Mohit Saraf, Senior Partner

Luthra and Luthra Law Offices

Clause 49 of the Listing Agreement -A Comparative Analysis-

Presented to Alliance India 12 th August 2005 Luthra & Luthra Law Offices 1

Section I

Outline

Conceptualizing Corporate Governance Section II The Need for Corporate Governance Section III Evolution of Corporate Governance in India Section IV Clause 49 of the Listing Agreement Section V The Sarbanes Oxley Act, 2002 Section VI The Eighth Council Directive

 Section I Conceptualizing Corporate Governance

Narrow Definition

 A set of relationships between the company and shareholders, directors and management.

 Beneficiary of good governance- The Shareholder 

Broad Definition

 Looking to the implicit and explicit relationships of the company with employees, distributors, local communities.

creditors, consumers,  Beneficiary of good governance- Every Stakeholder Luthra & Luthra Law Offices 3

 Conceptualizing Corporate Governance (Contd.)

OECD Definition

– System by which corporations are directed and controlled.

– Spells out the rules / procedures for making decisions on corporate affairs.

– Provide the structure through which the company objectives are set, and the means of attaining those objectives and monitoring performance – Specifies the distribution of rights and responsibilities among different participants in the corporation, such as, the board, managers, shareholders and other stakeholders 

World Bank Definition

– Corporate governance is about promoting corporate fairness, transparency and accountability Luthra & Luthra Law Offices 4

Conceptualizing Corporate Governance (Contd.)   What constitutes profitability) shareholders’ interest? (sustainable Need for external regulation – FOR: » Conflict of interest b/w Management/Promoters and other constituencies » To protect small investors » To account for Externalities – AGAINST: » Risk of excessive policing » Increase costs Luthra & Luthra Law Offices 5

Section II

The Need for Corporate Governance  Responsibility to Stakeholders  Easier access to capital (FII, VCF, Foreign Markets)  Efficiency (at the firm level) and Global Competitiveness Luthra & Luthra Law Offices 6

    

Section III

The Evolution of Corporate Governance in India December 1995: CII sets up task force to voluntary code of corporate governance April 1998: CII Governance: A Code” releases design “Desirable Corporate May 1999: SEBI sets up the Kumar Mangalam Birla Committee February 2000: Clause 49 introduced pursuant to KM Birla Report 2002: DCA sets up Naresh Chandra Committee Report recommends financial and non-financial disclosures and independent auditing and board oversight of management (Draft Companies Bill) Luthra & Luthra Law Offices 7

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Section III

The Evolution of Corporate Governance in India 2002: Narayana Murthy Committee set up by SEBI to review clause 49 2003: Clause 49 modified to reflect some of Narayana Murthy’s recommendations December, 2005: Deadline for compliance with modified Clause 49 Luthra & Luthra Law Offices 8

-Section IV Clause 49 of the Listing Agreement

Concerned with Independent Directors, Audit Committees, Disclosures, CEO/CFO Certification   Independent Directors Half of Board with executive CM to be independent; third of board with non executive CM to be independent.

Definition of independent director   Non executive No Material pecuniary relationships or transactions with company, promoters, directors, senior management, holding company, subsidiaries or associates Luthra & Luthra Law Offices 9

-Section IV Clause 49 of the Listing Agreement

 Definition of independent Director (…contd.)   Not related to promoters, to board members or to persons holding managerial positions one level below board Has not been an executive in company in preceding three years     Has not been a partner or executive in statutory audit firm or internal audit firm Has not been a partner or executive in law firm or consulting firm with material association to company Is not a material supplier, service provider, customer, lessor or lessee of company Does not hold more than 2% shares in company Luthra & Luthra Law Offices 10

-Section IV Clause 49 of the Listing Agreement

      The Audit Committee Company to constitute an audit committee with terms of reference At least three members- two thirds independent CM to be independent- must attend every AGM All members financially literate- at least 1 member to be expert- CS to be secretary May meet with or without executives To meet at least 4 times a year- quorum = greater of 2 members or 2/3 rd and at least 2 independent Luthra & Luthra Law Offices 11

-Section IV Clause 49 of the Listing Agreement

 The Powers of the Audit Committee Investigate all matter within its terms of reference  Seek information from any employee  Obtain outside legal/ professional advice  To invite outside experts Luthra & Luthra Law Offices 12

-Section IV Clause 49 of the Listing Agreement

        The Role of the Audit Committee Oversee financial reporting process Recommend to the Board the hiring and firing of statutory auditors and the fixing of their fees To review working of whistle blower mechanisms Discussing significant findings and follow ups with internal auditors Approval of payment to statutory auditors for any other services rendered Reviewing with the management annual/ quarterly financial statements before they are vetted by board especially Reviewing the adequacy of structures, staffing etc. of internal audit department Other functions specified in terms of reference Luthra & Luthra Law Offices 13

-Section IV Clause 49 of the Listing Agreement

Audit Committee to review following information      Statement of significant submitted by management related party Management letters and letters of weakness issued by the statutory auditors transactions internal control Internal audit reports relating to internal control weakness Review of appointment, removal remuneration of chief internal auditor and terms of Management discussion and analysis of financial condition and result of operations Luthra & Luthra Law Offices 14



-Section IV Clause 49 of the Listing Agreement

Disclosure Related party transactions ~ Place before the audit committee:   - summary of transactions in the ordinary course of business - details of transactions not in the ordinary course of business - details of transactions, with related parties or others, not on arms length basis If financial statements are prepared in a manner other than that prescribed in an accounting standard has been used, the same has to be disclosed in them.

Disclose in the Annual Report all pecuniary relationship or transactions of the non-executive directors with the company; criteria for making payments to such directors and number of shares and convertible instruments held by them.

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-Section IV Clause 49 of the Listing Agreement

    Disclosure Disclose in the Annual Report all elements of remuneration package of independent directors; service contracts, notice period, severance fee and stock options details Senior Management shall make disclosures to the Board relating to all material financial and commercial transactions, where they have a personal interest that may have a potential to conflict with the interests of the Company On appointment of a new director or re-appointment of a director, provide information to the shareholders with respect to his expertise, about his membership/directorship in other companies and his shareholding in case he is a non-executive director.

Quarterly results and presentations made by the Company to analysts shall be put on company’s website. Luthra & Luthra Law Offices 16

-Section IV Clause 49 of the Listing Agreement

CFO / CEO certification CEO = MD or Manager Appointed Under Companies Act o  CFO = Whole Time Finance Director or Other Person Heading the Finance Function CEO and CFO to certify to the board that they have reviewed financial statements and the cash flow statements and to the best of their knowledge and belief:  No materially untrue statement/ omission of material fact/ misleading statement  Statements together present true and fair picture of company’s affairs and are in compliance with existing accounting standards, laws and regulations Luthra & Luthra Law Offices 17

-Section IV Clause 49 of the Listing Agreement

 i.

ii.

   iii.

CFO / CEO certification CEO/ CFO to certify the following No transactions entered into by company during the year which are fraudulent, illegal or violative of the company’s code of conduct Accept responsibility for internal control systems, have evaluated the effectiveness of the systems.

Have indicated to auditors and audit committee Significant changes in internal control during the year Significant changes in accounting policies Instances of significant fraud of which they have become aware Luthra & Luthra Law Offices 18

-Section IV Clause 49 of the Listing Agreement

Non Mandatory requirements of Clause 49  Only reporting required- compliance discretionary   Whistle Blower Policy: mechanism to prevent victimization and provide direct access to CM of audit committee Independent directors may have tenure in aggregate of 9 years   Half yearly declaration of performance to be sent to each shareholder household Move towards unqualified financial statements Luthra & Luthra Law Offices 19

-Section IV Clause 49 of the Listing Agreement

 Report and Compliance Separate section in annual report compliance with corporate governance on  Quarterly compliance report to stock exchange signed by Compliance Officer or CEO  Company to disclose compliance with non mandatory requirements in annual reports Luthra & Luthra Law Offices 20

Clause 49 of the Listing Agreement -

The pre and post Amendment positions compared     Independent director before the amendment Pecuniary relationship with company, promoters, management and subsidiaries Board to determine whether director independent.

Could be related to anyone in the company Silent about nominee directors     Independent director after the amendment “management” prohibition substituted “directors and senior management”; extended to with cover holding company and associates Reference to Board’s judgment in this matter omitted Cannot be related to promoters, persons occupying management positions in board or at one level below the board Nominees of public financial institutions and corresponding new banks deemed independent Luthra & Luthra Law Offices 21

Clause 49 of the Listing Agreement -

The pre and post Amendment positions compared Independent director before the amendment Independent director after the amendment     Could of have executive of the company in the previous years professional been Could have been executive firms associated with company Other interested could have qualified an parties Could have been interested as a shareholder     Can not have been an executive in company in the immediately preceding 3 years Cannot be (have been) an executive in internal or external auditor firm Can’t be a “material supplier, service provider or customer or a lessor or a lessee of the company Cannot hold 2% or more of the voting shares Luthra & Luthra Law Offices 22

Clause 49 of the Listing Agreement -

The pre and post Amendment positions compared Audit Committee before the Amendment to Clause 49 Audit Committee after the Amendment to Clause 49      At least 3 directors All directors non-executive Majority independent have to financial knowledge and Meet at least thrice a year be At least one member to have accounting      At least 3 directors No such requirement Two-thirds independent have to be All members to be “financially literate”; At least one member to be an expert Meet at least four times a year Luthra & Luthra Law Offices 23

-Section V The Sarbanes Oxley Act, 2002

    Concerned with Auditor independence, the Public Companies Accounting Oversight Board, Disclosures and corporate fraud

Applies to

: Companies listed or traded in the U.S (including non U.S Companies) Subsidiaries of U.S Companies in India (provided they have a business connection in the U.S) Foreign accounting firms that prepare or furnish audit report for an issuer must comply with SOX Compliance usually expected by U.S Companies from business partners in India (implications for BPO sector) Luthra & Luthra Law Offices 24

-Section V The Sarbanes Oxley Act, 2002

Salient Features of the SOX Act     Primary concern- integrity of audit reports- issue in Enron and Worldcom debacles- requirement of independent directors comes from outside SOX Inroad into Attorney Client privilege Protects Whistleblower- restitution and penalties for victimization CEO-CFO certification of compliance Luthra & Luthra Law Offices 25

-Section V The Sarbanes Oxley Act, 2002

Salient features of the SOX Act (…contd.)      Audit Committee to be composed entirely of independent directors Ban on loans to executive officers and directors Accelerated filings of periodic reports Filing of change of beneficial ownership within 2 days Reimbursement by CEO/CFO upon restatement of financial statements due to misconduct  Bonus/other incentive based compensation  Profits from sale of securities Luthra & Luthra Law Offices 26

-Section V The Sarbanes Oxley Act, 2002

    Independence of Board of Directors/ Committees Enhanced Criminal Penalties (upto $5 million fine for individuals, $25 million for entities, prison terms upto 20 years) Strict Reporting of illegal or unethical behavior Audit Committee  Independent  Financial Literacy of members  At least one financial expert Luthra & Luthra Law Offices 27

-Section V The Sarbanes Oxley Act, 2002

 Audit Committee (…contd.)  Responsible for appointment, compensation & oversight of auditor & approval of audit/non audit services  Create compliant accounting and auditing mechanism regarding   Approve all related party transactions Implementation of a ‘Whistleblower’ policy Luthra & Luthra Law Offices 28

-Section V The Sarbanes Oxley Act, 2002

 Additional Disclosures – Off Balance Sheet Items & transactions that may have material current/future effect on financial condition/results of operations – Pro forma Information must conform to financials prepared under GAAP - No untruth/omission – All fees billed by auditors in annual report – Audit Partner Rotation – Registration with Public Company Accounting Oversight Board (including foreign audit firms that audit Issuers) Luthra & Luthra Law Offices 29

Issues

  Rationale for deeming nominees of public financial institutions and corresponding new banks as independent directors unclear- conflict of interest ?

Shareholders not sole beneficiary of corporate governance norms- other stakeholders need protection too   Mr. Rahul Bajaj-

Indian companies being promoter controlled need no outside monitoring

- NASDAQ and NYSE Listing Manual exempt companies with 50% holding in one group from requirement of independent directors Clause 49 disqualifies holder of more than 2% stake from being independent director Luthra & Luthra Law Offices 30

Issues

   Audit Committees Required to review various legal requirements management.

with

the Required to ensure adequacy of

internal control systems

Efficacy?

  Chairman of Enron’s audit committee was a Stanford professor with 30 years experience in auditing and accounts Requirement of financial literacy only just been introduced  Is remuneration of members an issue?

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Conclusion

   Good corporate governance – sustainable wealth creation means to the end of The positive side of adherence to most rigorous standards in governance for corporations: Increased importance of corporate investment criteria among large investors governance as an Improved Equity Price Performance Higher Valuations Access to global markets Increased investor goodwill & confidence Balance between ‘enterprise’ and ‘constraints’ Luthra & Luthra Law Offices 32

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