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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. Outline . Section I Conceptualizing Corporate Governance Section II The Need for Corporate Governance

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Mohit Saraf, Senior Partner Luthra and Luthra Law Offices

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Mohit saraf senior partner luthra and luthra law offices

Mohit Saraf, Senior PartnerLuthra and Luthra Law Offices

Clause 49 of the Listing Agreement

-A Comparative Analysis-

Presented to

Alliance India

12th August 2005

Luthra & Luthra Law Offices


Outline

Outline

Section I 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

Section IConceptualizing 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, creditors, consumers, distributors, local communities.

    • Beneficiary of good governance- Every Stakeholder

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Conceptualizing corporate governance contd

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

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Conceptualizing corporate governance contd1

Conceptualizing Corporate Governance (Contd.)

  • What constitutes shareholders’ interest? (sustainable profitability)

  • 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

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Section ii the need for corporate governance

Section IIThe Need for Corporate Governance

  • Responsibility to Stakeholders

  • Easier access to capital (FII, VCF, Foreign Markets)

  • Efficiency (at the firm level) and Global Competitiveness

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Section iii the evolution of corporate governance in india

Section IIIThe Evolution of Corporate Governance in India

  • December 1995: CII sets up task force to design voluntary code of corporate governance

  • April 1998: CII releases “Desirable Corporate Governance: A Code”

  • 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)

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Section iii the evolution of corporate governance in india1

Section IIIThe 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

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Section iv clause 49 of the listing agreement

-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

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Section iv clause 49 of the listing agreement1

-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

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Section iv clause 49 of the listing agreement2

-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 2/3rd and at least 2 independent

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Section iv clause 49 of the listing agreement3

-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

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Section iv clause 49 of the listing agreement4

-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

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Section iv clause 49 of the listing agreement5

-Section IV-Clause 49 of the Listing Agreement

Audit Committee to review following information

  • Statement of significant related party transactions submitted by management

  • Management letters and letters of internal control weakness issued by the statutory auditors

  • Internal audit reports relating to internal control weakness

  • Review of appointment, removal and terms of remuneration of chief internal auditor

  • Management discussion and analysis of financial condition and result of operations

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Section iv clause 49 of the listing agreement6

-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 agreement7

-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.

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Section iv clause 49 of the listing agreement8

-Section IV-Clause 49 of the Listing Agreement

CFO / CEO certification

CEO = MD or Manager Appointed Under Companies Act

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

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Section iv clause 49 of the listing agreement9

-Section IV-Clause 49 of the Listing Agreement

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

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Section iv clause 49 of the listing agreement10

-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

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Section iv clause 49 of the listing agreement11

-Section IV-Clause 49 of the Listing Agreement

Report and Compliance

  • Separate section in annual report on compliance with corporate governance

  • Quarterly compliance report to stock exchange signed by Compliance Officer or CEO

  • Company to disclose compliance with non-mandatory requirements in annual reports

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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” substituted with “directors and senior management”; prohibition extended to 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

Clause 49 of the Listing Agreement-The pre and post Amendment positions compared-

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Clause 49 of the listing agreement the pre and post amendment positions compared1

Independent director before the amendment

Could have been an executive of the company in the previous years

Could have been executive of professional firms associated with company

Other interested parties could have qualified

Could have been interested as a shareholder

Independent director after the amendment

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

Clause 49 of the Listing Agreement-The pre and post Amendment positions compared-

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Clause 49 of the listing agreement the pre and post amendment positions compared2

Audit Committee before the Amendment to Clause 49

At least 3 directors

All directors non-executive

Majority have to be independent

At least one member to have financial and accounting knowledge

Meet at least thrice a year

Audit Committee after the Amendment to Clause 49

At least 3 directors

No such requirement

Two-thirds have to be independent

All members to be “financially literate”; At least one member to be an expert

Meet at least four times a year

Clause 49 of the Listing Agreement-The pre and post Amendment positions compared-

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Section v the sarbanes oxley act 2002

-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)

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Section v the sarbanes oxley act 20021

-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

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Section v the sarbanes oxley act 20022

-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

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Section v the sarbanes oxley act 20023

-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

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Section v the sarbanes oxley act 20024

-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 mechanism regarding accounting and auditing

    • Approve all related party transactions

    • Implementation of a ‘Whistleblower’ policy

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Section v the sarbanes oxley act 20025

-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)

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Issues

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

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Issues1

Issues

Audit Committees

  • Required to review various legal requirements with the management.

  • 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

Conclusion

  • Good corporate governance – means to the end of sustainable wealth creation

  • The positive side of adherence to most rigorous standards in governance for corporations:

    • Increased importance of corporate governance as an investment criteria among large investors

    • Improved Equity Price Performance

    • Higher Valuations

    • Access to global markets

    • Increased investor goodwill & confidence

  • Balance between ‘enterprise’ and ‘constraints’

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    Our contact details

    Our Contact Details

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    Mumbai OfficeDelhi Office

    704-706, 7th Floor, 103, Ashoka Estate,

    Embassy Center, Nariman Point, 24, Barakhamba Road,

    Mumbai – 400 021 New Delhi - 110 001.

    Tel : (91) (22) 5630 3600 Tel: (91) (11) 51215100

    Fax: (91) (22) 2287 3700 Fax: (91) (11) 2372 3909

    Email - [email protected]

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