clause 49 of theListing Agreement.

The provisions of the revised Clause 49 wererequired to be implemented as per the schedule ofimplementation given below:

(a) For entities seeking listing for the first time, atthe time of seeking in-principle approval forsuch listing.

(b) For existing listed entities which wererequired to comply with Clause 49 which isbeing revised i.e. those having a paid up sharecapital of Rs. 3 crores and above or net worthof Rs. 25 crores or more at any time in thehistory of the company, by April 1, 2005.

Companies complying with the provisions of theexisting Clause 49 (issued vide circulars dated 21stFebruary, 2000, 9th March 2000, 12th September 2000,22nd January, 2001, 16th March 2001 and 31stDecember 2001) shall continue to do so till the revisedClause 49 of the Listing Agreement is complied with ortill March 31, 2005, whichever is earlier.

However, noticing that a large number of companiesare still not in the state of preparedness to be fullycompliant with the requirements of revised clause 49of the listing agreement, SEBI allowed more time tothe corporates to conform to clause 49 of the listingagreement and extended the date for ensuringcompliance with the revised clause 49 of the listingagreement to December 31, 2005. the major highlightsof revised clause 49 are given below :

Definition of Independent Director

The clause defines the ‘Independent director’ asto mean non-executive director of the company, whoapart from receiving director’s remuneration, does nothave any material pecuniary relationships or transactions

with the company, its promoters, its directors, its seniormanagement or its holding company, its subsidiaries andassociates which may affect the independence of thedirector; is not related to promoters or persons occupyingmanagement positions at the board level or at one levelbelow the board; has not been an executive of thecompany in the immediately preceding three financialyears; is not a partner or an executive or was not partneror an executive during the preceding three years, ofany of the the statutory audit firm or the internal auditfirm that is associated with the company; the legal firm(s)and consulting firm(s) that have a material associationwith the company; Is not a material supplier, serviceprovider or customer or a lessor or lessee of the companywhich may affect the independence of the director; andis not a substantial shareholder of the company, i.e.owning two percent or more of the block of votingshares.

Nominee Directors to be treated as IndependentDirector

The revised clause provides that Nominee directorsappointed by an institution which has invested in or lentto the company shall be deemed to be independentdirectors.

Non executive directors’ compensation anddisclosures

The new clause provides that all fees/compensation,if any paid to non-executive directors, includingindependent directors, shall be fixed by the Board ofDirectors and require previous approval of shareholdersin general meeting.

Limits on Membership of Committees

For the purpose of considering the limit of thecommittees on which a director can serve,Chairmanship/membership of the Audit Committee andthe Shareholders’ Grievance Committee alone are tobe considered.

Declaration to be signed by CEO

The revised clause states that all Board membersand senior management personnel shall affirmcompliance with the code on an annual basis and theAnnual Report of the company shall contain a declarationto this effect signed by the CEO.

Audit Committee

(i) The requirement of giving terms of referenceof the Audit Committee is a must.



(ii) There is no requirement that all members ofthe Audit Committee shall be non-executivedirectors.

(iii) Two Third of the members of audit committeeshall be independent directors.

(iv) All members of audit committee shall befinancially literate and at least one member shallhave accounting or related financialmanagement expertise.

(v) The term “financially literate” has been definedto mean the ability to read and understandbasic financial statements i.e. balance sheet,profit and loss account, and statement of cashflows.

(vi) There is requirement of holding atleast fourmeetings in a year. The revised clause alsoprovides that not more than four months shallelapse between the two meetings of auditcommittee.

The role of the audit committee has also beenspecified and the information which has been requiredto be mandatorily reviewed by the Audit Committeehas been specified.

Subsidiary Company

(i) At least one independent director on the Boardof Directors of the holding company shall be adirector on the Board of Directors of materialnon-listed Indian subsidiary company.

(ii) The Audit Committee of the listed holdingcompany shall also review the financialstatements, in particular the investments madeby the unlisted subsidiary company.

(iii) The minutes of the Board meetings of theunlisted subsidiary company is required to beplaced at the Board meeting of the listedholding company.

(iv) The management should periodically bring tothe attention of the Board of Directors of thelisted holding company, a statement of allsignificant transactions and arrangementsentered into by the unlisted subsidiary company.

(v) The term “material non-listed Indian subsidiary”has been defined to mean an unlisted subsidiary,incorporated in India, whose turnover or networth (i.e. paid up capital and free reserves)exceeds 20% of the consolidated turnover ornet worth respectively, of the listed holding

company and its subsidiaries in the immediatelypreceding accounting year.

(vi) The term “significant transaction orarrangement” has been defined to mean anyindividual transaction or arrangement thatexceeds or is likely to exceed 10% of the totalrevenues or total expenses or total assets ortotal liabilities, as the case may be, of thematerial unlisted subsidiary for the immediatelypreceding accounting year.

(vii) Where a listed holding company has a listedsubsidiary which is itself a holding company,the above provisions also apply to the listedsubsidiary insofar as its subsidiaries areconcerned.

Related Party Transactions

(i) A statement in summary form of transactionswith related parties in the ordinary course ofbusiness is required to be placed periodicallybefore the Audit Committee.

(ii) Details of material individual transactions withrelated parties which are not in the normalcourse of business are also required to beplaced before the audit committee.

(iii) Details of material individual transactions withrelated parties or others, which are not on anarm’s length basis should be placed before theaudit committee, together with Management’sjustification for the same.

Disclosures

The following disclosures are required to be madeunder the revised clause:

(i) Basis of Related Party Transactions

(ii) Disclosure of Accounting Treatment

(iii) Risk Management

(iv) Proceeds from Public Issues, Rights Issues,Preferential Issues etc.

(v) Remuneration of Directors

(vi) Management

(vii) Shareholders.

CEO/CFO Certification

The CEO, i.e. the Managing Director or Managerappointed in terms of the Companies Act, 1956 andthe CFO i.e. the whole-time Finance Director or any



other person heading and discharging the financefunction shall certify to the Board that:

(a) They have reviewed financial statements andthe cash flow statement for the year and thatto the best of their knowledge and belief: thesestatements do not contain any materially untruestatement or omit any material fact or containstatements that might be misleading; thesestatements together present a true and fair viewof the company’s affairs and are in compliancewith existing accounting standards, applicablelaws and regulations.

(b) There are, to the best of their knowledge andbelief, no transactions entered into by thecompany during the year which are fraudulent,illegal or violative of the company’s code ofconduct.

(c) They accept responsibility for establishing andmaintaining internal controls and that they haveevaluated the effectiveness of the internalcontrol systems of the company and they havedisclosed to the auditors and the AuditCommittee, deficiencies in the design oroperation of internal controls, if any, of whichthey are aware and the steps they have takenor propose to take to rectify these deficiencies.

(d) They have indicated to the auditors and theAudit Committee significant changes in internalcontrol during the year; significant changes inaccounting policies during the year and thatthe same have been disclosed in the notes tothe financial statements; and instances ofsignificant fraud of which they have becomeaware and the involvement therein, if any, ofthe management or an employee having asignificant role in the company’s internal controlsystem.

Report on Corporate Governance

The companies are required to submit a quarterlycompliance report to the stock exchanges within 15 daysfrom the close of quarter as per the prescribed format.The report is required to be signed either by theCompliance Officer or the Chief Executive Officer ofthe company.

Compliance Certificate

The revised clause provides that the company shallobtain a certificate from either the auditors or practisingCompany Secretaries regarding compliance of conditions

of corporate governance as stipulated in this clause andannex the certificate with the directors’ report, which issent annually to all the shareholders of the company.The same certificate shall also be sent to the StockExchanges along with the annual report filed by thecompany.

Non-Mandatory Requirements

The clause also prescribes non-mandatoryrequirements relating to the tenure of independentdirectors, Remuneration Committee, ShareholderRights,Audit qualifications,Training of Board Members,Mechanism for evaluating non-executive Board Membersand Whistle Blower Policy.

INDIAN HOUSEHOLD INVESTORS’ SURVEY 2004

Indian Household Investors’ Survey 2004 sponsoredby Investor Education and Protection fund, Ministry ofCompany Affairs was conducted by Society for CapitalMarket Research & Development, New Delhi. Asummary of the major highlights of the survey is givenbelow :

1. The price validity, price manipulation andcorporate mismanagement/fraud havepersistently been the top three worries ofhousehold investors in India.

2. Price volatility and manipulation are the causeof worry for as many as 50% of the respondent.

3. In respect of investors’ perceptions aboutCorporate Governance, the number ofhouseholds who have trust in companymanagement is far less than these who haveno trust. This is so in every income-class andevery age-class.

4. More than 50% of the respondents werepositive about the current efforts being madeto improve Corporate Governance.

5. 38% of the respondents were shareholders ofdelisted companies. Of these 38%, 80%complained that share are unsalable; 60%complained that share value had beendestroyed; 53% complained that thesecompanies do not pay dividend; and 63% saidthat these companies do not send annualreports.

6. In respect of retail investors’ share portfoliopractices, the share portfolio diversification byretail investors’ lies in the narrow range of 3-10 companies' shares. 20% had only one ortwo companies in their portfolio. However,roughly about 50% held 3-10 companies in



their portfolio. About one-sixth of total samplehousehold held shares of 11-20 companies andabout one-eighth held shares in more than 20companies.

7. The middle and upper middle class householdare a conservative lot. The pre-dominance oflong-term investors is significantly more in thehigher income and higher age category.

8. Less than 20% intend to held shares for a fewdays only. About one third intend to holdshares for some months but not exceeding oneyear.

9. The share owning householder were nearly 74%in the lowest income class (upto Rs.10,000 permonth) 58% in the highest income class (aboveRs.25000 per month).

10. The number of shareholders having a depositoryaccount at the end of December 2004 was onlya little over 70 lakh.

11. One out of every five respondents mentionedthat demat charges are too high. This complaintwas mentioned by 24-25% among the elderlyshareowners aged 65 years and 16-17% amongthe young shareholders aged 30 years andbelow.

CONCLUSION

Though SEBI has done a commendable job and hasbeen recognised globally as an effective regulator, a lotstill needs to be done, as is evident from the findings ofthe survey discussed above. The survey clearly highlightsthe need for investor education and awareness in India.Investors are the backbone of the securities market andone must look after their interest aggressively whichwould contribute to their continued support to thesecurities market. Many investors do not possessadequate expertise/knowledge to take informedinvestment decisions. Some of them are not aware ofthe complete risk return profile of the differentinvestments options. Some investors are not fully awareof the precautions they should take while dealing withthe market intermediaries and rating in differentsecurities. Most of the investors are unfamiliar with themarket mechanism and the practices as well as theirrights and obligations. Thus the Global Benchmarkingin investor education and awareness hold the key tosustaining their interest in the securities market.

Over 9,000 listed companies will need to complywith the Listing Agreement by 31 December 2005,

which mandates that Independent Directors shouldconstitute 50% of their Boards. An estimate puts therequirement of Independent Directors at over 30,000.There is an increasing realization among listedcompanies that they should get best professionals asindependent directors who should not only add valueto their companies but also build confidence amongthe investors. Therefore another area which requiresglobal benchmarking is the availability of adequatenumber of quality independent directors to cater to therequirements of thousands of listed companies.

Mere presence of directors who are independentin terms of the provisions of law does not mean thatthere would be checks and balances. What is to beensured is that these directors think and actindependently, i.e., qualitatively independent. Suchqualitative directors independence include the will andability in terms of knowledge and experience to ask thehard questions required to provide effective oversightand character and integrity in general and especially indealing with potential conflict of interest situations.

REFERENCES

1. Annual Reports, SEBI.2. Operational Review, SEBI.3. Strategic Action Plan, SEBI.4. Press Releases, SEBI.5. Rules and Regulations, SEBI.6. SEBI Discussion Paper on Innovations in The

Securities Market.7. Kumarmangalam Birla Committee Report on

Corporate Governance.8. Report of SEBI Committee on Corporate

Governance.9. Report of SEBI Committee to examine issues

relating to MAPIN.10. Report of the Expert Group headed by

Mr. Justice M H Kania (Former Chief Justice ofIndia) for suggesting amendments to SEBI Act,1992.

11. Report of Dr. J J Irani Expert Committee onNew Company Law, 2005.

12. Handbook of Statistics, 2004, SEBI.13. SEBI (Disclosure & Investor Protection),

Guidelines, 2000 updated till date.14. Indian Household Investors' Survey, 2004

sponsored by Investor Education and ProtectionFund, Ministry of Company Affairs.


Juristic Personality — A Novel Dimension 73

JURISJURISJURISJURISJURISTIC PERSONTIC PERSONTIC PERSONTIC PERSONTIC PERSONALITALITALITALITALITY — A NOY — A NOY — A NOY — A NOY — A NOVEL DIMENSIOINVEL DIMENSIOINVEL DIMENSIOINVEL DIMENSIOINVEL DIMENSIOIN

ARCHANA KAUL*

The question of criminal liability of a juristic personhas troubled Legislatures and Judges for long. Though,initially it was supposed that a corporation could not beheld liable criminally for offences where mens rea wasa requisite, the judicial thinking appears to be that themens rea of the person in-charge of the affairs of thecorporation, the alter ego, is liable to be extrapolatedto the corporation, enabling even an artificial person tobe prosecuted for such an offence. At the same time,another question related to the above aspect i.e.,whether a corporation could be prosecuted for anoffence for which mandatory sentence of imprisonmentis provided continued to agitate the minds of the courtsand jurists and the law continued to be the old lawdespite the recommendations of the Law Commissionand the difficulties expressed by the superior courts inmany decisions.

It may be pointed out that in India, situation hasnot been free from doubt. This is evident from twoReports of the Law Commission of India whichrecommended specific amendments in order to get overthis difficulty. The Law Commission’s recommendationsfocused on the fact that the law as it exists renders itimpossible for a court of law to convict a Corporationwhere the statute mandates a minimum term ofimprisonment plus fine. It would not be open to thecourt of law to hold that a corporation would be foundguilty and sentenced only to a fine for that would bere-writing the statute and exercising a discretion notvested in the court by the statute. It is precisely for thatreason that the Law Commission recommended thatwhere the offence is punishable with imprisonment, orwith imprisonment and fine, and the offender isCorporation, the court should be empowered tosentence such an offender to fine only. However, theserecommendations have not been acted upon.

The position has been set at rest recently by alandmark decision of the Constitutional Bench of the

73

* Education Officer, The ICSI. The views expressed are personal views of the author and do not necessarily reflect those of theInstitute.

Supreme Court in Standard Chartered Bank and Othersv. Directorate of Enforcement, (2005) 4 SCC 530. Themajority of the Constitution Bench (3:2) in this caseheld that there is no immunity to the companies fromprosecution merely because the prosecution is in respectof offences for which the punishment prescribed ismandatory imprisonment and fine. The law appliesequally to actual and juristic persons. The minorityupheld the earlier ruling of the Supreme Court holdingthat a company not being an actual person could not beprosecuted for offences for which the prescribedpunishment was imprisonment and fine.

The issue involved in the case mentioned above,was whether a company, or a corporation, being a juristicperson, could be prosecuted for an offence for whichmandatory sentence of imprisonment and fine isprovided; and when found guilty, whether the courthas jurisdiction to impose a sentence of fine only.

Before dwelling on this judgement, it is pertinentto mention briefly the circumstances under which thereference was made to this larger Bench of the SupremeCourt. In ANZ Grindlays Bank Ltd. and Others v.Directorate of Enforcement, (2004)6 SCC 531 theSupreme Court doubted the correctness of its decisionin Velliappa Textiles Ltd. [(2003)11SCC 405] and heldthat the decision in Velliappa Textiles case needsreconsideration by a Constitution Bench for anauthoritative pronouncement on the subject.

Velliappa was concerned with prosecution for anoffence under Sections 276-C, 277 and 278 read withSection 278 –B of the Income Tax Act, 1961. Each ofthe punishing sections provides that a person found guiltyshall be punishable with a mandatory term ofimprisonment and fine. The majority in Velliappa tookthe view that since an artificial person like a companycould not be physically punished to a term ofimprisonment, such a section, which makes it mandatory



to impose a minimum term of imprisonment, cannotapply to the case of an artificial person. It was furtherheld that where punishment provided is imprisonmentand fine, the court cannot impose only a fine.

The majority was of the view that the legislativemandate is to prohibit the courts from deviating fromthe minimum mandatory punishment prescribed by thestatute and that while interpreting a penal statute, ifmore than one view is possible, the court is obliged tolean in favour of the construction which exempts acitizen from penalty than the one which imposes thepenalty. Following the decision in State of Maharashtrav. Jugamander Lal, AIR 1966 SC 940, it was held thatthe expression used is “imprisonment and fine” andthe court is bound to award sentence of imprisonmentas well as fine and that there is no discretion on the partof the court to impose only a fine and the court cannotinterpret the statutory provisions in a way so as to supplya lacuna in a statute.

In ANZ Grindlays Bank, an appeal was filed in theSupreme Court against the decision of the DivisionBench of the Bombay High Court contending that nocriminal proceedings can be initiated against theappellant company for the offence under Section 56(1)of the Foreign Exchange Regulation Act (FERA), 1973,(hereinafter called as Act) as the minimum punishmentprescribed under Section 56(1) (i) is imprisonment for aterm which shall not be less than six months and withfine.

In this case the Company an “authorized dealer”within the meaning of Section 2(b) of the Act wasindisputably required to comply with the statutoryrequirements contained in Sections 8, 9 and 49 of theFERA Act read with Chapter X of the RBI Manual. Theauthorized dealer contravened the provisions of the Act.

The appellants raised several contentions in supportof the appeal. One of them being that having regard tothe fact that as the offence is said to have beencommitted by a company; and as in terms of Section 56of the Foreign Exchange Regulation Act, 1973, thepunishment of mandatory imprisonment has to beimposed; no criminal proceedings can be initiated againstthe company and in that view of the matter, the companyas well as the person referred to in sub-sections (1) and(2) of Section 68 thereof cannot be proceeded with. Insupport of the said contention reliance was placed onthe decision of this Court in Asstt. Commissioner v.Velliappa Textiles Ltd. (discussed above).

The Supreme Court prima facie did not agree withthe ratio laid down in Velliappa Textiles. It held that the

contraventions of the provisions of the Act havingallegedly taken place at the hands of the authorizeddealer, and, thus, although it is a company it is liable tobe proceeded against. Section 56 of the Act providesfor different punishments for commission of differentoffences. It is true that in an offence of this nature, amandatory punishment has been provided for butoffences falling under other part of the said section donot call for mandatory imprisonment. Section 56 of theAct covers both cases where an offender can bepunished with imprisonment or fine and a mandatoryprovision of imprisonment and fine. In the event it isheld that a case involving graver offence allegedlycommitted by a company and consequently, the personswho are in charge of the affairs of the company as alsothe other persons, cannot be proceeded against, onlybecause the company cannot be sentenced toimprisonment, in our opinion, the same would not onlylead to reverse discrimination but also go against thelegislative intent. The intention of Parliament is toidentify the offender and bring him to book.

The court should take recourse to such principles ofinterpretation of statute as may be necessary to make thestatute workable keeping in view the doctrine of ut resmagis valeat quam pereat (rule of reasonable construction).

While taking recourse to the principle of purposiveconstruction, the Supreme Court relied on its decisionin Balram Kumawat v. Union of India, (2003)7 SCC 628and pointed out that an attempt should be made tomake Section 56 of the Act workable. It is possible toread down the provisions of Section 56 to the effectthat when a company is tried for commission of anoffence under the Act, a judgement of conviction maybe passed against it, but having regard to the fact that itis a juristic person, no punishment of mandatoryimprisonment can be imposed. Furthermore, even ifthe company cannot be punished, the same may notmean that the other persons referred to under sub-sections (1) and (2) of Section 68 cannot also bepunished.

Accordingly the Supreme Court held that thecorrectness of the decision of this Court in VelliappaTextiles Ltd., requires reconsideration by a ConstitutionBench, and thus the matters are referred to a ConstitutionBench for an authoritative pronouncement on the subject.

The appellants in Standard Chartered Bank put forththe following arguments:

1. A company cannot be prosecuted for anoffence for which the mandatory sentence isimprisonment.



2. Where an accused is found guilty and thepunishment to be imposed is imprisonment andfine, whether the court has got the discretionto impose the sentence of fine alone.

3. When the section commands the punishmentfor imprisonment and fine, the court is not leftwith any discretionary power to alter thesentence as that would amount to rewritingthe provisions of the law.

4. The penal provision in the statute is to be strictlyconstrued.

5. When an offence is punishable withimprisonment and fine, the court is not left withany discretion to impose any one of them andconsequently the company being a juristicperson cannot be prosecuted for the offencefor which custodial sentence is the mandatorypunishment.

1. While arguing that a company or a corporatebody could not be prosecuted for offences forwhich the sentence of imprisonment is amandatory punishment, the appellants seriouslyassailed the view expressed by the Apex Courtin Asstt. Commr. v. Velliappa Textiles Ltd. Whileconsidering the above argument advanced bythe appellants, the Supreme Court observedthat there is no dispute that a company is liableto be prosecuted and punished for criminaloffences. Although there are earlier authoritiesto the effect that corporations cannot commita crime, the generally accepted modern rule isthat except for such crimes as a corporation isheld incapable of committing by reason of thefact that they involve personal malicious intent,a corporation may be subject to indictment orother criminal process, although the criminalact is committed through its agents.

The Court pointed out that as in the case oftorts, the general rule prevails that thecorporation may be criminally liable for the actsof an officer or agent, assumed to be done byhim when exercising authorized powers, andwithout proof that his act was expresslyauthorized or approved by the corporation. Inthe statutes defining crimes, the prohibition isfrequently directed against any “person” whocommits the prohibited act, and in manystatues the term “person” is defined. Even ifthe person is not specifically defined, itnecessarily includes a corporation. It is usuallyconstrued to include a corporation so as to bring

it within the prohibition of the statute andsubject it to punishment. In most of the statutes,the word “person” is defined to include acorporation.

On amenability of the corporation toprosecution, the Court observed that mostlyall criminal and quasi-criminal offences arecreatures of statute. The amenability of thecorporation to prosecution necessarily dependsupon the terminology employed in the statute.In the case of strict liability, the terminologyemployed by the legislature is such as to revealan intent that guilt shall not be predicated uponthe automatic breach of the statute but on theestablishment of the actus reus, subject to thedefence of due diligence. The law is primarilybased on the terms of the statutes. In the caseof absolute liability where the legislature by theclearest intendment establishes an offencewhere liability arises instantly upon the breachof the statutory prohibition, no particular stateof mind is a prerequisite to guilt. Corporationsand individual persons stand on the same footingin the face of such a statutory offence. It is acase of automatic primary responsibility.Therefore, as regards corporate criminal liability,there is no doubt that a corporation or companycould be prosecuted for any offence punishableunder law, whether it is coming under the strictliability or under absolute liability.

2. Whether the court has got the discretion toimpose the sentence of fine alone where anaccused is found guilty and the punishment tobe imposed is imprisonment and fine, it wascontended by one of the appellants that if acorporate body is found guilty of the offencecommitted, the court, though bound to imposethe sentence prescribed under law, has thediscretion to impose the sentence ofimprisonment or fine as in the case of acompany or corporate body the sentence ofimprisonment cannot be imposed on it and asthe law never compels to do anything which isimpossible, the court has to follow thealternative and impose the sentence of fine.This discretion could be exercised only inrespect of juristic persons and not in respect ofnatural persons. It was contended that by doingso, the court does not alter the provisions ofthe law by interpretation, but only carries outthe mandate of the legislature. The otherappellants contended that the majority decision



in Velliappa Textiles has correctly laid down thelaw. They argued that the Parliament enactedlaws knowing fully well that the companycannot be subjected to custodial sentence andtherefore the legislative intention is not toprosecute the companies or corporate bodiesand when the sentence prescribed cannot beimposed, the very prosecution itself is futileand meaningless.

Various decisions were cited before the ApexCourt on the point. However, no unanimousview has been expressed on this question.Different High courts have taken different viewson this point. [See State of Maharashtra v.Syndicate transport co.(P) Ltd., AIR 1964 Bom.195; Kusum Products Ltd. v. S.K. Sinha (1980)126 ITR 804 (Cal); Badshah v. ITO(1987) 168ITR 332 (Ker); P.V Pai v. R.L. Rinawma,(1993)77Comp Cas 179 (Kant)].

In order to conceive a clearer language forcouching such command, the Supreme Courtreferred to its decision in State of Maharashtrav. Jugamander Lal, AIR 1966 SC 940. This wasa case where the accused was found guiltyunder Section 3(1) of the Suppression ofImmoral Traffic in Women and Girls Act, 1956.Under this section, any person found guilty shallbe punishable on his first conviction withrigorous imprisonment for a term of not lessthan one year and not more than three yearsand also with fine extending up to two thousandrupees. The High Court took the view that theword punishable used in the Section postulateda discretion on the court to impose a sentenceof imprisonment or a sentence of fine or both.

But this Court held that in the context in whichthe word ‘punishable’ has been used inSection 3(1), it is impossible to construe it asgiving any discretion to the court in the matterof determining the nature of sentence to bepassed in respect of a contravention of theprovision. By using the expression 'shall bepunishable’ the legislature has made it clearthat the offender shall not escape the penalconsequences. What the consequences are tobe, are then specified in the provision and theyare rigorous imprisonment for a period not lessthan one year and not more than three years.And also a fine which may extend to Rs. 2000.These are the punishments with respect to afirst offence and higher punishments are

prescribed in respect of a subsequent offence.By saying that a person convicted of the offenceshall be sentenced to imprisonment of not lessthan one year, the legislature has made it clearthat the command is to award a sentence ofimprisonment in every case of conviction. It isdifficult to conceive of clearer language forcouching such command.

3. Relying on the above decision, the appellantcontended that when the section commandsthe punishment for imprisonment and fine, thecourt is not left with any discretionary powerto alter the sentence and that would amountto rewriting the provisions of the law.

Reference was made to the contrary decisionsthat have been rendered on this point. [SeeMunicipal Corporation of Delhi v. J.B .BottlingCo. (P) Ltd., 1975 Cri L J 1148 (DeL); OswalVanaspati& Allied Industries v. State of U.P(1993) 1 Comp LJ 172.]

Reference was also made to a decision of theUS Supreme Court in United States v. UnionSupply Co.,215 US 50 (1909), where JusticeHolmes observed:

“… And if we free our minds from the notionthat criminal statutes must be construed bysome artificial and conventional rule, the naturalinference, when a statute prescribes twoindependent penalties, is that it means to inflictthem so far as it can, and that, if one of them isimpossible, it does not mean, on that account,to let the defendant escape.”

In this case there was an indictment of acorporation for willfully violating the sixthsection of the Act of Congress of 1902 andany person who wilfully violates any of theprovisions of this section shall, for each suchoffence, be liable to be punished with fine notless than fifty dollars and not exceeding fivehundred dollars, and imprisonment for not lessthan 30 days, nor more than six months. It isinteresting to note that for the offence underSection 5, the court had discretionary power topunish by either fine or imprisonment, whereasunder Section 6 both punishments were to beimposed in all cases. The plea of the companywas rejected.

4. The next contention of the appellant was thatthe penal provision in the statute is to be strictly



construed. In support of this contention,reliance was placed on Tolaram Relumal v. Stateof Bombay,1954 Cri L J 1333 and Girdhari LalGupta v. D.H. Mehta, (1971)3 SCC 189.

Agreeing with the contention raised by theappellants, the Court emphasized that thepenal provisions have to be construed as perthe legislative intent as expressed in theenactment. The Supreme Court stated that itis true that all penal statutes are to be strictlyconstrued in the sense that the court must seethat the thing charged as an offence is withinthe plain meaning of the words used and mustnot strain the words on any notion that therehas been a slip that the thing is so clearly withinthe mischief that it must have intended to beincluded and would have been included ifthought of. All penal provisions like all otherstatutes are to be fairly construed according tothe legislative intent as expressed in theenactment. Here, the legislative intent toprosecute corporate bodies for the offencecommitted by them is clear and explicit andthe statute never intended to exonerate themfrom being prosecuted. It is sheer violence tocommon sense that the legislature intended topunish the corporate bodies for minor and sillyoffences and extended immunity of prosecutionto major and grave economic crimes.

In modern times the distinction between a strictconstruction and a more free one hasdisappeared and now mostly the question is“what is true construction of the statute ?” Inthis context the Apex Court relied on a passagein Craies on Statute Law, 7th Edn. which readsas under:

“The distinction between a strict and a liberalconstruction has almost disappeared with regardto all statutes, whether penal or not, are nowconstrued by substantially the same rules. “Allmodern Acts are framed with regard toequitable as well as legal principles.”

Citing the Lyons Case (169 ER 1158) wherehundred years back court said “statutes wererequired to be perfectly precise and resort wasnot had to a reasonable construction of the Act,and thereby criminals were often allowed toescape. This is not the present mode ofconstruing Acts of Parliament. They areconstrued now with reference to the truemeaning and real intention of the legislature.”

What is the intention of the legislature, theCourt held that it is an undisputed fact that forall the statutory offences, company also couldbe prosecuted as the “person” defined in theseActs includes “company, or corporation or otherincorporated body.”

5. Another argument was when an offence ispunishable with imprisonment and fine, thecourt is not left with any discretion to imposeany one of them and consequently thecompany being a juristic person cannot beprosecuted for the offence for which custodialsentence is the mandatory punishment.

The Court held that this plea is acceptable ifthe custodial sentence is the only punishmentprescribed for the offence (i.e., the companybeing a juristic person cannot be prosecutedfor the offence for which custodial sentence isthe mandatory punishment). But when thecustodial sentence and fine are the prescribedmode of punishment, the court can impose thesentence of fine on a company which is foundguilty as the sentence of imprisonment isimpossible to be carried out. It is an acceptablelegal maxim that law does not compel a manto do that which cannot possibly be performed(impotentia excusat legem). So also “if anenactment requires what is legally impossibleit will be presumed that Parliament intended itto be modified so as to remove the impossibilityelement”. As the company cannot besentenced to imprisonment, the court cannotimpose that punishment, but whenimprisonment and fine is the prescribedpunishment, the court can impose thepunishment of fine which could be enforcedagainst the company. Such discretion is to beread into the section so far as the juristic personis concerned.

In fact, there are a series of offences undervarious statutes where the accused are alsoliable to be punished with custodial sentenceand fine. As per the scheme of variousenactments and also the Penal Code, mandatorycustodial sentence is prescribed for graveroffences. If the appellants’ plea is accepted,no company or corporate bodies could beprosecuted for the graver offences whereasthey could be prosecuted for minor offencesas the sentence prescribed therein is custodialsentence or fine. It could not be the intention



of the legislature to give complete immunityfrom prosecution to the corporate bodies forthe grave offences. The offences mentionedunder Section 56(1) of the FERA Act, 1973, forwhich the minimum sentence of six months’imprisonment is prescribed, are seriousoffences and if committed would have seriousfinancial consequences affecting the economyof the country. All those offences could becommitted by company or corporate bodies.The legislative intent cannot be not to prosecutethe companies for these serious offences, ifthese offences involve the amount or value ofmore than Rs. one lakh, and that they could beprosecuted only when the offences involve anamount or value less than Rs. one lakh.

The Apex Court held : There is no blanketimmunity for any company from any prosecutionfor serious offences merely because theprosecution would ultimately entail a sentenceof mandatory imprisonment. The corporatebodies, such as a firm or company undertake aseries of activities that affect the life, libertyand property of the citizens. Large-scalefinancial irregularities are done by variouscorporations. The corporate vehicle nowoccupies such a large portion of the industrial,commercial and sociological sectors thatamenability of the corporation to a criminal lawis essential to have a peaceful society withstable economy.

It was further held that there is no immunity tothe companies from prosecution merelybecause the prosecution is in respect ofoffences for which the punishment prescribedis mandatory imprisonment and fine. The viewsexpressed by the majority in Velliappa Textileswere overruled on this point.

Conclusion

The decision of the House of Lords in Salomon v.Salomon & Co, Ltd (1897) A.C.22 recognizing theprincipal of separate legal entity has had lasting influenceon the development of modern company law. This morethan one hundred year old decision articulated the

founding propositions of company law and is accordinglytreated with reverence by academics and practitionersalike. Since then many developments have taken placein the realm of company law. That apart, the globaleconomic environment has further pushed the frontiersof the corporate sector thereby enhancing theirresponsibilities and accountability. The decision of theSupreme Court is welcome. The corporate vehicle asrightly observed by the Apex Court now occupies sucha large portion of the industrial, commercial andsociological sectors that amenability of the corporationto a criminal law is essential to have a peaceful societywith stable economy. Mention should be made that thejudiciary in India has not been a salient spectator to thechanges that are taking place. In fact, it has been acreative organ actively involved in interpreting theprovisions of the law to ascertain the true intention ofParliament in enacting the statute and as far as possibleto advance such legislative intent.

There are several statutes making corporations andcompanies liable for conviction which prescribepunishment by way of imprisonment and fine. In factthe second offence is taken more seriously and that iswhy punishment of imprisonment has been mademandatory. It can ‘t be said that for first offence acorporation can be prosecuted and punished while inthe case of second offence it goes scot-free becauseimprisonment is a mandatory sentence in that case. Fordifficulty in sentencing offenders need not escapeprosecution. It may be pointed out that while layingdown criminal liability the statute does not make anydistinction between a natural person and corporations.Allowing corporations to escape liability for prosecutionon this specious plea based on difficulty in sentencing,will be doing violence to the statute. Any interpretationwhich leads to results contrary to the statutory mandatewill be in violation of the statute. Merely because thereis no specific mention in the section of the statute thatin the event of breach committed by the companiesand corporations, the punishment can only be in thenature of fine is no ground to read into the provision afatal lacuna. The provision, which is clearly applicableequally to natural and juristic persons, if construedreasonably would be found workable and capable offulfilling the object of the Act.


Cross Border Consumption Taxation under VAT Regime 79

CROSS BORDER CONSUMPTION TAXATION UNDERCROSS BORDER CONSUMPTION TAXATION UNDERCROSS BORDER CONSUMPTION TAXATION UNDERCROSS BORDER CONSUMPTION TAXATION UNDERCROSS BORDER CONSUMPTION TAXATION UNDERVVVVVAAAAAT REGIME — A NEW AREA OF SPET REGIME — A NEW AREA OF SPET REGIME — A NEW AREA OF SPET REGIME — A NEW AREA OF SPET REGIME — A NEW AREA OF SPECIALIZACIALIZACIALIZACIALIZACIALIZATIONTIONTIONTIONTION

FOR PRFOR PRFOR PRFOR PRFOR PROFESSIONOFESSIONOFESSIONOFESSIONOFESSIONALSALSALSALSALS

YOGINDU KHAJURIA*

INTRODUCTION

Many organisations feel that they lack control oversubsidiary tax compliance affairs. This situation becomesmore complex in the light of focus on good taxgovernance and compliance. The approach of taxspecialists fits well with groups seeking better taxgovernance and tax management across a number ofterritories or with multiple entities in one territory. Thisis particularly so where corporates are entering newcountries or where accounting and finance resourcesare being moved into shared service centres. Thespecialists can provide quality technical support including:coordination of multi country compliance requirements;corporate tax return preparation; compliance supportwith other taxes (eg. State and local taxes); tax paymentadvice; tax compliance time limit monitoring; taxcompliance outsourcing services; tax complianceprocess improvement; and integration with local countrystatutory accounting compliance services.

NEED OF SPECIALIST SERVICES

Need of tax-efficient international assignmentstructures and policies is a must. The ability of professionalspecialists to operate profitably in diverse geographicmarkets, and to shift operations flexibly betweencountries results as an essential to the success of thebusiness. But operating globally generates a wide varietyof practical, legal, HR and finance issues. Multinationalfirm has to comply with host countries’ laws on tax,pensions, business practices and human resources. Onecountry’s entrepreneur may be another’s antitrust violator.

With the increasing focus on governance andregulation, tax compliance has never been so important.

79

* Assistant Education Officer, The ICSI. The views expressed are personal views of the author and do not necessarily reflect thoseof the Institute.

Cross-border transactions need to manage multi-territory compliance requirements and keep abreast ofchanges in local legislation in each country that affectthese requirements, while often facing additionalpressures such as a lack of resources and the need tocontrol costs and reduction of taxes. Multinationalbusinesses are increasingly affected by tax, legislativeand regulatory developments throughout the world.Understanding the impact of these developments onbusiness operations and transactions between countriesis vital for a company’s survival. Professional specialistscan help in managing global tax compliance issues, risksand opportunities. Having a strong international networkof tax practitioners, they provide a consistently highquality service, coordinated across as many territoriesas possible.

The network of professionals in international taxstructuring can help in greater tax governance byaddressing latest developments as well as all aspects ofcross-border taxation. They are well equipped and canstructure cross border businesses in a tax-efficientmanner, besides local managing by constructing effectivecross-border strategies and managing global structuraltax rate. Being enriched in knowledge and abreast ofnew developments in the international arena that affectinternational business, the professional specialists canadvise on various issues like:

— foreign companies tax planning;

— income tax treaties;

— tax efficient holding company locations;

— cross-border financing and treasury solutions;



— tax efficient supply chain and shared services;

— tax harmonization and regional tax issues underVAT etc.

CROSS-BORDER TAXATION

The term, “cross-border taxation” means taxationin more than one country. In the international scenario,analysis of corporate taxation is very complex. This taxcomplexity arises due to a number of reasons. Theprominent three reasons are:

1. Ways of Cross-border Investment;

2. Issues of Double Taxation involved;

3. Involvement of Minimum two Countries.

1. Ways of Cross-border Investments

Various ways in which cross-border investments canbe made are:

(a) Investment by an individual in a domesticcompany which further invests in a foreignbusiness i.e., permanent establishment;

(b) Investment by an individual in a foreigncompany which further invests in a business inits own country;

(c) Investment by an individual in a domesticcompany which invests in a foreign company,which further invests in a business unit in itsown country.

The main taxation issue in the above alternatives is,whether or not income derived through a company istaxed in the same way as income derived directly by anindividual. In order to resolve the above issue, onegenerally tends to assume that an individual investmentin a company is portfolio e.g., small shareholding in alisted company. Second assumption is that theinvestment by a corporate resident in one country incorporate resident in another country is directinvestment. Investment in the business by the companyis also assumed as one form of direct investment througha branch. In multinational companies, there is differentset up. In general, above three types represents taxcompliance in vast majority of cross-border investmentsthrough companies. The main concern in all the aboveis international double taxation.

2. Issues of Double Taxation Involved

The issues involved in double taxation include:double taxation of company shareholder income andinternational double taxation. The term internationaldouble taxation means taxation in more than one country.

One of the main reasons of tax complexity arises dueto a shift of emphasis to consider both forms of potentialdouble taxation together.

India has been acknowledged as sovereign republicin the preamble to the Constitution of India. UnderEntry 14 of the Union List, the matter relating to“Entering into treaties and agreements with foreigncountries and implementing of treaties agreements andconventions with foreign countries” have been included.Thus, the exclusive power of the Parliament to makelaws with regard to entering into treaties and agreementsis all encompassing and consequently, includes thepower to legislate in this regard in the field of taxationof income.

This special power has been exercised by theParliament by enacting Section 90 of the Income TaxAct, 1961. As per this Section, the Central Governmenthas been empowered to enter into agreements withforeign countries for granting reliefs in respect ofavoidance of double taxation so as to promote mutualeconomic relations, trade and investment. Centralgovernment has been empowered not only to enterinto agreements for the avoidance of double taxationbut also for exempting income from taxation. The effectof entering into these agreements provide that if no taxliability is imposed under the Act, then the question ofresorting to the agreement would not arise. Where taxliability is imposed then the agreement may be resortedto for negativing or reducing it. However, in case ofdifference between the provisions of the Act and ofthe agreement, the provisions of the agreement shallprevail over the provisions of the Act to the extent theyare beneficial to the subject and shall be enforceableby the appellate authorities and the Court.

3. Involvement of Minimum Two Countries

There is a requirement of a minimum two countriesas there is a possibility that the countries apply differenttax systems and there is no uniformity among varioustax systems. Thus, it becomes difficult as to whichcountry’s tax system should effectively govern. Therearises a necessity of having two perspectives that is oneof the source country of the company and second thatof the residence country to see how it relievesinternational double taxation. Such reliefs can beprovided either by granting relief from corporate doubletaxation or by extending any such domestic relief to theinternational sphere. In the source country, the outcomeshall depend upon how it taxes non-residents. Thecurrent international tax system as implemented in taxtreaties is premised on the basis that the source country



can generally tax the company’s income from thebusiness carried on in that country in the same way as ittaxes resident locally owned companies. The exceptionto this is most of the branch income of shipping andairline companies, which are not taxable in the countryof the branch. In respect of the business carried out inthe branch, the source country is obliged by the businessprofits article of tax treaties to apply corporate tax on anet basis. The source country is bound to follow taxtreaties in respect of business branch or subsidiary formso as to eliminate discrimination against the non-residentowners and to apply the arm’s length principle indetermining the allocation of income between thesource country and the residence countries because thissystem is entrenched by treaties.

CONSUMPTION TAXATION

The growing interest in consumption taxation canbe explained by the substantial increase in internationaltrade and cross border services during the last decadeand by the new phenomenon of electronic commerce,both business to business and business to consumer.Consumption taxation has from early times when a partof goods sold by merchants had to be given to the rulersof the community where commerce was generally done.In 1900 BC, Assyrian caravans paid 2.9 per cent of thevalue of textile and tin upon exportation of these goodsto neighboring States. In European countries sales taxesinspite of being an important source of revenue for localand national governments, lost favour in the 18th and19th centuries, when the doctrine of ability to pay causeda shift toward taxing income and wealth. In WesternEurope, the sales tax became unimportant in thebeginning of the 20th century. A large number ofcountries introduced general sales taxes despite of greatopposition after the economic crises of the 1930s as atemporary measure and after the World War II, theirrates increased substantially.

In 1960s, sales or turnover taxes developed intoconsumption taxes in Europe. After a span of aroundthree years after the foundation of the EuropeanEconomic Community (1957), study group of theEuropean Commission came to the conclusion that theclassical system of sales taxes or turnover taxes, acumulative system of taxes in almost all stages ofproduction distribution, should be converted into a creditinvoice method VAT (Value Added Tax) based onprinciples of internal and external neutrality. The term,“internal neutrality” meant that the burden ofconsumption tax shall be proportional to the price paidby the final consumer for goods and services, irrespectiveof the number of transactions during the previous stages

of the production and distribution process. The basicprinciple behind “external neutrality” was that theconsumption tax in the country of consumption shallbear upon the goods or services and hence the revenuesof the consumption tax accrue to the country ofconsumption. In the year 1967, the Council of EECadopted the First (67/227/EEC) and Second (67/228/EEC) Directive of VAT containing the basic principles ofVAT. The First Directive is still in force and but the SecondDirective has been replaced by the Sixth VAT Directive(77/388/EEC), setting the rules for harmonization of thetaxable base for the VAT.

The aim of consumption type of VAT is to tax allfinal consumption expenditures of goods and servicesso that final consumer bears the VAT charged to him byher supplier. It is leviable at each stage of the productionand distribution process and in each stage the supplierof goods and services is liable for VAT.

In cross-border production and distribution chain,the credit invoice method of VAT follows the countryof destination principle by applying zero rate tax for suchtransaction and levying VAT upon importation in thecountry of destination. In non-Vatable consumption taxeslike, sales tax , the cascading effect of sales tax can bemitigated by applying an exemption of sales tax onsupplies of goods and services to business customers.

VAT is in force in more than 130 countries rangingfrom Sri Lanka to China. India too has a VAT at theCentral level (CENVAT).

VAT IN OTHER COUNTRIES

It shall not be an exaggeration to say that theemergence of the VAT as an important and elastic sourceof revenue over the last four decades is unparalleled inthe history of taxation. Despite the widespreadproclamation of VAT, there have been difficulties inimplementing VAT in its true spirit in the countries like,Japan, Colombia, Russia, USA etc. Despite of suchdifficulties, it can be said with confidence that ValueAdded Tax system definitely has its advantages and iscertainly recommended for most economies, particularlythe developing ones.

VAT IN JAPAN

Japanese Ministry of Finance introduced nationalconsumption tax in the year 1970 for the first time. Ithowever took three tries due to massive publicopposition which desired to reduce or suspend thisconsumption tax in order to stimulate the Japaneseeconomy, before finally passing the law. Consumption



tax is a sales tax levied in Japan with main objective totax consumer expenditure.

This consumption tax was designed in such a mannerthat it passed on to and is ultimately borne by the finalconsumer. The levy of this tax was at every stage ofproduction and distribution. This tax used a credit methodfor intermediary businesses and in actual practice, it wasto be added to the price of products sold and servicesprovided by an enterprise. Thus, it provided an additionalcost for the individual consumer. The system ofconsumption taxation in Japan allowed businesses toset off some or all of input tax that it suffers against theoutput tax collected with only the net amount havingto be paid over to the government.

Under Japanese context, a tax payer for consumptiontax purposes is an enterprise supplying taxable goods orservices in the country above a certain limit forconsideration. The term enterprise for the abovepurposes includes individuals as well as companiesresident and foreign corporations.

The consumption tax on taxable purchases during ataxable period is classified into three groups namely,tax on taxable transactions, tax on non-taxabletransactions and tax incurred on both taxable transactionsand non-taxable transactions in common.

VAT IN COLOMBIA

In Colombia, VAT is an indirect tax and is applicableto sales of goods, services rendered within the nationalterritory and imports of tangible movable assets. It doesnot apply to the sale of fixed assets except for sales ofautomobiles and airplanes and of other fixed assets soldin the name and on behalf of third parties.

The general VAT rate in Colombia is 16 per cent.VAT is equivalent to the difference between the taxgenerated by the taxed transactions and the tax creditsthat are legally deductible. VAT generated on taxabletransactions is established by applying the rate of thetax to the taxable base and deducting VAT on returnsand transactions rescinded, resolved or rendered void.VAT paid on the acquisition of goods and services up tothe limit resulting from applying to the value of thetransaction evidenced by the respective invoices, thetax rate on the activity that is being taxed, the portionexceeding this percentage shall constitute a higher valueof the cost or of the respective expenditure.

VAT Credits in respect of acquisitions of goods andservices and for imports are available only if it is incurredin respect of transactions, which are allowed as costs orexpenses of the enterprise as per income tax laws.

Cross-border services in Colombia are subject todouble taxation taking into account the services renderedin the country which are subject to VAT unless therelevant services are documented as exempt exports.So, the cross-border transactions shall be so structuredthat they amount to export of services in order to beexempt from VAT.

VAT IN GREECE

The principle of neutrality as laid out in article 2 ofthe Sixth Directive is adopted by the Greek VAT law. InGreece, VAT system was introduced by Law 1642/1986which implemented the EC Council Directive 77/388/EEC “on harmonization of the laws of the Member Statesrelating to turnover taxes-common system of ValueAdded Tax: uniform bases of assessment” (SixthDirective). This law was amended number of times andthe latest codification of Greek VAT law was effectedby Law 2859/2000.

The method of taxation followed in Greece is creditinvoice method besides special schemes introduced byvarious articles.

The standard fixed for VAT in Greece is eighteenper cent subject to certain exceptional items wherereduced rates are made applicable for computing VAT.In the instances where a EU resident makes a taxablesupply in Greece, he is required to get registered forVAT purposes through appointment of a representative,who is not a VAT representative and is not co-liable forthe payment of VAT. On the contrary, where a non EUresident makes a taxable supply in Greece and does nothave a permanent establishment, then he shall berequired to get registered for VAT purposes throughappointment of a VAT representative who shall be co-liable for the payment of VAT.

There is no concept of forming VAT Groups inGreece allowing Member States to consider and treatas a single taxable person, who are legally independentand are closely bound to one another.

VAT IN SOUTH AFRICA

In South Africa VAT is transaction-based tax. It wasintroduced in the year 1991 by implementation of ValueAdded Tax Act No. 89 of 1991. The levy of VAT extendsto supply of goods and services by a vendor, who is aperson registered for VAT in South Africa. There aretwo ways in which a person can register as a vendor.First is voluntary and second is compulsory. South AfricanRevenue Services allocates different tax categories tothe vendor on obtaining registration on the basis of taxsupplies of the vendor during the course of the year ,



which are categories A, B, C, D. Generally, categoriesA and B are allocated to most of the vendors. In termsof these categories, tax returns are submitted everysecond month. Where turnover of a vendor exceedsR30 million in one year period, the vendors are requiredto get registered under category C. In this category, taxreturns are submitted on monthly basis. Fourth categoryis category D which is available to farmers or farmingenterprises on a total turnover of less that R1 millionper annum. Under this category, the vendors are requiredto submit VAT returns on half yearly basis.

VAT is leviable on the supply of goods and services.The standard rate of tax in South Africa is 14 per cent. Itis levied at each stage of a transaction. In a system ofinput tax claimable and output tax payable, it is the endconsumer who bears the VAT burden. In cases of exemptsupplies, the vendor shall not levy VAT on the supply orclaim his input tax credit thereon.

VAT IN UNITED KINGDOM

In UK, VAT is based on invoice credit method andfollows the European Union model. VAT in UK is amultistage and tax is charged and collected at each stageof the production and distribution cycle. There are tworates of VAT in UK. One is standard rate i.e., 17.5 percent and another is reduced rate i.e, 5 per cent. It is aself assessed tax and the traders are entitled to certaintyin dealing with their tax affairs.

The taxable person in the context of VAT is supplierof goods and services who shall obtain registration forVAT purposes and shall also be liable to pay tax. Refundof VAT is made to the traders on purchases of goodsand services and on importations so that the tax is borneby the final consumer. There shall be no refund of taxto the traders if the goods and services are used to makeexempt supplies.

The governing legislation in UK is EU Sixth Directivealong with the national provisions implementing thedirective. There have been numerous changes in theUK rules since the adoption of the Directive forcomputing relief for input tax for partly exempt traders.The amendments to the legislation have been made tobring harmonization and improvement in the accuracyof the computation of the relief. These regulationsprovide for a standard method for computing input taxdeduction for partly exempt businesses but customs havethe power to approve and device special methods wherethe value of particular outputs could unfairly distort thecomputation of the input tax deduction.

UK recognizes registration of groups consisting ofsingle taxable person as two or more companies under

common control. The general effect of grouping is thatthe supplies of goods and services between the groupmembers are ignored for VAT purposes. One of themembers is recognized as representative member whois responsible for all supplies to and by members of aVAT group. This has been done by traders for taxavoidance purposes. Recently, the financial institutionsin UK have started using joint venture companies inVAT groups in order to reduce the VAT cost ofoutsourcing.

VAT IN UNITED STATES

There is no broad–based federal tax on consumptionin United States. There exists single stage retail salestaxes in majority of the American States with anexception to two States where modified form of VATexists that reaches some of the value added by financialinstitutions operating in that State. There is no borderadjustable tax on consumption in U.S. In the year 1971,Congress enacted income tax reliefs for exporters tiedto export sales receipts. The law of DomesticInternational Sales Corporation was modified andrenamed over the next thirty years and in 2002, itssuccessor legislation Foreign Sales Corporation Tax washeld to be a prohibited subsidy under World TradeOrganisation Rules. The report on consumption taxationexplored the VAT with limited scope including cross-border transactions. This report does not mention VATimplications for a US company operating in a VAT countrywhich is registered for VAT.

US major trading partners rely on destinationprinciple to tax cross-border transactions. In case ofimposition of VAT on cross border transactions under anormative destination principle tax base, there wouldbe imposition on all imports of goods and services to beconsumed domestically and all exports would have beenfree from tax. Thus, none of the forms of VAT in usetoday are imposed on this normative tax base.

VAT IN RUSSIA

In Russia, there are three main consumption taxesnamely, excise tax, sales tax and VAT. Chapter 21 ofthe Russian Federation Tax Code which came into forceon January 2001 regulates the VAT system in Russia byreplacing the former federal law on VAT and the relatedlegislative documents. It is a tax levied by the federalgovernment and is payable to the federal budget only.

VAT obligations are determined by credit invoicesystem. For VAT purposes, the seller of goods andservices and not the buyer is considered as a taxpayer.Taxpayers include Russian companies, foreign



companies, private entrepreneurs and small businessesincluding companies and private entrepreneurs whosegross proceeds net of VAT do not exceed 10 lac roubles.

Standard rate of VAT is 20 per cent, while a reducedrate of 10 per cent is applicable to certain types of goods.Export of goods and services is subject to VAT at arate of 0 per cent.

VAT IN INDIA

In India, State-level VAT is a multi-point tax on valueaddition which is collected at different stages of salewith a provision for set-off for tax paid at the previousstages i.e., tax paid on inputs. It is to be levied as aproportion of the value added (i.e. sales minus purchase)which is equivalent to wages plus interest, other costsand profits. It is a tax on the value added and can beaptly defined as one of the ideal forms of consumptiontaxation since the value added by a firm represents thedifference between its receipts and cost of purchasedinputs. It is commonly referred to as a method of taxationwhereby the tax is levied on the value added at eachstage of the production and distribution chain. It intendsto tax only the value added at each stage and not theentire invoice value of the product. By ensuring thatonly the incremental value is taxed, it aims at eliminatingthe cascading effect of taxes on commodities and reducesthe eventual cost to the consumer.

It is one of the most radical reforms, albeit only inthe sphere of State level taxes on sale, that have beeninitiated for the Indian economy after years of politicaland economic debate aiming at replacing complicatedtax structure to do away with fraudulent practices.

With the objective to introduce State-Level VAT inIndia in the Year 1992, the Government of Indiaconstituted a Tax Reform Committee headed by Dr. RajaJ. Chelliah. In 1993, the Committee recommendedthe introduction of VAT in place of existing tax system.Thereafter, the Government appointed NIPFP (NationalInstitute of Public Finance and Policy), New Delhi, asthe Nodal Agency to work out the modalities of VAT.

The first preliminary discussion on State-Level VATtook place in a meeting of Chief Ministers convened byDr. Manmohan Singh, the then Union Finance Ministerin 1995. In this meeting, the basic issues on VAT werediscussed in general terms and this was followed up byperiodic interactions of State Finance Ministers.

For implementing the above decisions, anEmpowered Committee of State Finance Ministers wasset-up. Thereafter, this Empowered Committee metfrequently and got full support from the State Finance

Ministers, the Finance Secretaries and theCommissioners of Commercial Taxes of the StateGovernments as well as Senior Officials of the RevenueDepartment of the Ministry of Finance, Government ofIndia. Through repeated discussions and collective effortsof all, it was possible to achieve remarkable successwithin a period of about one and half years. Afterreaching this stage, steps were initiated for the systematicpreparation for the introduction of State-Level VAT.

Along with these measures ensuring convergenceon the basic issues on VAT, steps were taken fornecessary training, computerization and interaction withtrade and industry, particularly at the State level. Thisinteraction with trade and industry was speciallyemphasized. The conference of State Chief Ministerspresided over by Shri Atal Behari Vajpayee, the thenPrime Minister, held on October 18, 2002 at which ShriJaswant Singh, the then Finance Minister was alsopresent, confirmed the final decision that all the Statesand the Union Territories would introduce VAT fromApril 1, 2003.

The Empowered Committee of State FinanceMinisters on February 8, 2003 again endorsed thesuggestion that all the State legislations on VAT shouldhave a certain minimum set of common features. Mostof the States came out with their respective draftlegislations. Shri Jaswant Singh the then Union FinanceMinister, also announced the introduction of VAT from1st April, 2003 in his 2003-2004 budget speech madeon February 28, 2003. Owing to some unavoidablecircumstances, VAT could not be implemented w.e.f.April 1, 2003 and also on the revised date June 1, 2003,Despite all obstacles, Haryana was the first State toimplement VAT w.e.f. April 1, 2003. In rest of the StatesVAT Laws were at draft stage.

The Empowered Committee of the State FinanceMinisters constituted by the Ministry of Finance,Government of India, on the basis of the resolutionadopted in the conference of the Chief Ministers onNovember 16, 1999 under the Chairmanship of Dr.Asim Dasgupta came out with a White Paper on State-Level VAT, which was released on January 17, 2005by Shri P. Chidambaram, The Finance Minister,Government of India. On this occasion, FinanceMinister remarked:

“This is the first document which has beencollectively prepared and put out to the peopleof the country by the Finance Ministers of allStates…. We have formed the rainbowcoalition to undertake one of the biggest taxreforms.”



This Paper consists of three parts. In Part I,justification of VAT and the background has beenmentioned. In Part II, main Design of VAT as evolvedon the basis of consensus among the States throughrepeated discussions in the Empowered Committee hasbeen elaborated. In Part III, other related issues foreffective implementation of VAT have been discussed.

The White Paper specified that registration underthe VAT Act shall not be compulsory for the small dealerswith gross annual turnover not exceeding Rs.5 lakh.However, the Empowered Committee of State FinanceMinisters has subsequently allowed the States to increasethe threshold limit for the small dealers to Rs.10 lakh,but the concerned State shall have to bear the revenueloss, on account of increase in the limit beyond Rs. 5lakh. The VAT Acts are designed so that high valuetaxpayers should not be spared and on the contrary smalldealers should be hassle free from complianceprocedures.

The objective of all such composition schemes isnot to burden small dealers by the provisions of recordkeeping. Therefore, such schemes will generally containthe following features:

(i) small amount of tax shall be payable;

(ii) there shall be no requirement to calculatetaxable turnover;

(iii) a simple return form to cover longer returnperiod shall be sufficient.

All sales or purchases of goods made within theState except the exempted goods would be subjectedto VAT as a consumption tax.

In his speech introducing Union Budget 2005-06,the Hon’ble Finance Minister said, “In a remarkabledisplay of the spirit of cooperative federalism, the Statesare poised to undertake the most important tax reformever attempted in this country. All States have agreedto introduce the value added tax (VAT) with effect fromApril 1, 2005. VAT is a modern, simple and transparenttax system that will replace the existing sales tax andeliminate the cascading effect of sales tax.

In the medium to long term, it is my goal that theentire production-distribution chain should be coveredby a national VAT, or even better, a goods and servicestax, encompassing both the Centre and the States.

The Empowered Committee of the State FinanceMinisters, with the solid support of the Chief Ministers,has laboured through the last 7 years to arrive at aframework acceptable to all States. The Central

Government has promised its full support and has alsoagreed to compensate the States, according to an agreedformula, in the event of any revenue loss. I take thisopportunity to pay tribute to the Empowered Committee,and wish the States success on the introduction andimplementation of VAT”.

EXTRACTS FROM KELKAR COMMITTEE REPORT

Considering that the implementation of VAT wasclosely linked to the administration of other indirect taxesand impacts the tax to GDP ratio, it had becomenecessary to examine the relevant issues. In thisdirection the Task Force has had the benefit of meetingwith the Empowered Committee of the Finance Ministersof the States, constituted for the purpose ofimplementing a nationwide State-level VAT. TheEmpowered Committee experimented on federal fiscalplanning and achieved much in terms of building aconsensus on many of the critical issues relating toimplementation of VAT in a relatively short spell of time.Most countries have taken several years to implementVAT. Decisions were taken on the important features ofVAT relating to replacement of the State Tax levied bythe States though some other local taxes like octroi,mandi, cess etc. may continue.

It was recommended that a publicity awarenessprogramme shall be started jointly by the CentralGovernment and the State Governments. The CentralGovernment shall extend financial support for this, ifneeded. Since the State VAT is expected to beimplemented from 1.4.2003, it is also necessary thatthe publicity awareness programme should beimplemented at the earliest.

One of the issues which had impact on the transitionof VAT was the compensation to be given to the Statesupon the removal of Sales-tax and the introduction ofState VAT, in the event the tax revenue drops due tothe change over. In this regard, it had been observedthat the experience worldwide has been that a movetowards VAT results in higher revenue realization.

During the meetings that the Task Force had withseveral industry and trade bodies, it was representedthat the switch-over to VAT must ensure that the desiredbenefits are achieved, especially in view of the fact thatthis switch-over shall entail a major overhaul of systemsand procedures for business and governments and atsubstantial expenditure of money, time and effort.

Under the existing sales-tax structure, there areproblems of double taxation of commodities andmultiplicity of taxes resulting in a cascading tax burden.



As per the existing structure before a commodity isproduced, inputs are first taxed and then after thecommodity is produced with input tax load, output istaxed again. This causes an unfair double taxation withcascading effects. In the VAT, a set-off is given forinput tax as well as tax paid on previous purchases.

The design of State-level VAT had been workedout by the Empowered Committee through severalrounds of discussions and striking a federal balancebetween the common points of convergence regardingVAT and flexibility for the local characteristics of theStates.

Vat Liability

In India, the VAT is based on the value addition tothe goods and the related VAT liability of the dealer iscalculated by deducting input tax credit from tax collectedon sales during the payment period (say, a month).

The White Paper specifies that registration underthe VAT Act is not compulsory for the small dealerswith gross annual turnover not exceeding Rs.5 lakh.However, the Empowered Committee of State FinanceMinisters subsequently allowed the States to increasethe threshold limit for the small dealers to Rs.10 lakh,but the concerned States will have to bear the revenueloss on account of increase in the limit beyond Rs.5lakh.

VAT is so designed that high value taxpayers arenot spared and on the contrary small dealers are alsohassle free from compliance procedures.

Advantages

Introduction of VAT in India has many advantagesi.e.,

— to encourage and result in a better-administeredsystem;

— to eliminate avenues of tax evasion;

— to avoid under valuation at all stages ofproduction and distribution;

— to claim credit of tax paid on inputs at eachstage of value-addition;

— do away with cascading effect resulting in nondistortion of the business decisions;

— permit easy and effective targeting of tax ratesas a result of which the exports can be zero-rated;

— ensures better tax compliance by generating atrail of invoices that supports effective audit andenforcement strategies;

— contribution to fiscal consolidation for thecountry. As a steady source of revenue, it shallreduce the debt burden in due course;

— to help India to integrate better in the WTOregime;

— to stop the unhealthy tax-rate war and tradediversion among the States, which hadadversely affected the interests of all the Statesin the past.

Methods of Computation

In India, computation of VAT can be done by usingany of the following methods namely,

1. The Subtraction method : Under this methodthe tax rate is applied to the difference betweenthe value of output and the cost of input;

2. The Addition method : Under this method valueadded is computed by adding all the paymentsthat are payable to the factors of production(viz., wages, salaries, interest payments etc);

3. Tax credit method : Under this method, it entailsset-off of the tax paid on inputs from taxcollected on sales. Indian States opted for taxcredit method, which is similar to CENVAT.

Procedure

In India, VAT is based on the value addition to thegoods. Input tax credit is given for both manufacturersand traders for purchase of input or supplies meant forboth sales within the State as well as to the other Statesirrespective of their date of utilization or sale. If the taxcredit exceeds the tax payable on sales in a month, theexcess credit will be carried over to the end of the nextfinancial year. If there is any excess unadjusted inputtax credit at the end of the second year then the samewill be eligible for refund. For all exports made out ofthe country, tax paid within the State is refunded in full.Tax paid on inputs procured from other States throughinter-State sale and stock transfer shall not be eligiblefor credit.

The existing Sales Tax Acts in all States shall giveplace to the State VAT Act. Accordingly the Rules,Schedules and Forms under the erstwhile Acts shall beabolished. However, Central Sales Tax shall continue togovern inter-State sales and exports.

Rates of Tax

As contrasted to the multiplicity of rates under theexisting regime, there are four broad rates under VATregime -0% (Exempted for unprocessed agricultural



goods, and goods of social importance), 1% for preciousand semiprecious metals, 4% for inputs used formanufacturing and on declared goods, capital goods andother essential items, 20% for demerit/luxury goodsand the rest of the commodities shall be taxed at aRevenue Neutral Rate of 10-12.5%.

Distinction between Existing System and VAT

Indian States continue to tax declared goods onsingle point basis under the existing system subject to arate of 4%. Under VAT, declared goods shall also besubject to tax at multiple levels.

As per existing Sales tax law, inputs used formanufacture, whether capital or otherwise, are eligiblefor concessional rate of tax on furnishing the requisiteforms. However, under the VAT system, there is noplace for concessions. Goods are taxed at their respectiverates with a provision for set off in future. There is noincentive scheme under VAT, barring those carriedforward from the existing system.

Exports and supplies to exporters i.e. penultimatesales are exempt from tax under the existing systemsubject to certain conditions. Under VAT, exports arezero-rated i.e. they are not exempted, giving rise torefund of tax paid on inputs.

There is no set off of prior taxes paid under theexisting system of Single Point Tax and Multi-point tax.In Single point Tax too, further taxation is effected byway of turnover tax and hence set off assumes relevanceeven in a single point tax system. In the VAT system, allprior taxes are given set off against output tax if the saleis not an exempt sale.

In VAT regime, the rates shall be uniform. However,it is possible that items under the exempted categoryand 4% category may be broadly similar across all States.Each State has its own VAT Act, Rules, Schedules, andForms. Still there remain differences even in definitionsamong various Acts.

Petroleum products, like Aviation Turbine Fuel,Naphtha etc. used as fuel for running automobiles arebrought under VAT, but credit cannot be taken on thetax paid thereon. Tobacco, Textiles and Sugar, whichwere under additional duty in lieu of excise and notunder State taxation, are brought into the State Tax netat a rate not more than 4%, thereby integrating theseproducts in the VAT structure.

Registration

Every dealer up to the retailer level is required toget registered with the Sales Tax department in order to

avail the credit of input tax. However, there is a thresholdturnover level. The retailers with turnover below thethreshold can opt not to register, but pay a nominalcomposition tax. However, such dealers are not entitledto take credit of prior stage tax, nor can they pass thecredit to their buyers. In effect, the VAT chain breaks atthat stage. Those opting not to register under VAT canopt for general registration.

Registration of dealers with gross annual turnoverabove Rs.5 lakh is compulsory. There is a provision forvoluntary registration for dealers with gross annualturnover of less than Rs 5 lakh. All existing dealers getautomatically registered under the VAT Act. A newdealer is allowed 30 days time from the date of hisbeing liable to get registered.

Small dealers with gross annual turnover notexceeding Rs.5 lakh shall not be liable to pay VAT. Stateshave flexibility to fix threshold limit within Rs.5 lakh.Small dealers with annual gross turnover not exceedingRs.50 lakh who are otherwise liable to pay VAT, shallhowever have the option for a composition scheme withpayment of tax at a small percentage of gross turnover.The dealers opting for this composition scheme shallnot be entitled to input tax credit.

The entire design of VAT with input tax credit iscrucially based on documentation of tax invoice, cashmemo or bill. Every registered dealer, having turnoverof sales above an amount specified, shall issue to thepurchaser, who is entitled to tax credit and not to thefinal consumer, serially numbered tax invoice with theprescribed particulars. This tax invoice is to be signedand dated by the dealer or his regular employee, showingthe required particulars.

Exempt Sale

When a certain sale is exempt from tax, the dealereffecting the exempt sale shall not be entitled to anyVAT credit on the inputs purchased by him. The saleseffected by him shall also be exempt from any tax. Thisresults in breaking of the VAT chain.

Another example where reversal is made is whenthe goods are sold as samples or gifts i.e., non-taxabletransactions and the input tax credit relating thereto havealready been availed against output tax payable on othersale transactions. In such circumstances, the creditearned shall be reversed. This is called “Reverse Creditof Input Tax”.

Stock or Consignment transfers are exempt fromVAT as these were not under the purview of the StateTax Acts as well. The input tax paid on such commodities



or on the inputs that go into production of suchcommodities are available as credit to the extent ofexcess of input tax over and above 4%. Thus, if theinputs used in the commodity that is transferred, or theproduct itself when purchased, were taxed at 10%,credit can be taken by the transferring dealer to theextent of 6% against other taxable dispatches. Importedgoods shall continue to be exempt from VAT on imports.Under VAT, there is no place for Entry taxes and Octroi.

Credit and Set-Off under VAT Regime

VAT aims at providing set-off for the tax paid earlierand this is given effect through the concept of input taxcredit. Input tax credit in relation to any period meanssetting off the amount of input tax by a registered dealeragainst the amount of his output tax.

Tax paid on the earlier point is termed as, “inputtax”. This amount is adjusted against the tax payableby the purchasing dealer on its sales. This creditavailability is called input tax credit. “Input tax” is thetax paid or payable in the course of business on purchaseof any goods made from a registered dealer of the State.“Output tax” means the tax charged or chargeable underthe Act, by a registered dealer for the sale of goods inthe course of business. In other words, input tax is thetax a dealer pays on his local purchases including thegoods that he purchases for resale, raw materials, capitalgoods as well as other inputs for use directly or indirectlyin his business. Output tax is the tax that a dealer chargeson its sales that are subject to tax. The input tax creditis available for both manufacturers and traders forpurchase of inputs or supplies meant for sale within aswell as outside the States, irrespective of these beingutilized or sold. This results in reduction of tax liability.

Input tax paid in excess of 4% is eligible for taxcredit in respect of stock or consignment or branchtransfers of goods out of the State. Partial input tax creditis also available in respect of inputs used for manufactureof exempted goods.

Input tax credit is allowable to a registered dealerfor purchase of any goods made within the State from adealer holding a valid certificate of registration underthe Act. Input tax credit on capital goods is availablefor traders and manufacturers.

Input tax paid under the VAT Act is eligible for beingset off against Central Sales Tax payable on inter-Statesales. Therefore, excess of input tax over and abovethe output tax payable under the VAT Act can be appliedtowards Central Sales Tax payable. While taxes paid onraw materials and inputs are eligible for set off against

taxes on output, taxes paid on capital goods are noteligible for immediate set-off. The reason perhaps isthe huge credit that States may have to grant in casesof capital purchases of large value. Due to this, tax oncapital goods may be granted, but over a certain periodof time. However, the credit is limited only to capitalgoods actually used for manufacture and hence maynot be available to a trader.

In some cases, the input tax paid and taken creditof may have to be reversed, for example, when thematerial is consumed for personal purposes and notbusiness purposes, or when the input including packingmaterials is used for manufacture and/or sale as exemptgoods etc.

All tax-paid goods purchased on or after April 1,2004 and still in stock as on April 1, 2005 are eligible toreceive input tax credit, subject to submission ofrequisite documents. In respect of resellers holding tax-paid goods on April 1, 2005, the input tax credit is givenfor the sales tax already paid in the previous year. Thistax credit shall be available over a period of 6 monthsafter an interval of 3 months needed for verification.

Assessment

The VAT liability is be self-assessed by the dealerhimself. It pre-supposes that all the dealers act in anhonest manner. Scrutiny is done in cases where thereare doubts arising due to under reporting of transactionsor evasion of tax.

Audit

There shall no longer be compulsory assessment atthe end of each year. Correctness of self-assessment ischecked through a system of Department Audit. Acertain percentage of the dealers are taken up for auditevery year on a scientific basis. In case of detection ofevasions during the course of audits, the concerneddealer may be taken up for audit for previous periods.This Audit Wing remain delinked from tax collectionwing to remove any bias. The audit team conductsits work in a time bound manner and audit is completedwithin six months and the audit report is transparentlysent to the dealer as well.

Simultaneously, a cross-checking throughcomputerized system is done on the basis ofcoordination between the tax authorities of the StateGovernments and the authorities of Central Excise tocompare constantly the tax returns and set-offdocuments of VAT system of the States and those ofCentral Excise. This comprehensive cross-checking



system helps in reduction of tax evasions and lead tosignificant growth of tax revenue.

Returns

The return filing procedures are designed in such away that the compliance costs are minimum. A registereddealer is required to file a return along with the requisitedetails such as output tax liability, value of input taxcredit, and payment of VAT.

Under VAT, there are simple forms of return, whichare filed monthly, quarterly or annually as per theprovisions of various State laws. Returns are accompaniedwith the challans evidencing payment of tax. In certainStates, returns cum challan forms have been devised.In those cases, the returns along with the payment arerequired to be filed with the treasury.

Every return so furnished is required to be scrutinizedexpeditiously within the prescribed time limit from thedate of filing the return. If any technical mistake isdetected on scrutinizing, the dealer shall be required torectify the defect or pay the deficit.

Zero Rating

Zero Rating means that the tax payable on sale of acommodity is fixed at 0%. Though apparently, it lookssimilar to an exempt transaction, there is a significantdifference between the two. While in an exempttransaction, the tax paid on input lapses i.e., it cannotbe set off, under the Zero rated sales. Prior stage tax isset off against the 0% tax paid and effectively the entiretax paid on purchases is eligible for refund. Thus, ‘ZeroRating’ is advantageous to the dealer compared to‘exempting’ of sale transactions. Generally, export salesare zero-rated and thereby, exporters are granted refundof taxes paid by them on their inputs. Exporters gainsignificantly due to the ‘Zero Rating’.

Refunds

Refunds are to be granted by the end of the financialyear. Thus, the benefit of zero rating is not immediate,but deferred. Some States have also provided for refundwhere the tax paid on inputs exceeds the output taxpayable and cannot be set off in a given period. In suchcases, the excess tax not so set off shall be refundedafter adjusting any dues towards interest, penalty etc,in accordance with the State VAT Act.

Goods and Service Tax

Conceptually although not presently so in India, VATcovers both tax on sale of goods and tax on services. Infew countries such as, Singapore, Canada etc., it is known

as Goods and Service Tax. The Task Force headed byDr. Vijay Kelkar had recommended a comprehensivegoods and services tax.

Position of Company Secretaries in India

The profession of Practising Company Secretariesin India, which made a humble beginning in the sixties,has now reached greater heights. With the clear andblended knowledge of various laws that they possesshave made firms of Practising Company Secretariesversatile professionals capable of rendering wide rangeof services in diversified fields through specialist partnerswho develop expertise in VAT.

Company Secretaries in Practice have now beenrecognized in India to act as an authorized representativefor the purpose of appearing before VAT authoritiesunder Statutes of various States as well, like; WestBengal Value Added Tax Rules, 2005 under Rule2(1)(a)(iv) of the Rules; Bihar Value Added Tax Act, 2005,under Section 87(d) of the Act; Daman and Diu ValueAdded Tax Regulation, 2005, under regulation 82(1)(b)of the Regulation; and Goa Value Added Tax Act, 2005,under Section 82(1)(b) of the Act.

These States have begun the process of recognizingPractising Company Secretaries and others are boundto follow as VAT regime gets settled through out India.

In view of the Right to Information Act 2005effective from October 12, 2005 recognising the rightto information of the Citizens of India, companysecretaries are now required to be more consciencekeeper of the corporate affairs as their responsibilitieshave increased many folds in terms of filing of variousimportant documents, records with Government bodieslike, Commissioners, CBDT, CBEC, VAT authorities etc.Since the documents are of vital importance and depictinsight of the company therefore, they are entrustedwith greater responsibility so far as scrutinizing, filingand signing of the documents are concerned. This hasplaced company secretaries at an advantageous andresponsible position adding further weightage to theirroles in the changing scenario opening new vistas tothe profession of Company Secretaries in India.

CONCLUSION

Initial tax revenue benefits can be reaped fromextended geographic reach and from sharing capabilitiesin businesses that already have international elements.Longer-term revenue gains can arise from the transferof capabilities in domestic as well as cross-borderbusinesses. Once the institution has achieved substantial



size, the acquisition of large, competitively placedplayers in other countries becomes feasible.

Increasing liberalisation of the services sector hasled to an urgent need for a review of indirect tax rulesand VAT in particular. This is in order to ensure thatsuch indirect tax rules are compatible with the need forcorrect and simple VAT taxation of such supplies. Mostimportantly, it should be clear to all market players whatthe consequences of VAT are, bearing in mind thatindirect taxes are meant to be passed on to the consumerand should therefore in principle not create a burdenfor businesses.

Even, in certain EU countries as well, it has beenfelt that the unclear VAT treatment of certain transactionsgives local tax authorities a certain freedom in their owninterpretation often resulting in double taxation. Tax canno longer be taught or practised with a disregard forinternational tax and International tax can no longer bedealt with separately from domestic tax.

The major industrial powers, through theOrganization for Economic Cooperation andDevelopment (OECD), which is responsible forinternational tax treaties, have begun to focus on taxcompetition in the offshore tax havens.

At some point, this issue transforms from a taxcompetition to advanced economy protectionism withthe rich nations seen as a tax cartel maintaining thepoverty of poor nations. For instance, the U.S. can itselfbe seen as a tax haven with respect to its exclusion ontaxing foreign investment income as well as its lowincome tax rates compared to many nations. It is criticalto understand fully their own and their partner’s policiesin order to develop serving platforms with multi-countryscope.

To facilitate cross-border planning for expatriates,the VAT planning team shall be quite different from thecomposition of the team required to engage in country-specific tax planning. Cross-border practices require ateam of professionals to provide the necessary expertise.

Creating the appropriate team, involves formingstrategic alliances with other professionals and usingresources. Gaining access to cross-border planningexpertise is an important issue. To perform well, theprofessionals need more specialization in VAT than juststeady means. They must offer the potential servicesfor, growth and improved profitability in existingbusinesses. Cross border entrepreneurs must lookelsewhere for specialist partners to help in taxharmonization and expanding horizons. For example,

specialists not knowing what opportunities exist on theother side of the border, how the taxation system worksor how their social security entitlements might beaffected.

It is also true that the trails leading to cross-bordertaxation have been more thoroughly blazed in the pathof future growth. Professionals need to pay a particularattention to the structure and flexibility of processingplatforms to determine if any potential partners offercapabilities that would help them transform their taxpolicies.

Moving cross-border shall provide the specialistsadditional opportunities to reap the benefits of scale.Risk shall be diversified across markets and best practicesbe adhered to. The combination of large size andinternational scope of taxation can lower both overallcosts and unit costs as activities shall move in mostadvantageous locations. If they move early, they willdevelop the experience and scale to be a regional andglobal tax consolidator. Once the professional specialistsadopt cross border reach, they will tend to become amagnet for top talent and be well placed to capture thebest tax governance opportunities. At the same time,they need to anticipate the changing tax strategies andconsider what sort of services would allow them to builda competitively advantaged position to serve globally.While examining possible combinations, they need tohave a clear vision of what new methodology could befollowed.

The list of skills and technical knowledge requiredfor cross-border consumption tax planning specialists isvery vast, that is one of the reasons why we don’t findmany professionals specializing in this area. Cross-borderspecialists need to have a very strong technical andpractical knowledge of a number of different areas (tax,legal, estate planning, immigration/emigration issues,etc.), on both sides of the border. In addition, a cross-border specialist needs to be able to integrate all ofthese areas into one cohesive plan.

New forces coming into play shall make cross-borderconsumption taxation more feasible and capable ofcreating value. As the international tax is removing oldbarriers, professionals are taking more global perspective,paying particular attention to VAT issues. Theprofessionals that clear the cross-border hurdles will beable to gain and sustain competitive advantage in VATregime. Obstacles there may be, but they are notinsurmountable. To get started the professionals mustconcentrate and look at their current level of taxknowledge and determine how best they can improvefurther to serve globally.



In today’s changing scenario, professionals that donot investigate cross-border VAT opportunities may endup alone as markets converge and national boundariesbecome less important. The danger of waiting too longto choose a specialist partner is that the attractive onesmay quietly jump into the competition leaving othersbehind.

The cross-border practitioners need to be aware ofcompliance issues. If one is going to be working acrossborders there is a need to make sure that they arecompliant with the different regulations to which theirprofessional activities may subject them.

Since the key to growth as specialists under VATregime is, to snatch opportunities internationally in orderto have a competitive edge in dynamic cross-borderenvironment. Therefore, it becomes imperative for usto ponder upon the following issues:

1. How do the specialists grow and become bigin international scenario in the context of VATregime ?

2. Will their position change within a span of fewyears if they stay the same size ?

3. Do they possess plans to make themselvesattractive specialist partners ?

4. Do they need to be realistic about theirdomestic VAT scheme and about likely sourcesof growth. If the best opportunities clearly liecross-border, do they have to compromise inorder to integrate fully and achieve maximumbenefits ?

5. Will the professionals be able to seize the cross-border opportunities, by assessing their currentposition and vulnerability ?

6. How would they feel if they achieve success incross-border consumption taxation under VATregime ?

7. Will the specialists be able to examine potentialtargets for cross-border taxation of equals interms of possible synergies, value addition anddevelopment of future plans ?

8. Can the professionals quantify what additionalskills and technical or non-technicalcompetencies do they require while engagingin cross–border tax planning ?

REFERENCES

1. White Paper on VAT-www.finmin.nic.in.

2. Consumption Taxation and Financial Services-Cashiers De Droit Fiscal International.

3. State-Level VAT in India-A Study-ICAIPublication.

4. The Law and Practice of Income Tax-Kanga,Palkhivala and Vyas.

5. www.commodities-now.com.

6. http://www.intltaxlaw.com.

7. www.bcg.com.

8. http://www.fpanet.org/

9. http://www.pwcglobal.com.



LIMITED LIABILITLIMITED LIABILITLIMITED LIABILITLIMITED LIABILITLIMITED LIABILITY PY PY PY PY PARARARARARTNERSHIP —TNERSHIP —TNERSHIP —TNERSHIP —TNERSHIP —A NEW BUSINESS MODELA NEW BUSINESS MODELA NEW BUSINESS MODELA NEW BUSINESS MODELA NEW BUSINESS MODEL

AUROBINDO SAXENA*

INTRODUCTION

The inclination to collaborate to accomplish certaincommercial objectives has a long history. Thecommercial magnetism of such collaborations and a needto govern their business ultimately led to the codificationof corporate and partnership laws.

GENESIS AND DEVELOPMENT OF PARTNERSHIPLAWS

Corporations and Partnerships have been a primaryform of business structure for a long time now. For morethan a century, partnership law has offered an all-embracing and lucid alternative to corporate law.Although, the two bodies of law have much in common,historically they differed sharply on the role of thecontract and private ordering in structuring the firm.

Partnership law encourages private ordering throughbargaining by providing an agreement amongst partners.In contrast, corporate law historically has provided amandatory framework for firm structure highly resistantto shareholders’ attempts to define their relationshipsthrough bargaining1 . Proponents of private orderingwithin firms prefer the freedoms of partnership law tothe mandates of corporate law, and over time they haveenjoyed success in extending the bargaining model frompartnership law to corporate law.

However, certain inherent limitations of both theseforms of business have made them unsuitable for certainbusinesses. This ultimately led to the evolution of certainhybrid forms of business structures such as limitedpartnerships, limited liability partnership, limited liabilitylimited partnerships etc.

92


1 Robert W. Hillman, The Bargain in the Firm: Partnership Law, Corporate Law, and Private Ordering Within Closely-Held BusinessAssociations.

2 Hamilton 1995 at 1073.

CONCEPT OF LLP

A limited liability partnership (LLP) is a hybridcorporate business vehicle that has a perpetualsuccession and separate legal entity. It not only providesthe benefits of limited liability but also allows its partnersthe flexibility of organizing their internal structure as ageneral partnership.

The push for the creation of limited liabilitypartnership grew from several factors, such as generalincrease in the incidence of litigation for professional’snegligence and the size of claims; the risk to a partner’spersonal assets, when the claim exceeds the sum ofthe assets and insurance cover of the partnership; thegrowth in the size of partnerships; increase inspecialization among partners and the coming togetherof different professions within a partnership.

However, the concerns centered on the fact thatpartners had unlimited personal liability irrespective ofany fault or any degree of fault on the part of a particularpartner and the partners generally. The level of protectionthat a limited liability partnership affords to its partnersis an important factor that led to the proliferation of thisform of business structure. Major professional andventure capital firms around the world prefer this modelof business over the others.

The following paragraphs discuss the limited liabilitypartnership laws around the world.

LLP LAWS IN UNITED STATES

The idea for the LLP has been credited to “a twenty-odd person law firm from Lubbock,” Texas2 . Their idea,which led to the enactment of the first LLP statute in


Limited Liability Partnership — A New Business Model 93

Texas in 1991, was a reaction to the legal fallout froman economic calamity. The LLP was a direct outgrowthof the collapse of real estate and energy prices in thelate 1980s, and the concomitant disaster that befellTexas’s banks and savings and loan associations3 .

The enactment of Texas legislation allowedmembers of certain professions who were carrying onbusiness as ordinary partnerships to register as LLPs. Oncea firm was registered as an LLP, each partner wasshielded from personal liability claims against the firmarising from any future malpractice of other membersof the firm.

The “Texas model” for LLP legislation has two keycharacteristics. Firstly, its liability shield only coversprofessional malpractice claims. Secondly, the liabilityshield does not protect a professional for personalmalpractice, that is, where they are personally involvedin the wrongful conduct or have direct supervisoryresponsibility over those who are personally involved inthe wrongful conduct.

After Texas passed its LLP legislation, most otherstates quickly followed and today all 51 states havepassed laws that permit the formation of an LLP4 .

A limited liability partnership is considered as aspecial type of partnership that requires a special filingwith the State where the partners operate. Thispartnership form offers all partners the right to participatein the management and the operation of a partnershipwithout subjecting themselves to unlimited personalliability as is the case in general partnerships5.

However, if the special laws governing it are notprecisely followed, they can be held as general

partnership in a court of law. Moreover, if the partnerswant, the old partnership agreement can continue togovern the newly formed LLP. A partnership, especiallya limited liability partnership, transacting business in anystate other than the state of domicile is required toregister with the Secretary of the foreign state as a foreignpartnership6 .

LLP LAW IN JERSEY

The Channel Island of Jersey7 is a British CrownDependency8 . In 1997, Jersey enacted the LimitedLiability Partnership (Jersey) Law 1997. The driving forcethat led to the codification of the legislation was thatthe major Accountancy firms in UK were facing a numberof high profile lawsuits arising out of real/alleged auditfailures. But even after their long campaign, they couldnot secure liability concessions from the UK government.As a result they approached the Jersey Authorities inmid 1990s to enact similar legislation9.

The Jersey LLP Bill was drafted by Ernst & Youngand Price Waterhouse (now part ofPricewaterhouseCoopers), at a private cost of more than£1 million10 and was designed to dilute ‘joint andseveral’ liability and reduce the redress available to auditstakeholders11 .

The Bill was “championed by the Island’s leadingpoliticians”12 who also promised to ‘fast track’ it,effectively displacing the previously agreed legislativeprogramme13 persuading some to conclude that Jerseywas offering its ‘legislature for hire’14 to enable majoraccountancy firms (or international capital) to hold othernation-states (e.g. the UK) to ransom. The approach toJersey was accompanied by a threat that if the Britishgovernment failed to match the liability concessions,

3 Hamilton 1995 at 1069.4 See Alan R. Bromberg & Larry E. Ribstein, Bromberg & Ribstein On Limited Liability Partnerships, The Revised Uniform Partner-

ship Act, And The Uniform Limited Partnership Act (2001) 15 (Aspen 2003) (hereinafter Bromberg & Ribstein “LimitedLiability”). Some states, including New York, California, Nevada and Oregon, only offer LLP status to professional firms.

5 Margaret Bartschi, Foundations of Business Organizations for Paralegals, p. 3.6 Angela Schneeman, The Laws of Corporations, and other Business Organizations, p. 42.7 The Channel Islands consist of five island. These are Jersey, Guernsey, Sark, Herm and Alderney. Jersey is by the far the largest

of these islands. Each island has its own government.8 http://www.cia.gov/cia/publications/factbook/geos/je.html9 Cousins et al, 1999.10 The Accountant, November 1996, p. 5.11 Globalization and its discontents: Accounting firms buy limited liability partnership legislation in Jersey by Prem Sikka, University

of Essex.12 Financial Times, 26 September 1996, p. 7.13 Accountancy, September 1996, p. 29.14 Hampton and Christensen, 1999a.



the firms would relocate their operations to Jersey15 .The threat was sufficient to discipline the UK governmentand it promised similar legislation “within a week”16 .The UK government eventually enacted the LLPlegislation and the firms did not register in Jersey.

The externally drafted legislation was described bya member of Jersey parliament as “not offshore taxavoidance, on which our finance industry is built, butoffshore liability avoidance”17 .

As per the Jersey Law, an LLP is required to pay a£10,000 as registration fee, which makes it affordableonly to businesses of stature.

The Act classifies partners as 'partners' and'designated partners'. Every LLP must also have aregistered office in Jersey at which it must maintain thoserecords specified in Article 8(4) of the law, which areavailable for inspection by partners. The names andaddresses of all the partners of an LLP are also a matterof public record. Similarly, LLPs are not required to filepartnership agreement, accounts or to have theiraccounts audited; they must, however, maintain properaccounting records.

On a closer look at the provisions of the law, onefinds that the provisions are somewhat similar tolegislation in the State of Delaware (US). The law allowspartners to take an active part in the management of apartnership whilst retaining their own individual limitedliability. Every LLP is required to make a £5 millionprovision for judgments against the partnership and tocompensate creditors. This financial provision againstdebts and liabilities of the partnership are required tobe maintained throughout the life of the partnershipand are not permitted to be made the subject of asecurity or set-off18 .

Despite actually having a separate legal personality,the Jersey limited liability partnership is treated as apartnership for taxation purposes. It is rather fiscallytransparent i.e. tax is levied on the individual partner’sshare of profits rather than the overall partnership profit.In this respect the Jersey LLP is also similar to the Scottishgeneral partnership structure.

LLP LAW IN UNITED KINGDOM

In early 1997 the UK Department of Trade andIndustry (“DTI”) circulated a consultation paper thatbegins with the statement that the UK government hadannounced its intention to bring forward legislation atthe earliest opportunity to make limited liabilitypartnership available to regulated professions in the UK.As already discussed in preceeding paragraphs this wasa result of the pressure exerted by the major UKaccountancy and law firms which were expected to takeadvantage of the Jersey LLP.

The UK Limited Liability Partnerships Act 2000 cameinto force on 6 April 200119 providing limited liabilitypartnership the organisational flexibility and tax statusof a partnership with limited liability for its members.

The Act classifies partners into two categoriesnamely ‘members’ and ‘designated members’. A limitedliability partnership must have at least two, formallyappointed, designated members at all times. Designatedmembers are similar to executive or managing directorsand the company secretary of a company. If there arefewer than two designated members then every memberautomatically becomes a designated member. By virtueof section 24 of the UK Companies Act 1985, where alimited liability partnership continues for more than sixmonths with a single member, then that memberbecomes liable jointly and severally with the LLP forthe debts of the firms contracted for during that period.

The management structure of a limited liabilitypartnership is governed by its agreement amongmembers and LLP and members inter se. The agreementshould cover the sort of issues dealt within a normalpartnership agreement. It is however not mandatory tofile the same with the Registrar. The First Schedule ofthe Act provides for certain default provisions whichare applicable if the members agreement is silent on acertain issue.

A limited liability partnership is also considered tobe a ‘Legal Person’ in its own right, and can operate inthe same way as a company in most respects. Howeverone important difference between an LLP and a limitedcompany is the way in which the profits are taxed, with

15. Cousins et al., 1998.

16 Financial Times, 28 June 1996, p. 22; 24 July 1996, p. 9.

17. Jersey Evening Post, 25 July, 1996, p.1.

18 Jersey Evening Post, 25 July 1996, p. 1.

19. http://www.volaw.com/pg405.htm



each member of the partnership being taxed accordingto the share of the profits that they receive rather thanthe LLP paying tax directly on its profits.

A LLP is required to produce and publish financialaccounts with a similar level of details to a similar sizedlimited company and to submit accounts and an annualreturn to the Registrar of Companies each year. Thisrequirement is far more demanding than the positionfor normal partnerships and some specific accountingrules may lead to different profits from those of a normalpartnership. Further, the Act applies the provisions ofcompany law and insolvency law, with appropriatemodifications, to LLPs.

LLP LAW IN SINGAPORE

In Singapore, a Study Team on Limited Partnerships(“LPs”) and Limited Liability Partnerships (“LLPs”) wasset up by the Ministry of Finance in November 2002, towork out the details of the legal framework governinglimited partnerships and limited liability partnerships. TheSingapore Limited Liability Partnership Act, 2005 cameinto effect on April 11, 2005. By having a close look atthe legislation, one can conclude that the SingaporeLLP Act is broadly modelled on the Delaware RevisedUniform Partnership Act (the “Delaware Code”).

A LLP is required at all times to have at least twopartners, with the exception that if the LLP is left withonly one partner, the remaining sole partner is given agrace period of up to two years to find a new partner. Ifthe LLP continues with less than two partners for morethan two years, the remaining sole partner assumesunlimited liability and is vulnerable to winding-up bythe courts.

It is mandatory for a LLP to have a local managerwho is a natural person aged twenty one years and aboveand does not have a questionable character and mustalso meet other requirements specified under the LLPRegulations, including those pertaining to solvency. Oneof the important characteristics of a manager is that heneed not be a partner of the LLP.

Although the LLP structure is available to all typesof businesses yet it is not subject to full financial reportingand disclosure requirements, for example, relating toits capital contributions and changes to capital, makingthis a suitable vehicle for small businesses and new start-ups. Further, it is also not mandatory to file the partnershipagreement with the Registrar.

LLPs are required to ensure that the partnershipname is followed by the words ‘limited liabilitypartnership’ or the acronym ‘LLP’. Invoices and official

correspondence are also required to carry the name,registration number and a statement that the partnershipis registered with limited liability. Additionally, LLPsformed by conversion of existing unlimited partnershipsare required to carry a statement regarding the conversionand the effective date on all official correspondenceand invoices for 12 months commencing 14 days afterthe date of registration.

LLPs are also required to file a declaration ofsolvency or insolvency, which will be publicly available.Failure to file a declaration of solvency implies insolvencyleaving the LLP vulnerable to winding-up action bycreditors. As a measure of creditor protection, there isa claw-back mechanism, which allows LLPs to recoveramounts distributed to its partners within a period ofthree years preceding the commencement of thewinding up of an LLP.

INDIAN SCENARIO

In India, businesses mainly operate as companies,sole proprietorships and partnerships. Each of thesebusiness structures has its own advantages andshortcomings and is subject to different regulatory andtax regimes. The idea that there should be theopportunity in India to organize as an LLP emerged outof the Report of the Naresh Chandra Committee onRegulation of Private Companies and Partnership andReport of the Dr. J. J. Irani Expert Committee onCompany Law. After studying the major LLP statutesaround the World it is suggested that the Singapore LLPAct, 2005 along with the Indian Companies Act, 1956with apposite adaptations and modifications may form abase to the Indian LLP statute.

ISSUES FOR CONSIDERATION

Some of the important issues that need indepthanalysis, debate, discussion and deliberations are asunder:

1. Whether LLP form of business structure shouldbe made available to Professionals only ?

2. Whether LLP Agreement should be mademandatory to be filed with the Registrar ?

3. What contents of the LLP agreement shouldbe filed with the Registrar ?

4. Whether foreign individuals should be allowedto be a partner or not ?

5. Whether LLPs should be allowed to have onegeneral partner with unlimited liability or not ?

6. Whether manager should be a partner of LLPor not ?



7. Whether LLP should have a limit on the numberof partners it can have ?

8. What should be the extent of liability of apartner ?

9. How should the LLPs be taxed ?

10. What should be the disclosure requirementsfor an LLP ?

11. What should be the procedure for existing firms,private companies and unlisted publiccompanies to convert to LLP ?

12. How should the Act deal with foreign LLPs ?

13. What should be the procedure for the merger,amalgamation and demerger of LLPs ?

14. What should be the procedure for the windingup and dissolution of LLPs ?

15. What provisions of the Companies Act, 1956should apply to LLPs ?

16. What all other legislations, rules, regulationsand procedures need to be amended forfacilitating a smooth entry of LLPs ?

17. What can be the various forms of contribution?

18. Whether a partner can bring his share ofcontribution in installments ?

19. For how long an LLP should be allowed to carryon business with less than two partners ?

20. Should the audit of financial records be mademandatory for all LLPs ?

21. Should LLPs be required to file an annual reportwith the Registrar ?

22. What should be the period of claw back ?

23. What should be the disqualifications of a partnerand manager ?

24. Whether the provision for compulsory insurancefor LLPs be provided ?

25. Who shall regulate and administer the LLPs ?

CONCLUSION

Following international trends, predominantly thosein the United States of America, United Kingdom andSingapore, the debate on Limited Liability Partnership(LLP) structure in India is recent one. This structure isrecognized as the “world’s best practice” structure,

designed to not only attract venture capital from offshoreinstitutional investors but also to retain domesticinvestment. Some of the advantages of this form ofbusiness structure include low cost of incorporation,unlimited capacity, limited individual liability, flexiblemanagement structure, tax benefits and less audit andfiling requirements.

However, at the same time this form of businessstructure is susceptible to abuse as well. Probably theweakest link is the private limited liability partnershipagreement. Especially, after the Enron collapse, it is feltthat limited liability has a degree of correlation withprofessional lapses and malpractices. The OECD alsoidentifies limited liability partnership as being a corporatevehicle, which is vulnerable to misuse, principally forthe reason that it is less regulated than corporations.

The limited liability partnership form of businessstructure is keenly awaited in India. However, suchintroduction will require amendments in severallegislations and Regulations. Therefore, an in-depthunderstanding of the concept is inexorable.

References

1. Alberta Law Review, (1998). Limited LiabilityPartnerships and other hybrid business entities,Edmonton, Alberta Law Reform Institute.

2. Angela Schneeman, The Laws of Corporations,and other Business Organizations, ThomsonDelmar Learning, p. 42.

3. Jonathan Walker, Limited Liability Partnerships:True Partnerships ?

4. Joseph A McCahery, Theo Raaijmakers, Erik PM Vermeulen, The Governance of CloseCorporations and Partnerships: Us and EuropeanPerspectives, Oxford University Press, p. 361.

5. Linda L Crawford, Edward J O’Donnell, FloridaReal Estate Broker’s Guide, Dearborn RealEstate Education, p. 30.

6. Linda L. Crawford, David S. Coleman, FloridaReal Estate Principles, Practices & Law, DearbornReal Estate Education, p. 89.

7. Margaret Bartschi, Foundations of BusinessOrganizations for Paralegals, Thomson DelmarLearning, p. 3.

8. Michael K de Chiara, Michael S Zetlin, NewYork Construction Law, Aspen Publishers, p. 21.



9. Morris, P., and Stevenson, J., (1997a). TheJersey Limited Liability Partnership; A New LegalVehicle for Professional Practice, Modern LawReview, Vol. 60, pp. 538-551.

10. Morris, P., and Stevenson, J., (1997b).Accountancy Firms and the Jersey LimitedLiability Partnership, Business Law Review, April,pp. 80-83.

11. Robert W. Hillman, The Bargain in the Firm:

Partnership Law, Corporate Law, and PrivateOrdering Within Closely-Held BusinessAssociations.

12. Scott E. Waxman and Eric N. Feldman,Delaware Limited Liability Partnerships.

13. Sikka, P., (1996b). Secrecy is the aim of thosewho want limited liability in Jersey ”,Accountancy Age, 5 September, p. 10.



CODES OF CORPORACODES OF CORPORACODES OF CORPORACODES OF CORPORACODES OF CORPORATE GOTE GOTE GOTE GOTE GOVERNVERNVERNVERNVERNANCE :ANCE :ANCE :ANCE :ANCE :AN ASIAN PERSPECTIVEAN ASIAN PERSPECTIVEAN ASIAN PERSPECTIVEAN ASIAN PERSPECTIVEAN ASIAN PERSPECTIVE

SHIKHA KATOCH*

GENESIS OF CORPORATE GOVERNANCE

Corporate Governance systems have evolved overseveral decades, often in response to corporate failuresor systemic crises. The first well-documented failure ofgovernance was the South Sea Bubble in the 17thcentury, which revolutionized business laws and practicesin England. Similarly, much of the securities laws in USwere put in place following the stock market crash of1929. There has been no shortage of other crises either,such as the secondary banking crises of the 1970s inUK and savings and loan debacle of the 1980s in US. Inaddition to these major crises, history of corporategovernance is also punctuated by a series of well-knowncorporate failures. Each crises or major corporate failure,often a result of incompetence, fraud and abuse, wasmet by an improved and more effective system ofcorporate governance.

Through this process of continuous change,developed countries have established a complex mosaicof laws, regulations, institutions in the Govt. and privatesector. The purpose was not to shackle corporations butrather to balance the promotion of enterprise withgreater accountability. The systematic enforcement oflaw and regulations has created a culture of compliancethat has shaped business culture and the managementethos of firms, spurring them to improve as a means ofattracting human and financial resources on the bestpossible terms. This continuous process of change andadaptation has accelerated with the increasing diversityand complexity of shareholders and stakeholders.

The developing world has also faced its owncorporate governance challenges. The economic crisisin Asia, which started in July 1997 in Thailand andaffected currencies and stock markets of several AsianCountries, demonstrated how macro economicdifficulties can be intensified by a systemic failure ofcorporate governance stemming from weak legal and

98


regulatory systems, inconsistent accounting and auditingstandards, ineffective oversight by corporate board ofdirectors and little regard for the rights of minorityshareholders.

CODES OF BEST PRACTICES FOR CORPORATEGOVERNANCE

Codes of Best Practices for Corporate Governanceare important tools in corporate governance reformbecause they raise awareness and help build consensusand ownership of reform processes and outcomes. Theyare non-binding rules that go beyond the law, takingcountry-specific conditions into account and oftenexceeding the standards set by international guidelines.While adherence to such codes and standards is voluntary,compliance by specific companies sends a signal toinvestors to help them identify companies that matchtheir criteria for investment. Since the release of theCadbury Report, the importance of corporate governancestandards and codes has become increasinglywidespread. For example, countries such as Singaporehave recently released its Code of corporate governance.

In the context of corporate governance, codes tendto be adapted to the country’s economic environmentand to address the countries’ most serious governanceproblems. Despite differences between and amongcountries, codes tend to make similar recommendationsregarding the behavior of the board, protecting the rightsof shareholders by tackling, primarily, the transparencyand accountability of board practices throughencouraging an increase in the number of directors notpart of the company’s management and the creation ofsub-committees of boards.

As stated above, successive corporate failures havebeen responsible for focused attention on corporategovernance. This led to the evolution of Codes by thecountries all over the world to suit their domestic


Codes of Corporate Governance : An Asian Perspective 99

requirements. Similarly, the international organisationssuch as World Bank, Organization for EconomicCooperation and Development, CommonwealthAssociat ion of Corporate Governance, Euroshareholders etc. have also lent support to the causeby bringing out their own principles, codes andguidelines on Corporate Governance.

CODES OF CORPORATE GOVERNANCE IN ASIA

In Asia, approximately two-thirds of listedcompanies, and substantially all private companies, arefamily-run. Over the last several decades, the collectivetalents and efforts of these family-business owners haveresulted in strong economic growth and substantialincreases in living standards. A particular characteristicof the Asian corporate landscape, however, is atendency for such individuals (and their families) toestablish large interlocking networks of subsidiaries andsister companies that include partially-owned, publicly-listed companies. On the one hand, the use of suchsubsidiaries and sister companies permits investors notonly to place their money with the management teamof their choice, but to direct this money to the marketsand industries in which particular subsidiaries specialiseand which investors believe hold the greatest potentialfor profits. On the other hand, such pyramidal structurescan lead to severely inequitable treatment ofshareholders. By conducting operations through acomplex network of subsidiaries, controllingshareholders acquire control of operations and/or cashflows disproportionate to their equity stake in individualcompanies. The extent of this disproportionate controlis frequently opaque to outsiders and undisclosed byinsiders. A particular challenge for corporate-governancereform in Asia is, therefore, to encourage the dynamismand growth of family businesses while channelling theirenergies and operations into structures that are moretransparent and, consequently, more clearly equitablefor non-family investors.

The Asian business landscape comprises considerablelegal and economic diversity. With respect to legaltraditions, Hong Kong, China, India, Pakistan andMalaysia, for example, have common law frameworks.Thailand and the Philippines have frameworks based onFrench civil law, while China, Chinese Taipei and SouthKorea draw upon German civil law traditions. Stateownership of enterprises remains strong, particularly inChina and India, where aspects of stakeholder relationsmay draw upon or reflect elements of socialist law.Overlaying these legal traditions in many countries arebehavioural norms arising from various cultural andreligious traditions.

Since the 1997 financial crisis, Asian regimes havemade considerable progress in raising awareness of thevalue of good corporate governance. To a large degree,raising awareness means convincing people thatcorporate governance is in their self-interest. Many Asianbusiness leaders and controlling shareholders are thusbeing challenged to re-think their relationships with theircompanies and with the minority shareholders who layclaim to partial ownership in them. Such re-orientationin thinking requires not only a strong nationalcommitment to corporate governance, but one that isalso broad-based. Over the past several years, mostAsian jurisdictions have substantially revamped their laws,regulations and other formal corporate-governancenorms. The corporate landscape in most Asian countriesis characterised by concentrated ownership. In manyAsian jurisdictions, there have been instances wherecontrolling shareholders of family dominated, publicly-listed companies and other enterprises with concentratedownership have abused their control to exploit othershareholders. Regionally, exploitation of non-controllingshareholders has been identified as the most seriouscorporate-governance challenge.

The Asian Corporate Governance Associationrecently released the latest version of “CG Watch 2004”,their annual survey of corporate governance in Asia.Titled “Spreading the word: Changing rules in Asia”,the report covers corporate governance standards in 10Asian markets and 450 large listed companies. In thesurvey, it has been found that despite the large amountof new rules in Asia in recent years in areas such asdisclosure, board independence and accounting/auditingstandards, there is still a long way to go before the regionhas a truly robust legal and regulatory regime forcorporate governance.

In Asia, three-quarters of the region’s majoreconomies have a code of best practice or are developingone (Hong Kong, India, Indonesia, Japan, Korea,Malaysia, Singapore and Thailand all have codes).Although this process started before the financial crisisin some common law jurisdictions in Asia, it was therecession that opened the floodgates to a fundamentalrethinking as to how companies should be governed infuture.

COMPARATIVE ANALYSIS OF ASIAN CODES OFCORPORATE GOVERNANCE

China

The main guardian of corporate governance in Chinais the China Securities Regulatory Commission. This isreflected in the Code of Corporate Governance that



was issued by the China Securities RegulatoryCommission (CSRC) in 2002. This Code has more formalauthority than similar codes in other countries due tothe administrative pressure that the Commission maybe able to impose on listed companies that fail tocomply with them. However, this applies mainly to themandatory provisions of the Code, with companies atleast seeking to meet the minimum standards that theCode requires. The Code sets forth, among other things,the basic principles for corporate governance of listedcompanies in China, the means for the protection ofinvestors’ interests and rights, the basic behavior rulesand moral standards for directors, supervisors, managersand other senior management members of listedcompanies.

The Code is applicable to all listed companies withinthe boundary of the People’s Republic of China. Listedcompanies are required to act in the spirit of the Codein their efforts to improve corporate governance. TheCode is the major measuring standard for evaluatingwhether a listed company has a good corporategovernance structure, and if major problems exist withthe corporate governance structure of a listed company,the securities supervision and regulation authorities caninstruct the company to make corrections in accordancewith the Code. The salient features of Code are:

— The corporate governance structure of acompany shall ensure fair treatment toward allshareholders, especially minority shareholders.All shareholders are to enjoy equal rights andto bear the corresponding duties based on theshares they hold.

— Besides ensuring that shareholders’ meetingsproceed legally and effectively, a listedcompany shall make every effort, including fullyutilizing modern information technology means,to increase the number of shareholdersattending the shareholders’ meetings.

— Written agreements shall be entered into forrelated party transactions among a listedcompany and its connected parties. Suchagreements shall observe principles of equality,voluntarity and making compensation for equalvalue. The contents of such agreements shallbe specific and concrete. Matters such as thesigning, amendment, termination and executionof such agreements shall be disclosed by thelisted company in accordance with relevantregulations.

— Institutional investors shall play a role in theappointment of company directors, the

compensation and supervision of managementand major decision-making processes.

— Listed company shall be separated from itscontrolling shareholders in such aspects aspersonnel, assets and financial affairs, shall beindependent in institution and business,practice independent business accounting, andindependently bear risks and obligations.

— A company shall establish a standardized andtransparent procedure for director election inits articles of association, so as to ensure theopenness, fairness, impartialness andindependence of the election.

— A listed company shall introduce independentdirectors to its board of directors in accordancewith relevant regulations. Independent directorsshall be independent from the listed companythat employs them and the company’s majorshareholders. An independent director may nothold any other position apart from independentdirector in the listed company.

— The board of directors of a listed company mayestablish a corporate strategy committee, anaudit committee, a nomination committee, aremuneration and appraisal committee andother special committees in accordance withthe resolutions of the shareholders’ meetings.The audit committee, the nominationcommittee and the remuneration and appraisalcommittee shall be chaired by an independentdirector, and independent directors shallconstitute the majority of committees.

— The supervisory board of a listed company shallbe accountable to all shareholders. Thesupervisory board shall supervise the corporatefinance, the legitimacy of directors, managersand other senior management personnel’sperformance of duties, and shall protect thecompany’s and the shareholders’ legal rightsand interests.

— Supervisors shall have professional knowledgeor work experience in such areas as law andaccounting. The members and the structure ofthe supervisory board shall ensure its capabilityto independently and efficiently conduct itssupervision of directors, managers and othersenior management personnel and to superviseand examine the company’s financial matters.

— A listed company shall establish fair andtransparent standards and procedures for the



assessment of the performance of directors,supervisors and management personnel.

— The evaluation of the directors andmanagement personnel shall be conducted bythe board of directors or by the remunerationand appraisal committee of the board ofdirectors. The evaluation of the performanceof independent directors and supervisors shallbe conducted through a combination of self-review and peer review.

— Information disclosure is the ongoingresponsibility of listed companies. A Listedcompany shall truthfully, accurately, completelyand timely disclose information as required bylaws, regulations and the company’s articles ofassociation.

— When controlling shareholders increase ordecrease their shareholding or pledge thecompany’s shares or when the actual controlof the company transfers, the company and itscontrolling shareholders shall timely andaccurately disclose relevant information to allshareholders.

Hongkong

Hong Kong enjoys the distinction of being the firstplace in Asia to produce an official code of best practicebefore the Asian crisis. It released its Code in 1993,inspired in large part by the publication of the CadburyReport in the UK in the year 1992. It remained theshortest code in Asia (at just over a page) and the mostnarrowly focused. Unlike more recent Asian codes,which all aim to cover the gamut of modern disclosureand accountability issues facing listed companies, theHong Kong Code (1993) was limited to a few generalstatements about board meetings and the role ofdirectors, with a brief reference to audit committees

Hong Kong’s progress on the corporate governancefront is well recognised by bodies such as theInternational Monetary Fund, which in its 2004 report,commended Hong Kong for its corporate governanceimprovements. On November 19, 2004, the StockExchange of Hong Kong published a final report on itsnew “Code on Corporate Governance Practices” (initiallyreleased in late January 2004 for public comment). Thenew Code is a big improvement on Hong Kong’s originalCode of Best Practice, a terse document dating back to1993. It has been published in conjunction with a newset of rules requiring issuers to include a “corporategovernance report” in their annual reports.

The Code on Corporate Governance Practices setsout the principles of good corporate governance, andtwo levels of recommendations: (a) code provisions; and(b) recommended best practices. Issuers must statewhether they have complied with the Code Provisionsset out in the Code for the relevant accounting periodin their interim reports and annual reports. In the caseof the Recommended Best Practices, issuers areencouraged, but are not required, to state whether theyhave complied with them and give considered reasonsfor any deviation. Issuers are expected to comply with,but may choose to deviate from the code provisions.The recommended best practices are for guidance only.Issuers may also devise their own code on corporategovernance practices on such terms, as they may considerappropriate.

In each section, the Code sets out the CodeProvisions and/or Recommended Best Practices,together with the underlying principles of the relevantprovisions to assist listed issuers in developing their owncode of board practices.

The Code has five sections dealing with directors,remuneration of directors and senior management,accountability and audit, delegation by the Board andcommunication with shareholders. The highlights of theCode are as follows:

— There are two key aspects of the managementof every issuer – the management of the boardand the day-to-day management of the issuer’sbusiness. There should be a clear division ofthese responsibilities at the board level toensure a balance of power and authority, sothat power is not concentrated in any oneindividual.

— The board should include a balancedcomposition of executive and non-executivedirectors (including independent non-executivedirectors) so that there is a strong independentelement on the board, which can effectivelyexercise independent judgment Non-executivedirectors, should be of sufficient caliber andnumber for their views to carry weight.

— An issuer should appoint independent non-executive directors representing at least one-third of the Board.

— There should be a formal, considered andtransparent procedure for the appointment ofnew directors to the board. There should beplans in place for orderly succession forappointments to the board. All directors should



be subject to re-election at regular intervals.An issuer must explain the reasons for theresignation or removal of any director.

— Every newly appointed director of an issuershould receive a comprehensive, formal andtailored induction on the first occasion of hisappointment, and subsequently such briefingand professional development as is necessary,to ensure that he has a proper understandingof the operations and business of the issuerand that he is fully aware of his responsibilitiesunder statute and common law, the ExchangeListing Rules, applicable legal requirements andother regulatory requirements and the businessand governance policies of the issuer.

— All directors should participate in a programmeof continuous professional development todevelop and refresh their knowledge and skillsto help ensure that their contribution to theboard remains informed and relevant. The issuershould be responsible for arranging and fundinga suitable development programme.

— The board of directors of a listed companyshould establish an audit committee, anomination committee, and a remunerationcommittee. Board Committees should beformed with specific written terms of reference,which deal clearly with the committees’authority and duties.

India

In India Confederation of Indian Industry (CII) tooka special initiative on Corporate Governance – the firstinstitutional initiative in Indian industry. The objectivewas to develop and promote a code for CorporateGovernance to be adopted and followed by Indiancompanies, be these in the Private Sector, the PublicSector, Banks or Financial Institutions, all of which arecorporate entities. The final draft of this code was widelycirculated in 1997. In April 1998, the code was released.It was called Desirable Corporate Governance: A Code.The salient features of the Code are as under:

— The Board should have a core group of excellent,professionally acclaimed non-executive directorswho understand their dual role of appreciatingthe issues put forward by management, and ofhonestly discharging their fiduciaryresponsibilities towards the company’sshareholders as well as creditors.

— For non-executive directors to play an important

role in corporate decision-making andmaximizing long-term shareholder value, theyneed to become active parts and not relegatedecisions in board into passive advisors; haveclearly defined responsibilities within the Boardsuch as Audit Committee; and

— Know how to read a balance sheet, profit andloss account, cash flow statements and financialratios and have some knowledge of companylaws. This, of course, excludes those who areinvited to join boards as experts in other fieldssuch as science and technology.

— It would be desirable for Financial Institutionsas pure creditors to re-write their covenants toeliminate having nominee directors except inthe event of serious and systematic debt defaultan in case of the debtor company not providingsix monthly or quarterly operational data to theFIs concerned.

Following CII’s initiative, the Securities andExchange Board of India (SEBI) set up a committee underthe chairmanship of Kumar Mangalam Birla to promoteand raise the standards of corporate governance. TheBirla Committee Report was approved by SEBI inDecember 2000. The said report led to introduction ofClause 49 in the listing agreement requiring companiesto comply with the corporate governance norms.

Following CII and SEBI, the Department of CompanyAffairs (DCA) modified the Companies Act, 1956 toincorporate specific corporate governance provisionsregarding independent directors and audit committees.Then came the Companies (Amendment) Act, 2000which introduced many provisions relating to CorporateGovernance like additional grounds of disqualificationof directors in certain cases, setting up of auditcommittees, Directors’ Responsibility Statement in theDirectors’ Report etc.

The Enron debacle of 2001 involving the hand-in-glove relationship between the auditor and the corporateclient, the scams involving the fall of the corporate giantsin the U.S. like the WorldCom, Qwest, Global Crossing,Xerox and the consequent enactment of the stringentSarbanes Oxley Act in the U.S. were some importantfactors which led the Indian Govt. to wake up and inthe year 2002 Naresh Chandra Committee was appointedto examine and recommend inter alia drasticamendments to the law involving the auditor-clientrelationships and the role of independent directors. In2002 SEBI analyzed the statistics of compliance withthe Clause 49 by listed companies and felt that there



was a need to look beyond the mere systems andprocedures if Corporate Governance was to be madeeffective in protecting the interest of the investors. SEBItherefore constituted a committee under theChairmanship of N.R.Naranyana Murthy, Chairman andMentor of Infosys Technologies Ltd. and mandated thesaid committee to interalia review the performance ofCorporate Governance in India and make appropriaterecommendations. The Committee submitted its reportin the year 2003. On the basis of recommendations ofthe Committee SEBI revised the Clause 49 of ListingAgreement. However SEBI received representations/suggestions from the corporate/public on variousprovisions in the revised clause. The Narayan MurthyCommittee then considered and deliberated on thesuggestions and comments received from corporate/public. Based on the revised recommendations of thCommittee, it was decided to further revise theprovisions of Clause49 of the Listing Agreement. Therevised clause will be effective from January 1, 2006.

Recently the Ministry of Company Affairs has setup National Foundation for Corporate Governance(NFCG) in partnership with CII, ICAI and ICSI. The NFCGwould focus on the following areas:

— Creating awareness on the importance ofimplementing good corporate governancepractices both at the level of individualcorporations and for the economy as a whole.The foundation would provide a platform forquality discussions and debates amongstacademicians, policy makers, professionals andcorporate leaders through workshops,conferences, meetings and seminars.

— Encouraging research capability in the area ofcorporate governance in the country andproviding key inputs for developing laws andregulations, which meet the twin objectives ofmaximizing wealth creation and fair distributionof this wealth.

— Working with the regulatory authorities atmultiple levels to improve implementation andenforcement of various laws related tocorporate governance.

— In close coordination with the private sector,work to instill a commitment to corporategovernance reforms and facilitate thedevelopment of a corporate governanceculture.

— Cultivating international linkages andmaintaining the evolution towards convergence

with international standards and practices foraccounting, audit and non-financial disclosure.

— Setting up of ‘National Centres for CorporateGovernance’ across the country, which wouldprovide quality training to Directors as well asproduce quality research and aim to receiveglobal recognition.

Indonesia

Since 2000, Indonesia has taken important steps toaddress the weaknesses that contributed to theeconomic crisis of 1997. As a result, the corporategovernance framework has been strengthened. Theequity markets grew significantly in 2003. The equitymarkets relative to other East Asian countries, however,remain small, with a market capitalization ofapproximately 26 percent of the GDP in 2003. Theownership structure of companies in Indonesia ischaracterized by concentrated ownership, family-ownedbusinesses, and controlling shareholders. The businessculture is known to be relationship-based rather thanrule-based. Most listed companies are either controlledby families or, in the case of state-owned enterprises,by the government.

The companies incorporated under the IndonesianCompany Law has two boards (thus called the two-boardsystem) the Board of Commissioners (Komisaris) thatperforms the supervisory and advisory roles, and theBoard of Directors (including management) that performsthe executive role. Thus, someone who is called a“director” in an Indonesian setting is actually part ofthe executive team, whereas in other jurisdictions theymight be part of the supervisory/advisory team or partof the executive team.

In 1999, the National Committee on CorporateGovernance was established through a ministerialdecree. It is responsible for strengthening, disseminating,and promoting good corporate governance principles inthe private sector. Since its establishment, it hasdeveloped a Code of Good Corporate Governance inthe year 2001, which is an improvement from theprevious version of the Code, which was developed inthe year 2000.

The salient features of the Code are as follows:

— The rights of the shareholders shall be protectedand, accordingly, shareholders shall be able toexercise their rights through reliance uponappropriate procedures that have been adoptedby the Company concerned, which procedures



shall be required under applicable regulationshaving the force of law.

— Shareholders owning a controlling interest in acompany shall be mindful of theirresponsibilities as shareholders when theyexercise any influence over corporatemanagement, whether by the exercise of theirvoting rights or otherwise. Any unlawfulintervention in the management of thecompany should be addressed through greatertransparency, accountability of management andultimately resolved by prevailing law. Minorityshareholders also have correspondingresponsibilities to the effect that they do notmisuse their rights under the prevailingregulations having the force of law.

— Shareholders of the same kind of shares shallbe treated equitably based on the principle thatshareholders of the same kind of shares haveequitable position in the company.

— The Dewan Komisaris (Commissioners) shall beresponsible and shall have the authority tosupervise the actions of Direksi (Board ofManaging Directors) and shall give advise tothe Direkshi when required. To assist it in doingso, the Dewan Komisaris may, pursuant to theprocedures it has adopted, retain independentprofessional advisors and/or establish specialcommittees. Each member of the DewanKomisaris shall be a person of good characterand shall have relevant experience.

— The Dewan Komisaris shall establish atransparent system for (a) the appointment ofthe executives who are not members of theDireksi; (b) the determination of theirremuneration; and (c) the evaluation of theirperformance.

— The Dewan Komisaris shall consider to establishfrom among their members certain committeesto support the implementation of the tasks ofthe Dewan Komisaris. Those Committees areNomination Committee, RemunerationCommittee, Insurance Committee, and AuditCommittee.

— The Direksi are charged with the overallmanagement of the company. The Direksi shallbe responsible for the implementation of theirduties to the shareholders at the GeneralMeeting of Shareholders.

— The Direksi (Board of Managing Directors)should be composed in such a way that its

members act independently by means that theyshall hold no interests that might impair theirability to perform their duties independentlyand critically. Depending on the specificcharacter of the Company, at least 20% of themembers of the Direksi should be “outsidedirectors” in order to increase the effectivenessof its management role, and the transparencyof its deliberations. Such members of theDireksi shall be independent from the DewanKomisaris (Board of Commissioners) andcontrolling shareholders.

— Stakeholders shall be provided with anopportunity to monitor and offer input to theCompany’s Direksi. Whereas, the Companyshall provide stakeholders with relevantinformation necessary for protecting their rights.The Company will cooperate with stakeholdersfor their mutual benefit.

— In addition to the contents of the annual reportrequired by prevailing regulations having theforce of law, companies shall take initiative todisclose not only matters required under theregulations having the force of law, but alsothose of material importance to the decision-making of institutional investors, shareholders,creditors and other stakeholders with respectto such matters such as but not limited to thecompany’s objectives, business goals andstrategies, status of major shareholders and allother shareholders and pertinent informationon the exercise of shareholders’ rights.

Korea

Having been battered by the Asian crisis and withheavily indebted local conglomerates, Korea has movedforward aggressively on corporate governance reform.In early 1998, the Korea Stock Exchange ruled that listedcompanies must allocate 25 per cent of their board seatsto independents (a proportion that has since been raisedto 50 per cent from 2001 for the biggest companies).And in September 1999, Korea published its “Code ofBest Practice for Corporate Governance”. One of themost comprehensive and ambitious of its kind in Asia,the code states in its preamble: “Corporations are theentities that create new economic value. And thecompetitiveness of businesses is crucial in determiningthe competitiveness of a country. Korean corporationsmust also take progressive and proactive measurestowards meeting the global trend to survive internationalcompetition. A faultless corporate governance system -



this is a major factor in making investment decisionsthe globalised capital market.”

The contents of the Code consist of five sectionsand recommendations viz. Preamble, Shareholders, Boardof Directors, Audit Systems, Stakeholders, andManagement Monitoring by the Market. For eachsection, the code is presented, along with appendednotes to aid understanding. The salient features of theCode are as follows:

— Shareholder rights shall be protected, andshareholders shall be able to exercise their rightsthrough proper procedure. Shareholders shallbe treated equitably under the principle ofshareholder equality. Controlling shareholdershave the corresponding responsibilities whenthey exercise any influence toward thecorporate management other than the exerciseof voting rights.

— Shareholders, as owners of the corporation,possess basic rights including interalia a rightto participate in profit sharing; a right both toattend and to vote at general shareholdermeetings; a right to obtain relevant corporateinformation in a timely and regular manner.

— Shareholders shall hold fair voting rightsaccording to the type and number of sharespossessed, and all shareholders shall equally bein possession of corporate information.

— The Board shall be composed so as to alloweffective decision-making and supervision ofthe management. The number of directors shallbe such that it allows the Board to have fruitfuldiscussions and to make appropriate, swift andprudent decisions. For large public corporations,it is highly advised that the number of directorson the Board be appropriate for effectivelymanaging internal committees.

— The Board shall include outside directors capableof performing their duties independently fromthe management, controlling shareholders andthe corporation. The number of outside directorsshall be such that the Board is able to maintainpractical independence. Particularly, it isrecommended that financial institutions andlarge-scale public corporations graduallyincrease the ratio of outside directors to overhalf of the total number of directors (minimumthree outside directors).

— Outside directors shall hold no interests thatmay hinder their independence from the

corporation, management or controllingshareholder. The outside director shall submita letter of confirmation, which the corporationshall disclose, stating that he holds no interestsaffiliated with the corporation, management orcontrolling shareholder at the time of hisconsent to the appointment.

— To have the Board run efficiently, committeescomposed of some of the directors may beestablished within the Board. The Board may,if necessary, establish internal committees thatperform specific functions and roles, such asthe Audit, Operation and RemunerationCommittees.

— Rights of stakeholders according to the law andcontract shall be protected, and stakeholdersshall hold appropriate means of redress forinfringement of rights. Corporations shallobserve creditor protection proceduresconcerning matters, such as mergers, capitaldecrease and split mergers, which greatly affectthe position of creditors. The corporations shallnotify beforehand the creditors concerned formatters that may bring changes in the creditors’priority, or may have material influence on thepossibility of collecting credit.

— Corporations shall not be negligent in theirsocial responsibilities such as consumerprotection and environmental protection.

— Corporations shall disclose material informationin a timely and accurate manner. Corporationsshall disclose any information, not just limitedto those required under law that may materiallyinfluence the decision-making of shareholdersand other stakeholders.

Malaysia

In Malaysia, historically, while developmentalinitiatives to improve the various aspects of the legaland institutional framework for corporate governancehave progressed on a periodic and ongoing basis, thefinancial crisis provided the further impetus necessaryfor the adoption of a concerted and holistic approachtowards corporate governance reform by bothGovernment and industry.

In March 1998, a high level Finance Committee onCorporate Governance, comprised of both governmentand industry was formed for the purpose of swiftlyidentifying and dealing with weaknesses highlighted bythe crisis in the then existing governance framework.



The Finance Committee’s findings, which were reportedthrough the publication of the Finance Committee Reporton Corporate Governance in March 1999, representsthe end-product of an extensive collaborative effortbetween government and industry, with theimplementation of key aspects of the Report, such asthe introduction of the Malaysian Code on CorporateGovernance, having been spearheaded by industry.

The Malaysian Code on Corporate Governance,released in March 2000, provides a set of principlesand best practices for companies on corporategovernance. The Code is the product of an industry-ledworking group, established under the auspices of theFinance Committee on Corporate Governance. TheCode sets out four forms of recommendations. Part 1sets out broad principles of good corporate governancefor Malaysia. Part 2 sets out best practices for companies.Part 3 is not addressed to listed companies but to investorsand auditors to enhance their role in corporategovernance. These are purely voluntary. Part 4 providesexplanatory notes to the principles and best practicesset out in Parts 1 and 2 and exhortations set out in Part3. Additionally Part 4 also sets out best practices directedat listed companies that do not require companies toexplain circumstances justifying departure from bestpractices - “mere best practices”. The salient featuresof the Code are as follows:

— The board should include a balance of executivedirectors and non-executive directors (includingindependent non-executives) such that noindividual or small group of individuals candominate the board’s decision making.

— There should be a formal and transparentprocedure for the appointment of new directorsto the board.

— The board should explicitly assume the sixspecific responsibilities, which facilitate thedischarge of the board’s stewardshipresponsibilities viz. Reviewing and adopting astrategic plan for the company; Overseeing theconduct of the company’s business to evaluatewhether the business is being properlymanaged; Identifying principal risks and ensurethe implementation of appropriate systems tomanage these risks; Succession planning,including appointing, training, fixing thecompensation of and where appropriate,replacing senior management; Developing andimplementing an investor relations programmeor shareholder communications policy for thecompany; and Reviewing the adequacy and the

integrity of the company’s internal controlsystems and management information systems,including systems for compliance withapplicable laws, regulations, rules, directivesand guidelines.

— There should be a clearly accepted division ofresponsibilities at the head of the company,which will ensure a balance of power andauthority, such that no one individual hasunfettered powers of decision. Where the rolesare combined there should be a strongindependent element on the Board. A decisionto combine the roles of Chairman and ChiefExecutive should be publicly explained.

— Non-executive directors should be persons ofcalibre, credibility and have the necessary skilland experience to bring an independentjudgement to bear on the issues of strategy,performance and resources including keyappointments and standards of conduct. To beeffective, independent non-executive directorsneed to make up at least one third of themembership of the board.

— As an integral element of the process ofappointing new directors, each company shouldprovide an orientation and education programfor new recruits to the Board.

— The board of every company should appoint acommittee of directors viz. audit committee,nomination committee, remunerationcommittee. Where the board appoints acommittee, it should spell out the authority ofthe committee, and in particular, whether thecommittee has the authority to act on behalfof the board or simply has the authority toexamine a particular issue and report back tothe board with a recommendation.

— The Committee of directors should becomposed exclusively of non-executivedirectors, a majority of whom are independentwith the responsibility for proposing newnominees for the Board and for assessingdirectors on an on-going basis.

— Boards must maintain an effectivecommunications policy that enables both theboard and management to communicateeffectively with its shareholders, stakeholdersand the public generally. This policy musteffectively interpret the operations of thecompany to the shareholders and mustaccommodate feedback from shareholders,



which should be factored into the company’sbusiness decisions.

Singapore

Singapore authorities have placed an increasingemphasis on corporate governance, generally bench-marking local standards to international best practices.In December 1999, the Government established threeprivate sector-led committees to review and enhancethe existing framework for corporate law andgovernance- the Corporate Governance Committee(CGC), the Disclosure and Accounting StandardsCommittee (DASC), and the Company Legislation andRegulatory Framework Committee (CLRFC).

The Code of Corporate Governance (the “Code”)was first issued by the Corporate Governance Committeeon 21 March 2001. Compliance with the Code was notmandatory but listed companies were required underthe Singapore Exchange Listing Rules to disclose theircorporate governance practices and give explanationsfor deviations from the Code in their annual reports forAnnual General Meetings (“AGMs”) held from 1 January2003 onwards.

The Code sets out recommended corporategovernance principles and practices in areas such asboard composition, board performance, directors’remuneration, accountability, and communication withshareholders. The private sector-led Council onCorporate Disclosure and Governance (CCDG) isresponsible for regularly updating the Code to ensure itremains relevant and consistent with internationalpractices.

The Council on Corporate Disclosure andGovernance initiated a review of the Code in May 2004and submitted its recommendations to the Ministry ofFinance in June 2005. The Ministry of Finance issued arevised Code on 14 July 2005, after considering theCCDG’s recommendations.

The Code of Corporate Governance 2005 issuedby the Ministry of Finance supersedes and replaces theCode that was issued in March 2001. The Code ofCorporate Governance 2005 takes effect from AGMsheld on or after 1 January 2007. Listed companies shoulddisclose their corporate governance practices and explaindeviations from the Code of Corporate Governance 2005in their annual reports for AGMs held from 1 January2007 onwards.

The salient features of the Codes are as follows:

— There should be a strong and independentelement on the Board, which is able to exercise

objective judgement on corporate affairsindependently, in particular, from Management.No individual or small group of individuals shouldbe allowed to dominate the Board’s decisionmaking.

— There should be a clear division ofresponsibilities at the top of the company –the working of the Board and the executiveresponsibility of the company’s business –which will ensure a balance of power andauthority, such that no one individual representsa considerable concentration of power.

— Every director should receive appropriatetraining (including his or her duties as a directorand how to discharge those duties) when he isfirst appointed to the Board. This should includean orientation program to ensure that incomingdirectors are familiar with the company’sbusiness and governance practices. It is equallyimportant that directors should receive furtherrelevant training, particularly on relevant newlaws, regulations and changing commercialrisks, from time to time.

— There should be a formal and transparentprocess for the appointment of new directorsto the Board.

— Non-executive directors should constructivelychallenge and help develop proposals onstrategy; and review the performance ofmanagement in meeting agreed goals andobjectives and monitor the reporting ofperformance.

— There should be a formal assessment of theeffectiveness of the Board as a whole and thecontribution by each director to theeffectiveness of the Board.

— The Board should set up an Audit Committee,Remuneration Committee.

— Companies should engage in regular, effectiveand fair communication with shareholders.

— Companies should regularly convey pertinentinformation, gather views or inputs, and addressshareholders’ concerns. In disclosinginformation, companies should be asdescriptive, detailed and forthcoming aspossible and avoid boilerplate disclosures.



CODE CONVERGENCE IN ASIA

There is a diversity of corporate governance systemsin the Asian countries. Despite the diversity of corporategovernance systems, the globalization of markets isproducing a degree of convergence in actual operationsand governance practices. Countries compete on theprice and quality of their goods and services. Theycompete for financial resources in global capital markets.Increasingly they also compete on their regimes forcorporate governance. These global market pressuresare providing the impetus for harmonization of corporategovernance practices.

Over the last few years different country groupshave been establishing their own common set ofbenchmarks for corporate governance, for instance, theOECD Council called upon the OECD to develop a setof corporate governance standards and guidelines andpublished in May 1999 a common set of guidingprinciples of corporate governance for all OECD membercountries. These Principles are intended to assist OECDand non-OECD Govt. in their efforts to evaluate andimprove the legal, institutional and regulatory frameworkfor corporate governance in their countries and to provideguidance and suggestions for stock exchanges, investors,corporations and other parties that have a role in theprocess of developing good corporate governance. TheOECD revised its Principles in the year 2004 to respondto the corporate governance developments includingcorporate scandals that further focused the minds ofGovernments on improving corporate governancepractices.

It is widely believed that “one size does not fitall”, meaning North America and Europe should notseek to impose their standards on developing economiesand that an international code of best practice isunworkable. Legal systems, business cultures andcorporate structures are just too different, even amongdeveloped nations. The OECD also reflects this view inthe preamble to its “Principles of CorporateGovernance”, where it states: “There is no single modelof good corporate governance.”

An analysis of the Codes of Corporate Governancein Asian countries indicates that Asian countries aremoving towards identical systems of governance. Thereis a striking agreement on the centrality of certainprinciples. These include:

— enhancing shareholder value as the primaryfocus of companies, and upholding or extendingshareholder rights;

— the need for non-executive and independentnon-executive directors to provide an “outside”view on strategic direction and tocounterbalance the executives on the board;

— the usefulness of board committees responsiblefor audit, nomination and compensation andcomprising a majority of independent directors;and

— the importance of higher levels of informationdisclosure from listed companies.

The aforesaid principles have been included in codesof best practice developed in the Asian countries overthe past years. One of the most interesting cases ofgovernance development in Asia concerns auditcommittees. Singapore mandated them as early as 1989-following the collapse of a major conglomerate and amarket crisis in the mid-1980s - and stated that theymust comprise a majority of independent directors.Malaysia followed suit in 1994. Thailand announced inearly 1998 that all listed companies must form them byDecember 1999. Korea also made them mandatory forthe listed subsidiaries of the top 30 conglomerates in1999. In Hong Kong, however, audit committees aremerely part of a code of best practice appended to thelisting rules and are not compulsory (although sinceJanuary 1999 it has been mandatory for companies todisclose whether or not they have such committees).Audit committees are also mandatory in India, wherethey have been included in recent years by inclusion ofClause 49 in the listing agreement requiring companiesto follow corporate governance norms.

This example shows that while there may have beenvariation in implementation, there has been convergencein policy direction; and that this convergence has grownover time. A similar theme runs through the other areaswhere convergence is occurring.

POINTS OF DIVERGENCE

Convergence does not imply total uniformity, somekey differences remain. One difference involves the“stakeholder” concept. Four countries explicitlysubscribe to this principle as part of their corporategovernance regimes viz. China, Korea, Japan andThailand. Two others, Singapore and Malaysia, recognizethe social importance of corporations, but do notemphasize stakeholders within the governance context.Singapore uses other means, such as legislation, toprotect employees, creditors and customers. Malaysiaencourages boards to be “responsible for relations withstakeholders”, but stresses that they are “accountableto the shareholders”.



A second difference concerns board structure:whether there should be single-tier or two-tier boards.Most countries have the former. Interestingly, Korea,despite the historic influence of Japan, does not havetwo-tier boards. While Thailand is alone in consideringmoving from single-tier to two-tier (it sees this as a wayto enhance board independence).

The other major differences reflect differentregulatory or legal systems. Singapore, Malaysia, HongKong, China have Anglo-Saxon legal systems whereasother economies have a variety of roots in their legalsystems.

CONCLUSION

As the Asian crisis has shown, attitudes towardscorporate governance among market regulators,government officials and professional associations canchange quickly. What doesn’t change so fast is businesspractice - except where it needs. Convergence also hasits limits: Asian governance will never simply become acarbon-copy of the Anglo-American model, since localbusiness cultures and legal systems will shape the wayin which these ideas are adapted by each country. Atthe very least, family ownership in most countries andstate ownership in places like China will continue toexert a powerful influence over the pace of change,the details of new regulations and the degree of powerallowed minority shareholders. Nor will Asian countriesmove towards a single “Asian” model of governance,given the diversity that exists in current governancesystems, the variations in regulatory philosophy, anddiffering political systems.

This status quo has to compete with other ideasand processes, many of which will become moreinfluential over time. The internationalisation of financeis driving a demand for common standards. Asiancompanies operating internationally will increasingly seegreater financial and non-financial disclosure, andaccountability to all shareholders, as in their commercialinterests.

Governments will continue to push corporategovernance as fundamental to the development ofadvanced and attractive securities markets. Groups ofshareholders will exercise their new-found and newlylearned rights (through the Internet and other means).The convergence at the policy level in Asia towards theAnglo-American shareholder model cannot but have aprofound impact on Asian business.

As corporate governance is the product of a complexset of cultural, economic and social issues and that the

governance structures of corporations differ from countryto country, it is appropriate that corporate governanceguidelines and practice code be designed and adoptedby each constituent country. In the end, corporategovernance should produce an environment within eachcountry that corporations identify with and can adhereto in their decision-making processes.

REFERENCES

1. http://www.sov.com/docs_eng framework_for_implemenation.pdf).

2. http://en.wikipedia.org.

3. http://rru.worldbank.org/PapersLinks/Codes-Best-Practice/

4. White Paper on Corporate Governance in Asia(2003).

5. Annual survey of corporate governance in Asiatitled “Spreading the word: Changing rules inAsia” by Asian Corporate GovernanceAssociation.

6. www.acga-asia.org

7. h t t p : / / w w w . c o r p g o v . n e t / n e w s /archives%202004/Sept-Oct.html.

8. http://www.ecgi.org/codes/all_codes.php

9. http://www.reds.msh-paris.fr/colloque/tomasic-fu.pdf

10. Regulation and Corporate Governance ofChina’s top 100 listed companies: Whither theRule of Law? By Professor Roman Tomasic,Victoria University Melbourne and Ms Jian FuDeakin, University Melbourne.

11. http://www.news.gov.hk/en/category/ontherecord/050913/html 050913en11001.htm

12. Corporate Governance in Asia by StephenY.L.Cheung and Bob Y. Chan, Asia-PacificDevelopment Journal, Vol. II, No. 2, December2004.

13. Chartered Secretary August 2003.

14. Report on the Observance of Standards andCodes (ROSC) Corporate Governance CountryAssessment, Republic of Indonesia, August2004.



15. http://www.worldbank.org/ifa/rosc_cg_idn.pdf

16. Code Convergence in Asia: Smoke or Fire?[2000] by Jamie Allen, Secretary General, AsianCorporate Governance Association.

17. http://www.sc.com.my/eng/html/cg/Oview.html

18. http://www.state.gov/e/eb/ifd/2005/42111.htm


Global Corporate Governance and Family Owned Entities 111

GLGLGLGLGLOBAL CORPORAOBAL CORPORAOBAL CORPORAOBAL CORPORAOBAL CORPORATE GOTE GOTE GOTE GOTE GOVERNVERNVERNVERNVERNANCE ANDANCE ANDANCE ANDANCE ANDANCE ANDFFFFFAMILAMILAMILAMILAMILY OY OY OY OY OWNED ENTITIESWNED ENTITIESWNED ENTITIESWNED ENTITIESWNED ENTITIES

RITU VIJ KOHLI*

A recent study by CRISIL (a credit rating company)has revealed some very interesting facets to the debateon whether Indian companies fit the bill when it comesto Corporate Governance. The study takes the top 50Indian companies—chosen from the NSE’s, S&P, CNX,Nifty 50 index and compares them on some keyparameters with the top 50 companies in the US whichwere chosen from the NYSE 100 index. The study findsthat:

— 48% of Indian companies have the largestshareholder, holding over 50% stake. However,in the US, among the top 50, the largestshareholder holds less than 10%

— In India, the largest Board size is 17 and thesmallest is 4, with 44% of the 50 companieshaving more than 12 directors. In the US, thelargest board size is 18, the smallest 10, and66% of the 50 companies have over 12 directors

— Out of the 50 Indian companies, 58% havemajority independent boards, while 12% haveless than one-third independent directors. Onthe other hand, in the US, all the 50 companieshave majority independent boards.

— In India, 35 of the 50 companies have 50% ormore executive directors—those performingkey functions in the company—on the boards,while in the US, 98% of the companies haveless than 25% executive directors, which meansthe majority directors on the US boards are non-executive directors.

— 60% of the 50 Indian companies have separatechairmen and CEOs, while this figure is only20% for the US companies. A leadindependent director—a kind of representativefor independent directors on the boards—ispresent in only three of the 50 Indiancompanies. In the US, all the 50 companies

111


have fully independent audit, remuneration andnomination committees. In India, percentagesof companies having independent committeesvary.

What do these findings really mean for CorporateGovernance in India? From the facts given above, it canbe argued that the majority of Indian companies areclosely held or may be classified as Family Controlledcompanies. Therefore there is need to address theCorporate Governance issues related to Family Controlin the Companies in India.

Corporate Governance is defined as the structures,systems and the processes that provide direction, controland accountability for an enterprise. In a macroperspective, task of having good Corporate Governancein India entails creating institutions and systems whichlead to better transparency and good governance. Ithowever cannot be achieved unless there is clearunderstanding of the underlying control structures ofthe Indian companies.

For example, as in many Indian companies, a majorshareholder, who is also chairman of the company, isable to give a more long-term direction than, say, aprofessional chairman in a widely-held company, like inthe US.

DEFINING A FAMILY FIRM

Before we proceed further it is very important todefine a Family Firm. This is necessitated because, someauthors refer to any firm with a dominant shareholderas a family firm. By this definition, Microsoft is a familyfirm, even though Bill Gates has given no notice of anyclear intention to pass control on to his children. Likewise,this definition would catch Andrew Carnegie’s turn ofthe century Carnegie Steel as a family firm, even thoughhe ultimately sold out and gave the $480 million hereceived away to charities.



In this article, we would define family firm morenarrowly to encompass only companies run by heirs ofthe people previously in charge or by families that areclearly in the process of transferring control of thecompanies to heirs.

Approximately one third of the 1000 largestcompanies in the world are controlled by families. Ofthese, half are traded publicly and half are privately held.The vast majority require a different model ofgovernance than is the norm for widely held companies.

FAMILY BUSINESSES : PROS AND CONS

With ownership controlled by one or a few peoplefrom a family, family firms have competitive advantagesand disadvantages over publicly held companies. Onthe plus side, controlling ownership can take the long-term view. Patient, consistent investments can yieldexcellent future benefits. Investments in corporateculture can yield higher benefits than companies thatare run for short-term. When looking at the returns offamily owned companies versus the overall market, theirstocks significantly outperform, in part because theirleadership tends to be more stable than most and thecompanies largely embrace a long term approach togrowth. On the other hand, firms controlled by a fewcan be isolated and insulated from market realities.Seeking personal comfort and forsaking externalaccountability can lead to stale strategy, no successionplanning, and organizational stagnation.

Another advantage of family control is that families,because of the blood ties that unite them, are betterable to manage corporate affairs smoothly. However theactual governance of family firms is replete withinterfamilial disagreements, especially disputes aboutsuccession, the exploitation of some family membersby others, and so on. We have recently seen ad-hocprice movements in Reliance Stock when the twoAmbani brothers were fighting over control of theReliance group. And unchecked quarrels among familyowners can be catastrophic to a company.

The difference between a family owned businessthat succumbs to its weaknesses and one that exploitsits relative strengths lies in the quality of the governancesystem. Successful family companies appreciate thepower of their ownership control, volunteer for theaccountability of an independent board, and take toproperly defined roles and responsibilities of ownership,management, and the board of directors.

Successful family firms also understand howgovernance practices need to evolve to reflect thechanges in the business and within the family.

Family Business and Agency Problem

It is a belief that family businesses are allegedlyfree of agency problems. Agency problems occur whenthe professional managers in a public company maximizetheir personal utility, rather than the wealth of theinvestors. For example, a professional manager mightspend crores of rupees on an unnecessary executive jetthat gives him utility, even though this decreases thevalue of the company. However, it is a myth to believethat professional managers squander away more wealththan a family member of the controlling family. Thereason being shareholders limit the squandering byprofessional managers

In Public Companies, shareholders limits the agencyproblems of this sort. Large shareholders are unlikely toallow professional managers too much leeway to neglectthe firm. Shareholders play a very crucial role to achievegood Corporate Governance in the Companies.

How Governance Differs in Family Businesses

Family business governance systems are more suitedto the pursuit of unconventional strategies. Familybusinesses can more readily bypass the adversarialqualities of conventional business governance.Ownership can exert influence and care on multiplelevels, making the family an agent of more effectivedecision making in management, on the Board, andamong owners. Rather than functioning as a costlysystem of checks and balances, governance in familybusiness often serves to enable transparency andpartnership across the system. This, in turn, can enablethe pursuit of strategies that are potentially moreproductive in the long term, despite short-term costs orrisks.

Conventional business governance often focuses onestablishing boundaries and defining the separation ofdecision-making powers. In contrast, family businessgovernance is often focused on establishing productive,procedural engagement across the system. Consultationsamong owners, directors, and managers permit a freerflow of ideas as well as speedier decision making. Theyalso contribute to an ongoing alignment of interests andobjectives over time.

The active participation of owners is the key toeffective family business governance. Family ownershipdefines the values, vision, and objectives of thebusiness. It articulates the financial goals andperformance expectations that guide board andmanagement decisions. Owners also provide an overallvision of the company that generally defines a business



strategy. This clarifies and focuses objectives across thesystem and helps in setting strategic constraints on boardand management decisions.

Establishing a clear and shared understanding of theseparate functions of the ownership, board, andmanagement is vital to effective family businessgovernance, all the more because family members oftenwear multiple hats, functioning as owners, directors,and managers.

While the direct involvement of the family onmultiple levels complicates the system, it also providesan important link between the different areas ofgovernance. This built-in link, combined with a positivedevelopment of family ties and relationships, canfundamentally change the trust that pervades thegovernance system. A well-functioning system helps inbuilding trust within the family, and a good family, inturn, becomes an asset to the business because it enableseach separate piece of governance to function betterand add more value while remaining aligned with theother components of the governance system.

Stages of Family Business Development

Most family businesses begin with anentrepreneurial founder. Initially, the founder embodiesthe governance system, being the all-powerful ownerand operator of the business. Founders sometimes makeuse of advisory boards, but they generally retain alldecision rights. In many cases, the chief challenge offounders is deciding how to sustain their family businessthrough succession. Some founders seek a single heirwho can re-create the concentrated power of the owner.More, however, see the business as a collectiveinheritance and divide it among members of the family.Live example of Lakshmi Niwas Mittal who is headingthe multinational steel company ‘Mittal Steel’ which hisfather ‘Mohan Mittal’ began. Mittal has grown the familybusiness into one of the largest steel companies in theworld, with steel making facilities in 14 countries andemploying more than 150000 people. The Indian born,British based steel magnate is the third richest man inthe world in 2005 according to the Forbes businessmagazine. Another example of entrepreneurial founderis Dhirubhai H. Ambani, the founder of Indian RelianceGroup Conglomerate.

When ownership passes down across generations,it passes through distinct stages. The first stage is thesibling or family partnership, with parents sharingownership with their children. Eventually, theinvolvement of the parents ends, and the siblings cometo share ownership in a partnership spirit. They must

decide among themselves how to govern the business;often, this is described as the “kitchen table” period.The siblings can sit down together and consult informally,and sometimes they form a board to help build consensusfor strategy. Roles may begin to separate at this stage,as some siblings may be active in the business whileothers are not. From this point on, the level of trust inthe family often determines how formal governancepractice becomes. Kokilaben Ambani, wife of DhirubhaiH. Ambani, the deceased founder of the Reliance Groupamicably resolved the power feud between her sons(Mukesh and Anil) by dividing the business betweenthem.

The third generation succession often involves adiverse group of cousins. This generally changes thescale of the family and differentiates family roles further.Family members may continue to be involved inmanagement, the board, and ownership. Ownershipholdings can become increasingly variable in size, withsome remaining quite concentrated. Family memberscan be active to varying degrees in the business andgovernance, and their level of involvement may notnecessarily reflect their level of economic interest. Thesecomplications generally lead to the development of moreformal governance practice. When majority ownershipmoves outside of management, the board will oftentake on more of a fiduciary characteristic. The extent towhich trust is cultivated directly between the controllingowners and the leaders of management oftendetermines how formal governance practice becomesat this stage and whether the family can continue tocreate effective agency in governance.

The next family succession causes another significantchange in ownership. At this stage, the developmentof family governance, which functions in parallel tobusiness governance, is often an added feature of anincreasingly formal and complex governance system.Family members may continue to be involved acrossthe governance system, linking ownership, the board,and management. Often, the business at this stage hasbecome a holding company, creating the need for aboard that can strategically manage a portfolio ofbusinesses.

The Evolution of Family Business Governance

As business grows, it becomes increasinglycomplex, creating its own demands for a more formalorganizational structure. While adapting governancepractices to the emerging needs of families andbusinesses as they grow is a very complex and challengingendeavor, over time it is also unavoidable.



Unity of Ownership and family Governance

Families need to organize their ownership and workto strengthen their ownership commitment in order toachieve the benefits of concentrated ownership andsatisfy issues of Corporate Governance. To do so,business family should develop a family governancesystem.

Family governance often begins with informal familymeetings at which the values and hopes for the businessare articulated. In order to assure inter-family harmony,the family educates itself on relationship skills, such ascommunications, conflict resolution and decision-making.

As the family grows, family governance can becomemore documented in the form of a family constitution.This is a comprehensive statement of the family’s values,purposes and principles comprising a set of policies toaddress family business issues such as employment,contracts, board selection and dividends. It also includesa shareholders’ agreement, which defines the legal rulesof ownership and redemption.

Of course, not all families need a full fledgedconstitution. For example, the Mogi family of Japan,producers of Kikkoman soy sauce, has had a simplestatement of 12 philosophic principles that has served itwell for more than 100 years.

Independent Board in Family Businesses

Family owned entities are pervasive in India. Wehave Tata’s, Birlas, Modi’s, Ambani’s etc dominating oureconomy. Further these families show little interest ingiving up their control in better interest of public. Forexample, Birlas are fighting tooth and nail against Lodha’sfor control over Priyamvada’s assets. Therefore it isimportant for the government to pay special attentionto enforce Corporate Governance in family ownedentities. Besides Government, the Family owned entitiesby themselves have many advantages if they follow amodern approach to Corporate Governance and adoptthese new mechanisms in their companies. By settingup an Independent Board, the company will havefollowing advantages:

1. Credibility with Financial Institutions

A family controlled company with truly supervisorygovernance impresses financial institutions. Aprimary concern of all lenders to family business ishow the loan will be repaid in the event of thedeath or disability of a new owner/manager. Thereshould be a forum and a process to manage the

process of management succession and to ensurethat the best interests of the business continue tobe the primary criterion for decision making.Moreover, knowing that a board is engaged instrategic review of operations or perhaps strategicplanning, gives “comfort” to the bank/FinancialInstitution that the borrower is prudently managinghis/her business affairs.

2. Disaster Management

In case owner/ manager of the family owned entitymeets some accident or unpredicted death, therewill be a severe jolt to the operations and directionsof the entity. The absence of a supervisory Board ofdirectors magnify problems faced by the familymembers who survived this tragedy. In such case,the Board can serve as a mentor to the newgeneration family members.

3. Strategic Planning

Access to other owner/managers of similarenterprises as well as to academics and advisors,who serve on the board of directors or council ofadvisors, is often the most effective way for owner/managers of family controlled enterprises toovercome their resistance to strategic planning.

Type of owners

There are several options to owners: they could beoperating owners; governing owners; active owners;investing owners; or passive owners. The emphasis inthese types is often a function of the generation of thefamily business. In the first and second generation,most families are operating owners, meaning they workin management full time. In later generations, as thefamily grows bigger the majority of owners becomeless involved in the day-to-day running of the company.For example, the German company Haniel has severalhundred family shareholders and, by family policy, noneof them is permitted in management.

Investing and passive owners are generally onlyinterested in their economic returns. Thus, thesebusinesses become, in effect, no different from anywidely held, listed company.

Still, non-management family owners can addsignificant value in many ways. Some business familiescan be governing owners who are very involved in thebusiness through conscientious board roles.

The Murugappa Group, an Indian conglomerate,carefully and thoughtfully defined the function of the



five governing owners who sit together on thecompany’s holding board. They are cultural ambassadorsthroughout their companies and spend a lot of timewith their non-family CEOs and executives to providesupport and to assure succession. They carry fertilisegroup competencies, such as technology, externalcontacts and human resource policies across theirportfolio. And they represent the family on all theircompany’s subsidiary boards.

All family owners, even if they do not have a positionon the board, can add value as active owners. Theseare involved and responsible contributors, who spendtime to understand the business in order to provideinformed opinion on management and board decisions.This strengthens the confidence and courage ofmanagement and protects against disloyalty. Thus,involved owners deepen their emotional commitmentand pride in the business.

Responsibilities of owners

For the family owners, there are four broadresponsibilities:

1. Defining the values that shape the company’sculture

Many families, such as the Bonnier mediacompany of Sweden and Cargill of the US, haveregular sessions between owners and managersto discuss important issues. Hatfield QualityMeats, a meat producer based near Philadelphia,has more than 200 family shareholders. It goesfurther than many of its peers by putting intopractice and measuring its core values, includingsafety, energy, waste conservation andcommunity support.

2. Owners set the vision

Family owners establish the parameters andboundaries for management strategies. Theygive instructions to the management. They maydefine the geographical scope of the business,for example, whether to become global andexpand the family’s horizons.

3. Owners are responsible for the financial targets.

Owners propose goals for growth, risk, liquidityand profitability. The Board evaluates these aimsfor feasibility and consistency. The four goalsforce the owners to grapple with the inevitabletrade-offs in expectations. In so doing, thefamily gets a better insight into the companywhich, hopefully, unifies it and leads to

appropriate expectations.

4. Owners elect the directors and design theBoard.

A good Board should be varied in its make upand should deal with the following issues:

— Should the Board have independent nonfamily directors on the Board? If so, howmany members and with whatqualifications ?

— Should the family be represented on theBoard? If so, by how many, and how shouldthey be selected ?

A research in North America and WesternEurope found that less than 25 percent of allfamily controlled businesses with more than 500employees have atleast three outside directors.In most developing economies like India,outside directors are less prevalent.

Most companies without active IndependentBoards say they never considered establishingone, they feared losing control, or they doubtedthey would be able to attract high quality, nonfamily directors. In fact, more family businessesneed to recognize the benefits of a good Boardand assure themselves that they can attractdirectors and retain control.

CONCLUSION

For well established large business families,maintaining ownership is not the ultimate end. Instead,the family ’s unity and commitment are moststrengthened by other motivations. For example, theymay rally round a social purpose for the company, likethe owning family of Roche, the Swiss pharmaceuticalcompany, which believes in the life-saving innovationsof medicine.

Or they might focus on a family foundation andharness the financial success of the company to make adifference in society. For example, the Belmont familyof Peru supports economic security opportunities forwomen by employing thousands of them to sell theircompany’s health and beauty products across SouthAmerica. What is more, through their family foundation,they offer the women educational scholarships.

These families are more than business owningfamilies – they are enterprising families. In other words,they work together for a collective purpose that unitesthem emotionally as well as economically.



The real backbone of good family businessgovernance is the purpose and governance of the familyitself. It is their commitment to family unity thatmotivates them to be effective owners and to supporttheir business for the long term.

REFERENCES

1. Article on ‘Governing Family Businesses’ by JohnL. Ward.

2. Article on ‘Keeping the Business within thefamily’ published in Business Standard,August 19, 2005.

3. Article on ‘Family Businesses Hold DifferentValues’, Times Daily, September 21, 2005.

4. Article on ‘Creating Effective CorporateGovernance in Family Businesses’ by RichardL. Narva, Esq.

5. Discussion Paper No.1,’ Corporate Governanceand Family Control’ by Randall Morck.

6. h t t p : / / w w w. f i n a n c i a l e x p r e s s . c o m /fe_full_story.php?content_id=102534

7. Article on ‘Governing the family run business’published in Harvard business school ’WorkingKnowledge’.


Emerging Avenues & Company Secretaries 117

EMEREMEREMEREMEREMERGING AGING AGING AGING AGING AVENUES & COMPVENUES & COMPVENUES & COMPVENUES & COMPVENUES & COMPANY SEANY SEANY SEANY SEANY SECRETCRETCRETCRETCRETARIESARIESARIESARIESARIES(BPO, KPO AND LPO)(BPO, KPO AND LPO)(BPO, KPO AND LPO)(BPO, KPO AND LPO)(BPO, KPO AND LPO)

MONIKA GOEL*

Globalization is a new, unprecedented phenomenonwhich has affected the present generation to a muchgreater extent. If we compare the three aspects ofeconomic globalization viz. Trade, International Financeand Foreign Investment in the Pre World- War I scenariowith today, we find that earlier 16 most industrializednations controlled nearly 21% of the world trade, andwhile that figure has not undergone any major revision,a major difference is that developing countries todayconstitute an important share (22%) when it comes totrade of manufactured products, especially in the stillinfant area of IT services. Now, private investment (inthe form of FDI) forms a major chunk of investment asopposed to the State’s investment in earlier times.

If we glance through India’s reform story, whichhas caught the imagination of the world, we find thatour merchandise exports crossed the US $ 60 billionmark in the 10 months of the current financial year(2004-2005), having reached US $ 61 billion during April2004 to January 2005, which was 26 % higher than inthe corresponding period of the previous financial year.India’s merchandise exports should therefore exceedthe target of 16 % growth set for the year to reach alevel of around US $ 75 billion. With the high growthachieved despite strengthening of the rupee vis-à-visthe US dollar and the overall impact of rise in fuel priceson competitiveness, the country is expected to doubleits percentage share of world merchandise trade byincreasing its exports to US $ 150 billion by 2009 whichis one of the major objectives of our Foreign Trade Policy2004-2009.

However, it is in the second and third aspect viz.International Finance and Foreign Investment - that wecome across a brave new world of globalization. In theearlier times, International Finance related diplomacy

117


1. Source : www.locomonitor.com.

was very intimately connected to power equations. Evenif all the reserve currency of all the central banks ofearlier times were to be pooled together, they wouldstill be insufficient to finance even a day’s transactionsof the foreign exchange market of the present times.Thus, today 98% of international trade is trade incurrency carried on by Private Intermediate Traders(creating largest number of jobs in this area); and it isprecisely this dimension that finds no parallel in thehistory of humanity. It is very difficult to analyze howthis process went on to acquire such leviathandimensions. It is like a black box; everybody can seethe input and the output; however what happens insideis never known. The new form of International Financeemerged when U.S.A. liberalized its capital flows andintroduced complete currency convertibility. Since thentrade in foreign currency has assumed monstrousproportions.

On the FDI front also India is making slow butcontinuous growth. The data given below provides anoverview of India’s FDI scenario1 :

Table I

FDI by year in India

Year FDI Projects **Capital Investment US$

*2005 368 $10.18 Bn

2004 685 $19.44 Bn

2003 456 $8.22 Bn

* Data for 2005 is up to the month ending September.

** Capital Investment data is not captured for all FDIprojects in India.



Table II

Top multinational companies in India

Company Projects

Cognizant Technology Solutions 14

LG Electronics 14

Intel 12

Bose 11

Hewlett-Packard (HP) 10

Table III

FDI projects by industry cluster in India

Industry clusters Projects

Information and CommunicationTechnology (ICT) 615

Electronics 227

Business & Financial Services 226

Heavy Industry 141

Transport Equipment 119

Property, Tourism & Leisure 86

Light Industry 70

Life Sciences 68

Chemicals, Plastics & Rubber 61

Consumer Products 54

Food/Beverages/Tobacco 48

Logistics & Distribution 43

Table IV

Source Country of Multinationalsinvesting in India

Source Country Projects

USA 839

UK 205

Germany 99

Japan 79

France 53

It is evident from the data above that the maximumnumber of FDI projects in India is in the Informationand Communication Technology (ICT) and three out oftop five multinationals in India belong to ICT sector.

India is emerging as the preferred offshoredestination for organizations across the world foroutsourcing on account of its following attributes;

1. Its cost effectiveness, costs being a tenth ofwhat it is in the US as a result of very low salarylevels, not very expensive real estate, etc.

2. Availability of highly educated professionals andother skilled workforce with strong work ethicsas well as capabilities to provide high qualitywork.

3. Robustness of its IT and other infrastructureincluding emergence of high bandwidthtelecom networks as well as technologicalsupport.

4. India’s unique geographic positioning whichenables a 24x7 service as well as a reduction inturnaround times by leveraging the time zonedifferences.

5. Significant political patronage in the promotionof outsourcing industry.

6. Applicability of Tax holidays on profits generatedfrom this industry.

Government’s Support to the IT EnabledOutsourcing (ITES) market in India

Recognizing the growing importance of the businessprocess outsourcing, the Government of India hasintroduced various policy concessions and initiatives toaccelerate the growth of the IT-enabled outsourcingmarket. Spearheaded by associations such as NationalAssociation of Software and Service Companies(NASSCOM), the Indian software and services industryhas also taken various steps to ensure that India becomesthe global hub for IT-enabled outsourcing in the future.Some of the steps taken by the Government and industryfor the ITES/BPO sectors are as follows:

1. In May 2002, the Government of Indiaaccepted the recommendations of NASSCOMand removed certain procedural bottlenecksthat were hampering the growth of the Indiancall center industry.

2. The Government of India (Central Board ofDirect Taxes - CBDT) allowed total income taxexemption on the export of IT enabledoutsourcing services under Sections 10A/10Bof the Income Tax Act, 1961. These IT enabledproducts or services are:

(i) Back-office Operations

(ii) Call Centres



(iii) Content Development or Animation

(iv) Data Processing

(v) Engineering & Design services

(vi) Geographic Information System Services

(vii) Human Resource Services

(viii) Insurance Claim Processing

(ix) Legal Database

(x) Medical Transcription

(xi) Payroll

(xii) Remote Maintenance

(xiii) Revenue Accounting

(xiv) Support Centres; and

(xv) Web-site services

3. Foreign Direct Investment (FDI) upto 100percent is permitted in this industry.

4. Permission of duty-free imports of capital goods(under the Export Promotion Capital GoodsScheme) for such companies.

5. The Government has promoted several SoftwareTechnology Parks (STPs) which provide ready-to-plug IT and telecom infrastructure. STPs alsoallow single-window clearance for all regulatorycompliance issues. Currently, several STPs havebeen established across the country.

Floodgates of opportunities have been opened forcompany secretaries in various outsourcing industries.It will be a worthwhile exercise to deliberate upon therelevance of these industries viz Business ProcessOutsourcing (BPO), Knowledge Process Outsourcing(KPO) and Legal Process Outsourcing (LPO) for theprofession of company secretaries.

BUSINESS PROCESS OUTSOURCING (BPO)

Over the last few years, outsourcing of businessprocesses has been gaining popularity driven by the factthat US firms have been enjoying much success fromadopting this business strategy. European organizationshave increasingly been focussing on what they identifyas their core competencies and have been looking toreduce costs while maintaining high levels of quality fornon-core activities and processes. To this end, two broadapproaches had developed. One, to centralise the non-core processes into an in-house shared service functionsto derive benefits of centralisation through an in-houseprocess or through a wholly owned subsidiary. Two, toidentify an acceptable third party service provider whowill handle the processing work. The current economic

climate has encouraged the latter trend as theorganizations continue to look for more innovative waysto improve efficiency and cut costs in order to survivethe turbulent marketplace. Hence, the business processoutsourcing.

As per the figures available from NASSCOM theWorldwide spending on IT/ ITES totaled approximatelyUS$ 712 billion in 2001. IDC projects that by 2006, thepotential ITES-BPO market may increase to US$ 1.2trillion, with an overall compounded annual growth rate(CAGR) of 11 percent. While traditionally the key driverfor ITES-BPO activities has been cost reduction,companies are increasingly viewing these services asstrategic and essential elements for overall corporategrowth.

Relevance of BPO for Company Secretaries

The BPO sector seems to have various opportunitieswhich can be capitalised by the company secretaries.Apart from the work relating to the mergers &acquisitions in BPO sector and Income Tax relatedmatters, provisions of FEMA are also quite involved asmore and more foreign multinational companies areentering into this sector, where role of the professionalslike company secretaries come into picture. Besides, asfar as practising company secretaries are concerned, inthe words of outsourcing they are out and out thirdparty service providers. The services rendered by theme.g. consultancy services, secretarial audit, variouscertifications, reports, issuance of various certificates,etc. and other matters relating to corporate laws aregenerally outsourced by the corporates on a large scale.

With reference to the BPO, if it is seen in detail,the outsourcing of work relating to ‘Transfer andDematerialisation of Securities’ is pretty commonpractice among the large public companies. Instead ofcarrying out the aforesaid work in-house, companiesuse to appoint a “Registrar and Share Transfer Agent”(RTA), which happens to be a BPO company. The RTAscarry out the work relating to transfer anddematerialisation of securities and charge the companiesas per the terms and conditions of the agreemententered into between the company and itself. What isimportant to mention here is that, looking at the skill-set and expertise, qualified company secretaries canpromote a company (i.e. a BPO company) with its mainobjective to undertake the share registry work and otherobjects which are allied and incidental thereto, whichwill perform as RTA to various corporates. Even to see itother way round, the companies which happen tooutsource the work relating to transfer and



dematerialisation of securities, will certainly prefer tohire such kind of RTA which is led by the professionalswho have requisite background and specialization in thefield.

Similarly, there may be other areas too which canbe explored in the present trend of BPO, which is seenas a tool by the corporates to reduce the costs incurringon account of carrying on the non-core processes in-house.

KNOWLEDGE PROCESS OUTSOURCING (KPO)

KPO covers the outsourcing of higher-endprocesses such as research and analysis in industries likedata and market research, financial research and planning,engineering, medical content, animation and design andlegal services. Knowledge Process Outsourcing is anotherindustry which is growing very fast and it is estimatedby CII that the global KPO industry will touch US$ 17billion mark by 2010, of which US$ 12 billion would beoutsourced to India. In India, the segment is expectedto employ over 250,000 professionals against the current25,000 professionals. It has been reported thatKnowledge Process Outsourcing will eventually outstripBusiness Process Outsourcing in revenue.

In Business Process Outsourcing, clients provide thebusiness process requirements and the outsourcingservice provider in India follow the needs of the client.But in Knowledge Process Outsourcing Indian companieswill be asked to provide vertical business segment drivenspecialized knowledgebase. It needs vertical businessalignment and strong networking with specializedconsulting firms. A client in KPO will not look at dollarfigures but will be mainly concerned with quality ofservices. This can be achieved by moving up in the valuechain besides augmenting human resources and domainknowledge.

Although very few Indian companies are workingin this space now, KPO will be one of the majorsegments of the outsourcing business in terms of creationof new jobs and generation of billions of dollars inbusiness. With India having quality human resources itis all set to become the hub for Knowledge ProcessOutsourcing. Professionals from diverse fields aretherefore finding interesting career options in this sector.In its recent study-’India in the new knowledgeeconomy’-the CII estimated that the services sectorwould grow at more than eight percent and itscontribution to GDP would be above 51 percent. Thestudy affirmed that India’s transition from being a BPOdestination to a KPO destination was imminent. Areaswith significant potential for KPO include

pharmaceuticals, biotechnology, information technology,legal services, intellectual property, research and design,and development of automotive and aerospaceindustries.

Relevance of KPO for Company Secretaries

Knowledge Process Outsourcing requiresspecialized knowledge in respective verticals and thecountry’s professionals must be geared to address themanpower demand. Unlike BPO companies, KPOs laya lot of emphasis on educational qualifications. The workin a KPO is very academic oriented wherein employeeshave to be fluent in processes with sound academicbase of the related field. By virtue of their expertise andindepth knowledge of corporate laws and commercialand trade practices company secretaries should be ableto provide research solutions in the various areas ofcorporate activity, investment research and intellectualproperty services to companies worldwide. Followingareas may be specifically explored by companysecretaries:

— Foreign Exchange Research and Forecast:Company Secretaries having a soundknowledge of forex and treasury managementcan provide accurate and reliable long termforecasts for any currency. These forecasts arevery useful for long term investors and corporatetreasurers in planning their hedging andinvestment policies. Besides, companysecretaries can also provide mid office and backoffice support to the foreign exchangedepartment of various institutions overseas.

— Intellectual Property : Advising oncommercialization, valuation, and enforcementof IPRs and legal issues surrounding the rightsof ownership of ideas, inventions, trade secrets,processes, programs, data, formulae, patents,copyrights, trade secrets, or trademarks and theapplication or registration thereof.

— Financial Management and Planning : Itincludes reviewing the company’s businessplans and annual budget and analyze andsummarize various financing proposals sent tothe company. Some of the main functionsinclude:

(i) Assessing the financial markets;

(ii) Preparing a competitive analysis of theindustry;

(iii) Preparing and reviewing the corporatebudget and business plan;



(iv) Gathering, analyzing, and summarizingpertinent treasury information in reportform;

(v) Developing sinking fund strategy forrepurchase of company bonds;

(vi) Preparing for agency rating reviews; and

(vii) Analyzing, designing, and implementing avariety of computer-based informationsystems for the worldwide treasuryapplications.

— Working Capital Management : It includes:

(i) Establishing accounts receivable guidelines;

(ii) Establishing credit, and collectionsguidelines;

(iii) Developing contingency plans;

(iv) Monitoing vendor financial conditions; and

(v) Reviewing and implementing externalregulations.

— Risk Management : Risk management isassociated with hedging- the reduction in orelimination of a type of risk. For example: Theprice risk of a commodity, or market risk ofinvesting. Some types of jobs that utilize thisskill are:

(i) Trader : Executes trades in contracts orexchanges of offset portions of the positionexposure faced by the firm.

(ii) Position Manager : Analyze the netexposure of the firm’s positions anddevelop strategies to manage thatexposure.

(iii) Research Director : Directs teams ofquantitative analysts who design newproducts and research areas that appearfertile.

— Personal Financial Planning : Process ofdetermining whether, and how an individualcan meet his or her life goals through propermanagement of financial resources. This is arelatively new field. Some of the duties include:

(i) Cash flow and budgeting analysis;

(ii) Insurance needs;

(iii) Investment management;

(iv) Analysis of debt;

(v) Portfolio analysis;

(vi) Retirement planning;

(vii) Forecasting retirement benefits and costs;and

(viii) Estate planning.

— Investment Analysis : There are two typesof investment analysis: Security Analysis andPortfolio Management.

(a) Security Analysis : Specializes in theevaluation of securities and otherinvestments in asset classes. This includes:

(i) Analyzing and staying current oncompanies under their responsibility;

(ii) Disseminating information and stockrecommendations to the clients; and

(iii) Satisfying investment needs.

(b) Portfolio Management : To work withindividual or institutional investor and tooversee portfolios consisting of equities,fixed-income securities, and other multipleasset classes. This includes :

(i) Making final decisions on whether totrade a security and then direct thetrades;

(ii) Specializing in an asset class;

(iii) Determining appropriate investorobjectives; and

(iv) Establishishing portfolio policies andstrategies

— Stockbrokering : Investing in the stock marketfor individual or corporation. You must be amember of the stock exchange to conducttransactions. This includes :

(i) Advising and counseling clients onappropriate investments;

(ii) Explaining the workings of the stockexchange to clients;

(iii) Sending orders out to the floor of thesecurities exchange by computer or phone;and

(iv) Transferring stock titles

— Insurance : This is another risk managementarea. The main goal is to protect the companyfrom the adverse financial impact of significantunexpected losses using self-insurance,



captive insurance, loss control, and safetytechniques. This covers

(i) Planning and establishing long-range riskmanagement objectives;

(ii) Developing, implementing, andmaintaining an overall risk managementprogram;

(iii) Maintaining effective communication withother departments that provide assistancein the administration of risk management;and

(iv) Reviewing the effects of mergers,acquisitions and joint ventures.

— Real Estate : Besides other things, it primarilyincludes mortgage analysis i.e to

(i) Handle all matters related to the production,analysis, and negotiation of application forthe acquisition of conventional mortgageloans and real estate investments;

(ii) Negotiate terms, conditions, interest rates,etc. to obtain a flow of acceptableapplications;

(iii) Analyze client’s financial status;

(iv) Inspect property under consideration;

(v) Assist in the negotiation of the finalcommitment terms and conditions; and

(vi) Prepare correspondence on all aspect ofapplication processing.

— Commercial Banking : There are many areaswithin the commercial banking area that areopen to people with backgrounds in finance.Some of these areas include:

(i) Commercial Loan Analysis;

(ii) Loan compliance and documentation;

(iii) Lending Assistants;

(iv) Cash Management Representatives; and

(v) Trust Management.

— Investment Banking : To

(i) Advise their clients on high-level issues offinancial organizations;

(ii) Manage the issuance o bonds;

(iii) Recommend and execute strategies fortaking over and merging with othercompanies; and

(iv) Handle selling a company’s stock.

— Advising on international investments:Advising on International IPOs-ADR’s, GDR’s,Sponsored ADR’s & GDR’s, preferentialallotments, sale of stake, FDI, debts, FCCBs,exchange traded derivative instruments, mutualfunds, money market instruments, creditappraisal, wealth management, providentfunds, pension funds and compliance with thestatutory requirements thereto.

— Corporate Restructuring : To be engaged inthe areas of advising, valuation andenforcement of mergers, acquisitions,takeovers, leveraged buyouts, creepingacquisitions, joint ventures and foreigncollaborations.

— Secretarial Functions : Includes Boardapprovals, documentation of minutes, researchand budgeting, approvals from regulatory bodiesand filing of documents, listing with stockexchanges, compliance with procedures,investors grievances, allotments, transfer,transmission, maintenance of statutory records,devising of investment policies, internal auditof the processes and operations, annual returnsetc.

Besides the above company secretaries can findtheir way in the privatization programmes ofGovernments, international funding of projects byinternational organizations, NGOs and other DFIassignments.

All this requires a basic interest and knowledge inspecific domains besides an aptitude for working withdata and information. Company Secretaries can establishthemselves and can prove to be an edge better thanother professionals in terms of better understanding andhands on experience of relevant laws relating to tax,securities, investment, financial management, WTO, etc.Rating agencies like S&P, Moody’s , Fitch etc ,consultancy firms like Mckinsey, BCG etc are resortingto KPO’s for specialized domain research. This is allhappening because of technological advancements andease of travel. Internet and fast data transfer modes aremaking the world one place without any barriers.

Company Secretaries having knowledge of intercountry laws, breadth of coverage, domain expertise,location advantage, compliance with regulator standardsand risk management will be able to differentiatethemselves in KPO industry and sustain a competitiveadvantage in the future.



LEGAL PROCESS OUTSOURCING (LPO)

Legal Process Outsourcing is a far more sophisticatedform of off shoring. It helps law firms to increase theirservice value by outsourcing low end legal work andfreeing attorney’s to concentrate on specialized legalservices. It ranges right from filing patents to draftingtransnational contracts to creating necessary informationback-up for global corporations in litigations andproviding support in contract management i.e. a widerange of legal work, bringing in similar scale ofeconomies that business process outsourcing brings tocompanies. There is lack of clarity in what constituteslegal services in the outsourced mode. This has createddifferent assessment of the current market size and thefuture potential India holds in the internationalmarketplace, given its advantages. As per estimates onlyUS has a $200 billion market for legal outsourcing.Significantly, while there are different projections as towhat is in store for the Indian market place, one estimateby Forrester puts this at about $3.9 billion by 2010.

Patent-related services can be offered fromoutsourced centres at a fraction of the cost. That meansfor the same amount, a US company can file for morepatents. If what can be offered under the ambit of legalservices is analyzed, we are just looking at the tip ofthe iceberg.

Relevance of LPO for Company Secretaries

Company Secretaries having wide and in depthunderstanding of intellectual property, taxation matters,secretarial practices and legal drafting have host ofopportunities for legal outsourcing assignments. Thereare a number of opportunities in the area of compliancewith US GAAP.

In general the following activities are covered underlegal process outsourcing:

1. Preparing and processing a variety of legalpaperwork including court pleadings andcorrespondence, such as opinions, proceedings,ordinances, contracts, orders, motions,information, complaints, warrants, subpoenas,commitments, indictments, decisions, requestsfor investigation, extraditions, affidavits, briefs,jury instructions, dismissal sheets, and otherdocuments.

2. Preparing legal papers and legal documents instandardized forms and formats from generalinformation.

3. Maintaining files of correspondence and legaldocuments.

4. Comparing forms and legal references withreference books to ensure that they areaccurate.

5. Preparing general correspondence, claims,requisitions, personnel forms and other material.

6. Maintaining records of cases, court calendars,case histories, and court dates.

7. Maintaining and preparing routine statisticalreports.

8. Transcribing notes, memos, legal documentsand minutes of meetings from tape.

9. Taking and transcribing oral dictation of notes,memos, legal documents, and minutes ofmeetings.

Some other areas open for legal outsourcing are:

— Legal BPO : In today’s competitive, worldwidelegal market; what is required is effective legalsupport provided by a combination of legalcapabilities: the ability to deliver highest quality,clearly stated service, deep knowledge of clientmarkets and their individual commercial andregulatory standards; acceptance by regulators;and perhaps most importantly, common senseunderstanding of the client’s commercialobjectives.

— Legal Transcription Services cover preparinglegal documents from written or dictatedinformation. It also includes drafting and fillinglegal documents, calendaring and tracking otherimportant works. In general the informationsfrom courtrooms is recorded into a tape or intoa digital voice processing system. So LegalTranscription refers to the process of transferringinformation from recorded dictation to harddocumentation using transcriptionists andcomputer word processors.

— Document Management Services : theseprovide an organization with the tools to create,manage, control, and distribute electronicdocuments reducing the amount of time spentin retrieving documents. It can provide bettersecurity provisions, audit trails showing who hasmodified or used documents, and increasedease of creating and using boilerplatedocuments.

— Deposition Summaries the work ofsummarizing depositions in a very accuratemanner and easy language.



— Legal Billing includes processing attorney timesheets and related billing functions and at thesame time providing clients and law firms withmeaningful cost information on legal servicesin a uniform and standardized manner.

— Legal Coding covers developing client projectbased on an understanding of legal codingprinciples, rules, conventions and terminologyusing the latest state-of-the-art software usedby major law firms. Coding should be basedon uniform standards being promulgated anddeveloped within the legal profession.

— Paralegal Services which include processingclaims, data entry, proofreading services,document review, deposition digesting andshepardizing cases.

— Legal Translation includes preliminary reviewof foreign language documents in discovery,and research on foreign language legal textsand its interpretation.

— Data Entry Services covers taking hard copydata, like surveys, mailing lists, warranties,coupons etc., and digitizing it into a workabledatabase.

— E-filing services uses the internet for the filing

of briefs, pleadings, motions, and other lawyer-generated documents for the courts.

CONCLUSION

Such continuous exploration of scope of practicedemand a brilliant focus on emerging opportunities,strengthening each link in the service-deliverymechanism and a clear-cut vision to deliver value addedservices. It is to be appreciated that the future of Indialies in outsourcing industry. This is the direction wherethe leading professionals are looking at. It is high timethat company secretaries sharpen their capacities anddevelop strategies for the leadership position in theseopportunity zones.

REFERENCES

1. Satish Menon, Legal Outsourcing Into India–A Concept Paper.

2. Harsh Mishra ,The BPO Strategy – New MantraFor Corporate Efficiency.

3. Nasscom Strategic Review 2003.

4. India in the new knowledge economy- CII.

5. Kusum Makhija, The Knowledge Processors(www.financialexpress.com).

6. www.locomonitor.com.


Modernisation of Company Law for Global Competitiveness 125

MODERNISMODERNISMODERNISMODERNISMODERNISAAAAATION OF COMPTION OF COMPTION OF COMPTION OF COMPTION OF COMPANY LAANY LAANY LAANY LAANY LAWWWWWFOR GLOBAL COMPETITIVENESSFOR GLOBAL COMPETITIVENESSFOR GLOBAL COMPETITIVENESSFOR GLOBAL COMPETITIVENESSFOR GLOBAL COMPETITIVENESS

ALKA KAPOOR*

INTRODUCTION

Most of the countries in the world today includingUK, Hong Kong, Singapore, Australia and Canada are inthe various stages of modernizing their company law.A fair modern and effective framework of company lawis crucial to the performance of any economy andsociety. To achieve competitiveness, it is essential thatwhile the law must balance the needs of many interests,for example, shareholders, directors, employees,creditors and customers, it must also avoid unnecessaryburdens.

In the current national and international scenarioof complex business operations there is a need forsimplifying corporate laws so that they are amenableto clear interpretation and provide a framework thatwould facilitate faster economic growth. It is alsobeing recognised that the framework for regulationof corporate entities has not only to be in tune withthe emerging economic scenario, it must alsoencourage good corporate governance and enableprotection of the interests of investors and otherstakeholders.

Growing emphasis on good corporate governance,corporate social responsibility and good corporatecitizenship is predominantly influencing company lawreforms the world over. Modernization of company lawhas in fact become a part of the drive to facilitateenterprise, enhance the attractiveness of the country asa preferred destination to do business and foster businesscompetitiveness. The overall objective is to achieve asimple, consolidated and accessible company law.Simultaneously, worldwide the Company Law reformsare focusing on transparency through enhanceddisclosures and increased accountability on the part ofcorporate owners while at the same time providing aflexible regime for small and medium businesses.Additionally, the reforms aim at cutting back on overly

125

* Deputy Director, The ICSI. The views expressed are personal views of the author and do not necessarily reflect those of theInstitute.

regulatory intervention thus providing companiesoperating flexibility to tune in conformity with changingenvironment.

The litmus test lies in the harmonization of companylaw with that of global standards, the process which hasbeen started about a decade ago in most countries, soas to achieve global competitiveness.

COMPANY LAW REFORMS IN UNITEDKINGDOM

Company Law in U.K. is currently undergoing majorreform under the Company Law Review (CLR), whichseeks to modernize the legal framework in whichcompanies operate. In 1998, the Governmentcommissioned the Company Law Review Group, anindependent group that comprised experts, practitionersand business people to take a long-term fundamentallook at core company law and see how it could bebrought upto date. The CLR conducted a thoroughreview and assessment and provided the essential blueprint in the form of a Report. As a response to the finalReport of the Company Law Review, the Governmentbrought out White Paper on Company Law 2002,introducing which the then competition Minister,Melanie Johnson stated “Our current company law iscreaking with age and needs to modernize and reform.A thorough overhaul is needed to make the law clearand accessible”.

The White Paper 2002 evoked huge response.Taking into consideration, the suggestions received, theDepartment of Trade and Industry released the UK WhitePaper on Company Law, 2005. This white paper, whichcontains draft clauses for Companies Bill was releasedin March, 2005 inviting views. The new CompaniesBill runs into 190 pages, has 11 main parts and 298clauses. It also includes draft model articles for privatecompanies limited by shares.



Key themes of the White Paper 2005

Proposed changes in the Company Law Reform Billconsist of 4 key themes:

— Enhancing shareholder engagement and a long-term investment culture

Shareholders are the lifeblood of a company,whatever its size. There is therefore, a needto promote wide participation of shareholders,ensuring that they are informed and involved,as they should be. Also, decisions should bemade on the longer-term view and not justimmediate returns.

— Ensuring better regulation and a “Think SmallFirst” approach

Although the vast majority of UK companiesare small, company law has been writtentraditionally with the large companies in mind.The law should be made easier for all tounderstand and use and should removeunnecessary burdens on smaller companies,which are so critical to the economic health ofthe country.

— Making law easier to set up and run a company

Remove unnecessary burdens on directors andpreserve Britain’s reputation as a favouredcountry in which to incorporate and operate.

— Providing flexibility for the future

Company law is not static. There is, therefore,a need to introduce a new reform power toallow updating and amendment ascircumstances dictate, subject to rigoroussafeguards for full consultation and appropriateParliamentary scrutiny.

Pillars of responsibility enshrined in White Paper2005

As a result of Enron and other recent corporatescandals there has been a significant push in U.K. tooblige companies to report clearly about their businessactions. Government has taken the opportunity ofreforms to create laws that protect society fromincreasingly powerful companies and hold themaccountable for their actions both at home and abroad,Corporate reporting of social and environmental aspectshas also become mandatory under the new Bill.

Accordingly the three pillars of responsibilityproposed to be imposed on corporates are :

1. Mandatory Reporting : Companies shall report

against a comprehensive set of social,environmental and economic performanceindicators with which they can benchmark andultimately better manage their operations andperformance in the UK and abroad.

2. Directors’ Duties : Current directors’ dutieshave been expanded to include a specific dutyof care for both society and the environment,in addition to their current financial duty toshareholders.

3. Foreign Direct Liability : Affected communitiesabroad should be able to seek damages in theUK for human rights and environmental abusescommitted by UK companies or their overseassubsidiaries.

The rationale behind these three requirementsis to establish a relationship of accountabilitybetween the two parties involved – thecompany and the stakeholder.

Highlights of major reforms proposed in the UKWhite Paper 2005

Company Formation

One person to be able to form any kind of company.Currently, only private limited companies can be formedby a single member.

Memorandum of Association (MOA)

Company constitutions shall be a single document,with simpler, clearer models for both private and publiccompanies.

MOA shall only be a means to identify the personswho wish to form a company. This will be the onlypurpose of MOA. It shall state that –

(i) subscribers wish to form a company;

(ii) subscribers agree to become members and totake at least one share in the company; and

subscribers shall sign the MOA.

There will be no mention of objects clause implyingthat unless a company positively chooses to restrict itsobjects, its objects shall be unrestricted. Further, objectsshall, in future, be in company’s Articles. Therefore,any restriction in objects shall be contained in the Articlesof the company.

Articles of Association (AOA)

Government shall specify model Articles for bothprivate and public limited companies, the adoption of



which would be entirely a matter for the company. Thisprovides flexibility to all companies to choose not toregister their own Articles of Association in which casetheir articles shall be the model articles prescribed.

Members can choose to ‘entrench’ elements ofcompany’s articles. This means that members shall havea power to lay down stringent provisions for amendmentof Articles say, unanimous resolution etc. However,such entrench clause should be included in AOA througha unanimous consent of members.

Change of Name of Company

In addition to the present circumstances, the nameof a company may be changed in these three newcircumstances :

(i) Order of a Tribunal. It will be possible for acompany to change its name if it was chosento exploit another’s company’s reputation orgoodwill (this is not a protection for trademarks);The tribunal will be constituted under provisionsrelating to opportunistic registration.

(ii) Restoration to the register. A new provisionsis introduced to simplify what happens when acompany is restored to register. These willcover the possibility that, while the companywas not on the register, its name was adoptedby another;

(iii) Any other means provided for by the company’sconstitution. This is a deregulatory proposal, aspecial resolution will no longer be the onlymeans by which a company can change its legalname. (At present there are no restrictions onthe method by which a company can chooseits trading name, and the Bill does not changethis.)

Simplifying the way companies take decisions

— Removal of the requirement for privatecompanies to hold Annual General Meetings(AGMs) unless members want them. Thisprovision shall also remove the requirement tolay down the accounts and re-appoint theauditors at a general meeting. Where privatecompanies hold an AGM, the re-appointmentof auditors will be decided by ordinaryresolution.

— The notice period for all meetings, for limitedcompanies will be 14 days.

— The extraordinary resolution will be abolished.Where a company’s constitution requires an

extraordinary resolution, it will become arequirement for a special resolution.

— Simplification of the rules on written resolutionsto make it easier for private companies to takedecisions. The use of ‘written resolution’, akinto the postal ballot mechanism prevalent inIndia, has been permitted but restricted toprivate companies only. Private companies maypass a written ordinary resolution with a simplemajority of the eligible votes and a writtenspecial resolution with 75% of the eligiblevotes. However, resolutions for removal ofdirectors/auditor of a private company cannotbe passed by written resolution.

Increased Transparency

— The current law requires companies to hold anAGM once a year and there can be a gap of 15months between AGMs. The Bill requires publiccompanies to hold their AGM within 6 monthsof the end of the financial year.

— Shareholders of quoted companies will have aright to propose a resolution to be moved atthe general meeting where the accounts arelaid within 15 days from the day the accountsbecome available.

— Shareholders will be able to require a scrutinyof a poll. The scrutiny will cover the activity ofthe company and its registrar, and examine theprocedure for establishing the admissibility ofvotes and proxies. Shareholders of quotedcompanies will have a new right, if a certainspecified minority so request, to require anindependent scrutiny of any polled votes.Quoted companies will also be required todisclose on their websites and in annual reportsthe results of polls at general meetings.

— A registered auditor, not necessarily thecompany’s own, will conduct the scrutiny.

— Proxies will have extended rights. Any proxyfor a shareholder will be able to speak, vote ona show of hands as well as on a poll, and joinwith others in demanding a poll.

— Companies will be able to recognise, the rightsof the holders of beneficial interests in sharesat the request of the registered member. Therewill be some exceptions to this, for example,only the registered holder will be able to transferlegal title, to ensure that the shares are readilytraded.



Share/Share Capital

— The requirement of the authorized share capitalbe removed on the basis that it is anunnecessary piece of regulation. It willhowever be possible for shareholders to includeprovisions with a similar effect in a company’sarticles if the special circumstances of thatcompany make such restrictions important tothe shareholders.

— Shareholders of both public and privatecompanies will be able to approve an allotmentof redeemable shares on terms that the directorsdetermine. The terms and manner ofredemption will need to be provided to theRegistrar of Companies in the return ofallotments.

— The share premium account can no longer beused to write off a company’s preliminaryexpenses.

Directors

— Primary role of directors will be to promote thesuccess of the company for the benefit of itsshareholders as a whole.

— Director’s general duties to be codified asproposed by the Company Law Review (CLR).Guidance to be given to new directors to coverthe statutory statement of duties, requirementsto provide information to Companies House,and key provisions such as the prohibition offraudulent trading, as well as relevant aspectsof insolvency law.

— A person may not be appointed as director of acompany unless he has attained the age of 16years. The Bill will remove restrictions ondirectors over 70 years.

— A company must have at least 1 director whois a natural person. This requirement is met ifthe office of director is held by a natural personas a corporation sole or otherwise by virtue ofan office.

— Directors and Officers (D&O) insurance.Companies may:

— indemnify directors against most liabilitiesto third parties; and

— pay directors’ legal costs upfront, providedthat the director repays if he or she isconvinced in any criminal proceedings or

judgments is given against him or her inany criminal proceedings brought by thecompany or an associated company.

— Every company director will be given the optionof providing a service address for the publicrecord with the home address being kept on aseparate record to which access will berestricted. This will replace the present systemunder which only directors at serious risk ofviolence and intimidation can have their homeaddresses kept off the public record. Thegeneral effect of the current law appears to beto deter some people from becoming directors.

Reporting and Auditing

— Companies shall provide accurate, accessibleinformation at reasonable cost.

— The current director’s report to be replaced,for small companies, by a short, simple,supplementary statement.

— “Small” companies can claim the right to file“abbreviated accounts”, with no profit and lossaccount and no directors’ report, with theRegistrar of Companies, while “medium-sized”companies can suppress their turnover andoperating costs information. Only “large”groups are required to prepare consolidatedaccounts. Charitable companies are entitled tothe full accounts requirement to be preparedby the directors.

— Reduction of the time allowed to file accountsto 7 months for private companies, and 6months for public companies.

— Quoted companies to prepare a directors’remuneration report. They shall also publishtheir accounts on their website within 4 monthsfrom the end of year.

— A requirement for companies to prepare a cashflow statement.

Auditor liability and audit quality

— Enhanced auditors liability and tougher penaltiesfor accounting offences. Seven yearsimprisonment for dishonestly failing to keepaccounting records and penalty of seven yearsimprisonment and fine and both for defectiveaccounts (currently this penalty is for two years).

— Shareholders to be able to agree to limit theauditor’s liability for damages incurred by acompany to such an amount that is determined



by the Courts to be just and equitable, havingregard to the relative extent of responsibility ofthe auditor for the damage incurred. The auditorwould continue to be fully liable for any fraudto which he or she was party and the existenceof any limitation of liability would be shown inthe company’s annual financial statements. Theauditor should also provide a list of allcompanies with which it has agreed on alimitation of liability in its own annual financialstatements.

To improve audit quality and value, the followingmeasures are proposed:

— Publication of audit engagement letters.

— Shareholders’ rights to question auditors.

— Publication of auditor resignation statements.

— Audit lead partner’s signature on audit reports.

Keeping the law upto date

— Those elements of company law that are likelyto need regular amendment will be put intosecondary legislation.

— The rule making body would also take over fromthe UK Listing Authority, regarding theirresponsibility to require listed companies todisclose their compliance with the CombinedCode on Corporate Governance. It will alsodecide on reviews of the Code (which willremain non-statutory).

Other areas of reform

— The requirement for private companies toappoint company secretaries to be abolished(they will still be free to do so voluntarily).

— The law regulating companies incorporatedoverseas and operating in Great Britain to besimplified.

— Government to consult Alternative DisputeResolution providers to increase awareness ofand accessibility to forms Alternative DisputeResolution as a way of resolving disputesbetween shareholders.

— The Government is considering restricting theuse of companies’ registers of members. It isconsidering an approach that would permit thecompanies not to provide copies of theirregisters if they are to be used for inappropriatepurposes (an ‘inappropriate purpose’ is citedas the use of the data for marketing and selling

purposes). The Government is inclined to allowa company to have the right to apply to theCourt for relief from the obligation to providea copy of its register, while the courts wouldcontinue to have discretion to refuse to orderaccess to the register.

E-communications

— Existing provisions of company law impose anumber of requirements about the use of papercommunications, which can prevent bothcompanies and shareholders from enjoying all thecost savings and other benefits that sensible useof new communications technology can bring.

— The Government therefore intends to allow allcompanies, subject to shareholder approval, tobe able to use electronic communications withshareholders. Electronic communications canbe used where the resolution can be receivedin legible form, or a form that can be convertedby the recipient into legible form. For example,a resolution can be passed through an e-mailor text message, but not a telephone call.Individuals will be able to request continuedcommunication on paper if they wish.

Further UK Initiatives on Company Law Reforms

The Government has come out with a number ofother legislations closely connected with the widercompany law reform project. These include:

(i) Companies (Audit, Investigations andCommunity Enterprise) Act, 2004 theC(AICE) Act which has been brought forwardto ensure better oversight and strongerregulation of the accounting and auditprofession, to increase investor confidence incompany reporting and enforcement, and tostrengthen powers to investigate companies.The Act encourages the development of thesocial enterprise sector by making it possibleto form a new type of company, the“community interest company”, whose profitsand assets must be used for the benefit of thecommunity.

(ii) The draft regulations which will require allquoted companies to produce an Operatingand Financial Review (OFR) have been laid.The OFR is a new form of narrative report inwhich companies will need to describe futurestrategies, resources, risks and uncertainties,including policies in relation to employees and



the environment where these are relevant tofuture strategy and performance. It is a stepforward in improving company reporting andtransparency and in promoting effectivedialogue on the key drivers of long-termcompany performance. It also recognizes thatin a modern economy, those who run successfulcompanies need to develop relationships withemployees, customers, suppliers and otherswhich support long-term value creation.

(iii) Directors’ Remuneration ReportRegulations, 2002, which require quotedcompanies to disclose and seek shareholderapproval for their executive remunerationpolicies, and to disclose how remunerationrelates to performance. Regulations act as acatalyst for increasing company accountabilityand effective shareholder engagement.

INDIAN SCENARIO

Companies Act, 1956 which provides the legalframework for corporate entities in India too is amammoth legislation. As the corporate sector grew inpace the need for streamlining this Act was felt and asmany as 24 amendments have taken place since then.Major amendments were made through the Companies(Amendment) Act, 1988 after considering therecommendations of the Sachar Committee, and thenagain in 1998, 2000 and in 2002 through the Companies(Second Amendment) Act, 2002. Unsuccessful attemptswere made in 1993 and 1997 to replace the presentAct with a new law. Companies (Amendment) Bill,2003 containing important provisions relating toCorporate Governance and aimed at achievingcompetitive advantage was also introduced.

To frame a law that enables companies to achieveglobal competitiveness in the fast changing corporatescenario, the Government has now taken up a freshexercise for a comprehensive revision of the CompaniesAct, 1956 albeit through a consultative process. As athe first step in this direction, a Concept Paper onCompany Law drawn up in the legislative format wasexposed for viewing on the electronic media so that allinterested may not only express their opinions on theconcepts involved but may also suggest formulationson various aspects of Company Law.

The response to the concept paper on CompanyLaw was tremendous. The Government, therefore, feltit appropriate that the proposals contained in the ConceptPaper and suggestions received thereon be put to

merited evaluation by an independent ExpertCommittee. A Committee was constituted on 2ndDecember, 2004 under the Chairmanship of Dr. J J Irani,Director, Tata Sons, with the task of advising theGovernment on the proposed revisions to the CompaniesAct, 1956 with the objective to have a simplified compactlaw that will be able to address the changes taking placein the national and international scenario, enableadoption of internationally accepted best practices aswell as provide adequate flexibility for timely evolutionof new arrangements in response to the requirementsof ever-changing business models.

DR. J J IRANI COMMITTEE REPORT

Dr. J J Irani Expert Committee on Company Lawhas submitted its report charting out the road map for aflexible, dynamic and user-friendly new company law.The Committee has taken a pragmatic approach keepingin view the ground realities, and has sought to addressthe concerns of all the stakeholders to enable adoptionof internationally accepted best practices. As one wadesthrough the report, one finds an arduous zeal to ensurethat flexibility is coupled with accountability andtransparency. Be it the role of directors in themanagement of the company or the role of promotersat the time of incorporation or the responsibility ofprofessionals in ensuring better governance, the reporthas made very dynamic and balanced recommendations.The Report of the Committee has also sought to bringin multifarious progressive and visionary concepts andendeavored a significant shift from the “GovernmentApproval Regime” to a “Shareholder Approval andDisclosure Regime”.

The Expert Committee has recommended thatprivate and small companies need to be given flexibilitiesand freedom of operations and compliance at a lowcost. Companies with higher public interest whichaccess capital from public need to be subjected to amore stricter regime of Corporate Governance. Further,Government companies and public financial institutionsbe subject to similar parameters with respect todisclosures and Corporate Governance as othercompanies are subjected to.

New Concepts introduced

To attune the Indian Company Law with the globalreforms taking place in the arena, the Report of theCommittee has sought to bring in multifarious visionaryconcepts, which if accepted and acted upon will reallysimplify the voluminous and cumbersome CompaniesAct in the country.



One Person Company (OPC)

To encourage corporatisation of business andentrepreneurship, the concept of single personeconomic entity has been introduced in the form of‘one person company’.

It is recommended that :

(a) OPC may be registered as a private Companywith one member and may also have at leastone director;

(b) Adequate safeguards in case of death/disabilityof the sole person should be provided throughappointment of another individual as NomineeDirector. On the demise of the original director,the nominee director will manage the affairsof the company till the date of transmission ofshares to legal heirs of the demised member.

(c) Letters ‘OPC’ to be suffixed with the name ofOne Person Company to distinguish it fromother companies.

The recommendation is in sync with the internationalpractice as U.K., Australia, Singapore and many othercountries provide that a company is capable of beingformed with a single person and having one director.Even the neighboring country Pakistan has introducedthe concept, albeit only for incorporation of privatecompanies limited by shares.

It is also recommended that such companies shouldbe regulated through a simpler regime so that the singleentrepreneur is not compelled to dissipate his time andenergy and resources on procedural matters. However,the OPCs should be permitted to be formed only bynatural persons.

Small Companies

The law should provide a framework compatible togrowth of small corporate entities and should enablethem to achieve transparency at a low cost throughsimplified requirements. With this aim and to enablesimplified decision making procedure by relieving smallcompanies from select statutory internal administrativeprocedures, the Committee has recommended that suchcompanies be governed by a simpler regime throughexemptions which can be given in the form of a scheduleto the Act. Such companies should be subjected toreduced financial reporting and audit requirements aswell as simplified capital maintenance regime. Suchcompanies should also be subjected to scaled downfree structure. The definition of small companies maybe based upon the gross assets comprising of fixed assets,

current assets and investments not exceeding a particularlimit as also the turnover of the company concerned.

Simplified regulatory regime for small companiesas proposed in U.K. white paper with its emphasis on‘think small first approach, also exists in many othercountries including Germany, France, U.S.A. etc.

Limited Liability Partnership (LLP) – The‘unlimited liability’ of partners has so far been the chiefreason why partnership firms of professionals, have notgrown in size to successfully meet the challenges posedtoday by international competition, WTO, GATT etc.As an alternative corporate business vehicle that hasthe benefits of limited liability but allows its membersthe flexibility of organizing their internal structure as atraditional partnership, the Committee has proposed theconcept of LLP to be introduced.

In an LLP, while the LLP itself is liable for the fullextent of its assets, the liability of the partners is limited.Partners are protected from vicarious liability i.e. liabilityarising from the incorrect decision or misconduct of otherpartners and employees not under their direct control.There is no recourse to attach the personal assets ofother members except the member who is negligent.However, the liability of negligent partner remainsunlimited. Also any new or existing firm of two or morepersons can incorporate as an LLP.

LLP is the very suitable vehicle for growth of theservice sector and specially for multi disciplinarypartnership firms. It provides flexibility to smallenterprises to participate in joint ventures and to accesstechnology and to professionalise business in order toface increasing global competition.

The laws of U.S.A., U.K. and Australia permitformation of LLPs. Most LLP statutes provide that partnerswill be personally liable for their own negligence ormalfeasance. In addition, most LLP statutes providethat LLP partners are liable for the negligence, wrongfulacts and misconduct of any person under the LLPpartner’s “direct supervision and control”, although thestatutory terminology differs in this regard. Further, themost recent LLP statutes including those enacted inColorado, New York etc., provide LLP partners with fullprotection from vicarious liability but limits LLPs toprofessional firms.

Though advocating the adoption of the concept ofLLP in the Indian legal system, the Committee hasrecommended that a separate Act be brought about tofacilitate limited liability partnerships. The concept neednot be introduced in the Companies Act.



Independent Directors

Though the concept of independent directors is notnew, it has so far been enshrined in the corporategovernance codes of various countries. It is for the firsttime that the concept has been proposed to beintroduced in Company Law in India. The Committeehas however suggested that independent directors arerequired to be appointed only in respect of listedcompanies or the companies which have acceptedpublic deposits.

The Committee has proposed that atleast one-thirdof the Board should comprise of independent directorsirrespective of whether the company has an executiveor non-executive Chairman. This is though in contrastwith Clause 49 of the listing agreement which providesfor proportion of the Independent Directors on the basisof chairman being non-executive or non-executive.

No minimum qualification has been laid for anindependent director. It has been specified that theappointment of independent directors should be madeby the company from amongst persons, who in theopinion of the Board, are persons with integrity,possessing relevant expertise and experience and whosatisfy the criteria for independence. This will indirectlyensure that only the persons possessing necessaryknowledge, skills, and ethics are kept on the Boards ofCompanies.

The Committee has recommended that theexpression ‘Independent Director’, shall mean a non-executive director of the company who:

(a) apart from receiving director’s remuneration,does not have, and none of his relatives or firms/companies controlled by him have, any materialpecuniary relationship or transactions with thecompany, its promoters, its directors, its seniormanagement or its holding company, itssubsidiaries and associate companies whichmay affect independence of the director.

(b) is not, and none of his relatives is, related topromoters or persons occupying managementpositions at the board level or at one level belowthe board;

(c) is not affiliated to any non-profit organizationthat receives significant funding from thecompany, its promoters, its directors, its seniormanagement or its holding or subsidiarycompany;

(d) has not been, and none of his relatives has

been, employee of the company in theimmediately preceding year;

(e) is not, and none of his relatives is, a partner orpart of senior management (or has not been apartner or part of senior management) duringthe preceding one year, of any of thefollowing:-

(i) the statutory audit firm or the internal auditfirm that is associated with the company,its holding and subsidiary companies;

(ii) the legal firm(s) and consulting firm(s) thathave a material association with thecompany, its holding and subsidiarycompanies;

(f) is not, and none of his relatives is, a materialsupplier, service provider or customer or a lessoror lessee of the company, which may affectindependence of the director;

(g) is not, and none of his relatives is, a substantialshareholder of the company i.e. owning twopercent or more of voting power.

Explanation :

For the above purposes -

(i) “Affiliate” should mean a promoter, directoror employee of the non-profit organization.

(ii) “Relative” should mean the husband, thewife, brother or sister or one immediatelineal ascendant and all lineal descendentsof that individual whether by blood,marriage or adoption.

(iii) “Senior management” should meanpersonnel of the company who aremembers of its core management teamexcluding Board of Directors. Normally, thiswould comprise all members ofmanagement one level below theexecutive directors, including all functionalheads.

(iv) “Significant Funding” – Should mean 25%or more of funding of the Non ProfitOrganization.

(i) “Associate Company” – Associate shall meana company which is an “associate” as definedin Accounting Standard (AS) 23, “Accountingfor Investments in Associates in ConsolidatedFinancial Statements”, issued by the Instituteof Chartered Accountants of India.



Key managerial personnel

The Committee has identified CEO /MD /CFO andCompany Secretary as the Key Managerial Personnelfor all companies, whose appointment and removalshall be by the Board of Directors of the companyconcerned.

Key Managerial Personnel should be in the whole-time employment of only one company at a time andboth the managing director and the whole time directorsshould not be appointed for more than 5 years at atime. However, the present requirement of havingmanaging director/whole time director in a publiccompany with a paid up capital of Rs.5 crores may berevised to Rs.10 crores by appropriate amendment ofthe Rules.

Special exemptions may be provided for smallcompanies, which may obtain such services, as may beconsidered mandatory under law, from qualifiedprofessionals in practice.

Directors and Officers (D&O) Insurance

The long felt need of the corporate sector in regardto extending insurance cover for the key man and keydirectors of companies has been addressed by thecommittee. It is recommended that insurance of keymen and key directors and senior officers of companiesmay be taken by means of general insurance policiesand the insurance premium paid by the company forsuch a policy need not be treated as perquisite or incomein the hands of director concerned. However, if thewrongful act of the director or concerned officer isestablished, then the appropriate amount of premiumattributable to such person shall be considered asperquisite or income for the purpose of remuneration.

Directors and officers (D&O) insurance as a meansby which directors/officers of companies seek to mitigatepotential personal liability, is very much prevalent inmany developed economies of the world.

Rights and liabilities of independent and non-executive directors

Independent directors should have access toaccurate, relevant and timely information in order todischarge their duties and responsibilities effectively withthis objective in mind, the Expert Committee hasrecommended that Independent/non-executivedirectors should be able to call upon the Board for duediligence or obtaining of record for seeking professionalopinion by the Board, right to inspect records of thecompany, review legal compliance reports prepared by

the company; and in case of disagreement, record theirdissent in the minutes.

The Committee also went into the question ofwhether independent directors should be liable for allacts on the same footing as executive directors or shouldthey be granted immunity from certain offences. It hasrecommended that a non-executive /independentdirector should be held liable only in respect ofcontravention of any provisions of the Act which hadtaken place with his knowledge and where he has notacted diligently, or where the contravention has beenwith his consent or connivance.

It is further recommended that if the independentdirector does not initiate any action upon knowledge ofany wrong, such director should be held liable. Thisimplies, if irregularities come to the knowledge of thedirectors and yet they do not act proactively and exercisedue diligence to ensure that the interest of the companyis duly protected, then they should be held responsible.

Knowledge should flow from the processes of theBoard. Additionally, upon knowledge of any wrong,follow up action/dissent of such independent directorsfrom the commission of the wrong should be recordedin the minutes of the Board meeting.

Freeing the Managerial Remuneration of limits

Managerial remuneration in India has so far beenrestricted to certain limits in the case of public companiesand private companies which are subsidiaries of publiccompanies, with the overall limit being 11% of the netprofits of the company during the financial year.

Internationally, the laws of various countriesincluding U.K., Australia, Canada and Singapore do notprovide for any upper ceiling or minimum level ofdirectors’ remuneration. The UK Companies Actprovides for necessary disclosures about ‘emolumentsand other benefits of directors and others’ in the notesto accounts (for a company which is not quoted). Incase of quoted companies, it provides for preparationof Directors’ Remuneration Report, which must be dulysigned. The auditors of the company must also auditthis report. The Act also provides for laying the Directors’Remuneration Report before the company in generalmeeting, approval by the members, delivery to theregistrar and other related matters.

The Australian and Singapore Companies Actsprovide that members with certain majority/votingpower may obtain information about directors’remuneration. The Acts also mandate for audit of thestatement of managerial remuneration paid, sending it



to the entitled persons and the laying the same beforethe general meeting.

Moving in tune with the international practice, theCommittee has recommended removal of all ceilingson payment of directors’ remuneration. Shareholdersof companies have been empowered to decide as tohow to remunerate their directors. However, this processis to be transparent and based on principals that ensurefairness, reasonableness and accountability. It isimportant that there should be a clear relationshipbetween responsibility and performance vis-à-visremuneration, and that the policy underlying Directors’remuneration be articulated, disclosed and understoodby investors/stakeholders. To ensure transparency, it isrecommended that Directors’ Remuneration Reportshould form part of the annual report of the companyand should contain details of remuneration package ofdirectors including company’s policy on directors’remuneration, the performance graph of the companyand the remuneration of directors vis-à-vis theperformance of the company.

Another important feature of the recommendationsrelating to managerial remuneration is the removal ofall government approvals. The Committee felt that inthe current competitive environment, where Indiancompanies have to compete for specialized manpowerglobally, it may not be feasible or appropriate for thegovernment to interfere. Instead of the restrictiveregime based on ‘government approvals’, the‘shareholder approval’, regime be adopted. Decision onhow to remunerate directors should be left to thecompany. However, this should be transparent and basedon principles that ensure fairness, reasonableness andaccountability. The shareholders have beenrecommended to be empowered to decide theremuneration of non-executive directors includingindependent directors with no government interference.The criteria for remuneration/compensation of non-executive/independent directors should be based ontheir attendance and contribution and performance ofthe company. This may be in the form of sitting feesfor Board and committee meetings attended physicallyor participated in electronically and/or profit relatedcommissions.

Committees of the Board

While recognizing the need for discretion of theBoard to manage and govern the company throughcollective responsibility, the Expert Committee hasmandated the constitution of certain committees ofBoard for certain categories of companies, whose

recommendations would be available to the Board fortaking final decisions. These Committees are AuditCommittee, Remuneration Committee and StakeholdersRelationship Committee. Although the concept of AuditCommittee was already there in the Companies Act,1956 the mandatory requirement of other twocommittees in respect of certain companies is new.While the constitution of Audit Committee andRemuneration Committee has been recommended asmust for all listed companies and companies acceptingpublic deposits, the stakeholders relationship committeeis suggested to be constituted in companies havingcombined shareholder/deposit holder/debenture holderbase of 1000 or more. The main recommendations inrespect of these committees are as below:

Audit Committee for Accounting and Financial matters

— Majority of directors to be independent, ifappointment of independent directors isrequired.

— Independent Chairman.

— Atleast one member to have financialknowledge.

— Chairman to attend AGM and provideclarifications relating to Audit. If Chairman isunable to attend, he may authorise any othermember of Audit Committee to do so.

— Recommendations of the Committee notaccepted by the Board to be disclosed inDirectors’ Report with reasons for overruling.

Stakeholders Relationship Committee

— To be constituted in companies havingcombined shareholder/ deposit holder/debenture holder base of 1000 or more.

— Main objective shall be to monitor redressal ofinvestor grievances.

— Non-executive director to act as Chairman.

Remuneration Committee

— Compulsory constitution in Public listedcompanies and any company acceptingdeposits.

— To comprise of non-executive directors includingatleast one independent director if appointmentof independent directors is required. In such acase, Chairman also to be independent.

— Main objective shall be to determine thecompany’s policy and remuneration packages



of MD/Executive directors/seniormanagement.

— Chairman or atleast one member of thecommittee should be present in GeneralMeeting to answer shareholders’ queries.

Recognition to joint venture/shareholders’agreements

Over the years, several Court judgments have beenpronounced in India on validity of joint ventureagreements vis-à-vis the provisions of the Act containedin sections 9, 111A, etc. It has been held that theprovisions of Joint Venture/Shareholders’ Agreement willbind the company only if such agreement is endorsed/incorporated in the articles of the company itself.

The Committee recognised the issues involved invalidity of joint venture covenants vis-à-vis the provisionsof the existing Act. It was noted that joint ventureagreements have several clauses pertaining to votingrights, additional quorum requirements, arbitrationprovisions, pre-emption rights or restrictions on transferof shares etc. The effect of this framework is thatdispute resolution in respect of joint venture provisionsbecomes subject to contract law provisions and issubject to lengthy arbitration. Companies, however,prefer such aspects to be addressed more speedilythrough the corporate processes.

The Committee has, therefore, recommended thata transparent modality for providing recognition toagreements between joint venture partners for corporateaction should be worked out in company law, keepingin view the concern that such arrangements should notbecome a window for circumventing the essentialprovisions of the law.

Tracking and Treasury Stocks

Tracking Shares - The Committee hasrecommended the introduction of ‘Tracking Stocks’,also known as ‘targeted stocks’. Tracking Stocks as afinancial vehicle that tracks the performance of aparticular division or subsidiary. A tracking stock is atype of common stock that “tracks” or depends on thefinancial performance of a specific business unit oroperating division of a company, rather than theoperations of the company as a whole. As a result, ifthe said unit or division performs well, the value of thetracking stocks may increase, even if the company’sperformance as a whole is not up to mark or satisfactory.The opposite may also be true.

By issuing a tracking stock, the different segmentsor divisions of the company can be valued differently

by investors. When a parent company issues a trackingstock, all revenues and expenses of the applicabledivision are separated from the parent company’sfinancial statements and bound to the tracking stock.Often this is done to separate financial statement of ahigh-growth division from the financial statements ofthe parent company which may contain huge losses.The parent company and its shareholders, however, stillcontrol operations of the subsidiary.

Tracking stock carries dividend rights tied to theperformance of a targeted division without transferringownership or control over divisional assets. In contrastto a spin-off or an equity carve-out, the parent retainsfull control, allowing it to enjoy any operating synergies,or economies of scale in administration or finance.Shareholders of tracking stocks have a financial interestonly in that unit or division of the company. Unlike thecommon stock of the company itself, a tracking stockusually has limited or no voting rights. When a trackingstock is issued, the company can choose to sell it to themarkets (i.e., via an initial public offering) or to distributenew shares to existing shareholders. Either way, thenewly tracked business segment gets a longer lease,but can still run back to the parent company if times gettough.

Even though the tracking stock is targeted at aspecific subunit, the business subunit is still responsiblefor all of the firm’s debts and the assets can betransferred in or out of the subunit as the common boardof directors think fit. The assets of the tracking stockportion of the business continue to be owned by theparent company and can be used against thecorporation’s liabilities. In addition the capital raisedthrough the issuance of tracking stock is not restrictedfor use only by the tracked business segment.

A key advantage of tracking stock is that it offersdivisional managers a degree of decision-makingauthority that might otherwise be unattainable, giventop management’s reluctance to dilute its control overthe division’s assets. The practical effect would be toenhance job satisfaction for divisional managers, thusreducing retention risk and also increasing the company’sresponsiveness to changing market conditions. Also,investors have more direct access to the specificbusinesses of the parent, which can be highly useful inthe case of a diversified company.

Treasury Stocks - The Committee has alsorecommended introduction of treasury stocks as ameasure for raising of funds at a low cost. Presently,section 77A of the Companies Act, 1956 provides for



buy-back of securities. Once bought back, the relevantsecurities are to be extinguished. Internationally,however, a company can, subject to certain restrictions,hold bought back shares itself under the name “TreasuryStock”. In other words, Treasury Stocks are the shareswhich a company legitimately holds on its share registerin its own name. The voting rights on these TreasuryStocks are suspended and company cannot exercisevoting rights on such shares. No distribution of dividend(including dividend during winding up) can be made tosuch stock.

The Committee felt that a number of preparatoryactions were required before the concepts of TrackingStocks and Treasury Stocks could be introduced, such asthe regulations to be framed by capital market regulator,development of appropriate, specific accountingstandards etc. It therefore recommended that while anenabling provision for Tracking / Treasury Stocks couldbe incorporated in the new Law, actual introduction ofTracking and Treasury Stocks in the Indian Capital Marketsbe made only when the necessary framework is ready.

Perpetual Preference Shares

As per the existing provisions, preference sharescan be issued for a maximum period of 20 years. Asmany companies may like to raise capital of a quasi equityand permanent nature on account of long gestationproject capital requirements, the Committee felt thatthe concept of perpetual preference shares or preferenceshares of higher tenure be permitted in the new Law.The Committee recommended that companies shouldbe permitted to issue perpetual/ longer durationpreference shares and that returns from such shares maybe linked to market benchmark or reset periodically. Incase the subscriber of perpetual preference shares wantsto redeem his shares prematurely, necessary enablingprovisions to redeem the shares by the company up toa certain percentage of preference shares on an annualbasis may be provided. This may be done through “call/put option mechanism”. The Committee also felt thatflexibility should be given to the companies to revisethe tenure of already issued preferential shares byobtaining prescribed approval of shareholders forvariation of rights.

Single Window Clearance for Mergers

The Committee recognised the fact that the Indianmerger law, as it exists today, is cumbersome and timeconsuming and rightly emphasized on the need forspeedier disposal of mergers and acquisitions (M&As)proposals. Mergers and acquisitions today are a widelyused multipurpose business tool that can bring long-

term benefits in the context of increasingcompetitiveness in the market. The Committeeaddressed on formulation of a corporate insolvencylegislation which would enable to carry out M&As with“digital speed” and made several recommendations inthis regard. One of the recommendation is a singlewindow clearance for the purpose. The law shouldprovide for a single forum which would approve theschemes of mergers and acquisitions in an effective timebound manner. The concept of 'deemed approval' shouldbe provided for in cases where the regulators do notintimate/inform their comments within a specified timeperiod to the Court/Tribunal before which the schemeof merger/amalgamation is submitted for approval.

Empowering the National Company Law Tribunalto grant clearance for all aspects of the merger/amalgamation would obviate the need to approachdifferent forums for clearances required for the merger/amalgamation and hasten the process. This wouldaddress the problem that has ailed Indian businessesfor long.

Contractual Mergers

The Committee was of the view that contractualmergers may be given statutory recognition in theCompany Law in India as is the practice in many othercountries as a restructuring tool to hasten the processof mergers and acquisitions. Such mergers andacquisitions are in the contract form (i.e. without theintervention of the court) and are made subject tosubsequent approval of shareholders by simple majority.

The recognition of such contractual mergers wouldeliminate obstructions to mergers and acquisitions, giveex-post facto protection and the ability to rectify them.

Committee felt that steps should be taken to validatecontractual mergers because court-oriented processmany times leads to delays. Even as judicial process isimportant to take care of the interest of minorityshareholders, many times it is used as a tool to abuseand derail the process. In fact, “Some very well-meaningmergers and acquisitions are taken to court by motivatedshareholders with vested interests to derail the process”.

Time-bound proceedings for restructuring andliquidation

The Committee recognised the business need forefficient and speedy procedures for exit as much as forstart up. The Committee noted that a recent survey byWorld Bank (Doing business in 2005 – India RegionalProfile) has pointed out that it takes an average 10 years



to wind up/liquidate a company in India as comparedto 1 to 6 years in other countries. Such lengthy time-frames are detrimental to the interest of all stakeholders.The process should be time-bound, aimed at maximizingthe chances of preserving value for the stakeholders aswell as the economy as a whole.

The Committee has recommended that a singleindependent forum should be created for acceleratingthe liquidation process and a definite and predictabletime frame should be provided for. The existing timeframe in India is too long and keeps precious assetslocked in proceedings for many years, destroying theirvalue in the process. In this protracted and never-endingprocess, the assets not only lose value but even disappearand vanish. On an average, a time frame of two yearsshould be feasible for the liquidation process to becompleted. A period of one year should be adequatefrom commencement of the process till sanction of aplan. There should also be a definite time period withinwhich proceedings may commence from the date offiling of the application for rehabilitation.

The legislation should limit the possibility of appealsat every stage so that the process is not delayed throughfrivolous appeals or stalling tactics. A fixed time periodshould be provided for at each stage of rehabilitationand liquidation process. Extension at every stage shouldbe rare and allowed only in exceptional circumstancesand in any case without effecting the outer time-limitprovided for the process.

On an average a time frame of 2 years should befeasible for the liquidation process to be completed.

Insolvency Practitioners

Keeping in view the important role of professionalsand experts in the insolvency process, the Committeehas recommended the recognition of the concept of‘Insolvency Practitioners’. Currently, the law does notsupport effective participation of professionals andexperts in the insolvency process. Law should encourageand recognize the concept of Insolvency Practitioners(Administrators, Liquidators, Turnaround Specialists,Valuers etc.) and disciplines of chartered accountancy,company secretaryship, cost and works accountancy, lawetc. can act as feeder streams, providing high qualityprofessionals for this new activity. Greater responsibilityand authority should be given to Insolvency Practitionersunder the supervision of the Tribunal to maximizeresource use and application of skills.

The insolvency fund

The Committee proposed that the provisionsrelating to rehabilitation cess should be replaced by theconcept of ‘Insolvency Fund’ with optional contributionsby companies. The Government may make grants forthe fund and provide incentives to encouragecontributions by companies to the fund. Companieswhich make contributions to the fund should be entitledto certain drawing rights in the event of insolvency.Administration of the fund should be by an independentadministrator. Insolvency fund should not be linked/credited to Consolidated Fund of India.

International Considerations

Key international initiatives like United NationsCommission on International Trade Law (UNCITRAL)legislative Guide on Insolvency, World Bank Principlesfor Efficient Insolvency and Creditors Right SystemsInternational projects were examined by the ExpertCommittee to bring the provisions in tune withinternational developments.

A strong need for a suitable framework for CrossBorder Insolvency which provides for rules of jurisdiction,recognitions of foreign judgments, co-operation andassistance among Courts in different countries and choiceof law is recommended by the Committee. It is alsosuggested that the Government may consider adoptionof UNCITRAL Model Law on Cross Border Insolvencywith suitable modifications at an appropriate time.

End Note

The process of reforms in Company Law is indeeda herculean task. And this task is being undertakenglobally to enact comprehensive, simple and effectivecompany law which not only provides a flexibleframework for corporate entities to compete globally,but also imposes strict corporate responsibility therebyensuring protection of all stakeholders. Corporatereporting of social and environmental aspects too isbeing recognised as an essential ingredient of newCompany Law.

The recommendations contained in UK WhitePaper 2005 and Dr. J.J. Irani Committee Report arevisionary and need to be implemented at the earliestby the respective countries, to provide a forwardlooking legal framework for corporates and allconcerned stakeholders.

Documents

CONTENTS · 2008. 5. 31. · CONTENTS 1. Restructuring Professional Firms For GATS Regime — N K Jain 1 2. Corporate Criminal Liability — The Issue Revisited in the Context of