The passage of the Companies Act of 2013 sparked tremendous hope in the country, with industrialists and academics alike believing that it would provide a boost to the country's growth momentum by introducing global best practices in corporate governance. Many years later, it is time to take a step back and ask ourselves how far have we actually progressed in our aspiration to develop an effective governance framework. Have corporates internalised governance as part of their value proposition? These were the very goals that the Parliamentary Standing Committee had in mind when developing the concept of the new business law.
So post-reforms, which are the areas of improvement in corporate governance?
According to the FICCI survey, the quality of financial and non-financial disclosures has improved the most since the reforms. Transparency in corporate decision making and the effectiveness of independent directors are two other key areas that have seen significant improvement. These modifications, however, are not consistent across companies.
Improvements in financial and non-financial disclosures: In comparison to unlisted and large listed companies, the improvement in disclosures among small listed companies is not as significant. While disclosure and reporting requirements for all types of companies have been strengthened, small listed companies do not see much benefit from this. For them, enhanced disclosure adds little tangible value to financial information readers.
Independent director effectiveness: Due to their inclusion and participation in this change process, unlisted companies have reaped the greatest benefit from the expertise of independent directors. Small listed companies, on the other hand, have seen the least improvement because they have been in compliance with previous SEBI regulations, and these reforms have not resulted in any tectonic shift in their governance mechanism. Larger publicly traded companies have inducted newer directors, resulting in a better balance of skills, diversity, and experience, and thus better oversight and effectiveness of the institution.
Board effectiveness: Only a small percentage of small listed companies believe their boards have become more effective as a result of the reforms, compared to a larger percentage of unlisted and large listed companies. The increased compliance burden, combined with their inability to attract quality independent directors, appears to be affecting the effectiveness of boards of directors of small publicly traded companies.
Improved evaluation of related party transactions (RPT): Both small and large listed companies believe that the evaluation of RPTs has improved significantly. The increased scrutiny has resulted in better systems and processes, but this has not resulted in significant benefits such as improved price discovery or increased investor confidence in the efficacy of such assessments.
Companies face a number of challenges as a result of the governance reforms. These challenges are not uniform and differ for different types of businesses.
Threat of regulatory action: The larger the company, the greater the perceived threat. Increased penalties and the threat of prosecution have created an uncertain environment for directors. Large publicly traded companies enshrine greater public interest and, as a result, are subject to increased vigilance and action by regulators. The problem is exacerbated further by increased compliance requirements, which expose companies and their directors to the risk of punitive action.
Greater emphasis on compliance: A greater emphasis on compliance is a challenge because it limits time spent on strategic matters. Smaller publicly traded companies believe this is significant and a distraction for their boards from strategic and operational functions. Smaller companies, unlike large publicly traded companies, do not have established processes in place. Such businesses believe that the compliance requirements have become a burden rather than an opportunity for improvement and growth, as was intended by the legislation.
Internal financial control adequacy and effectiveness: Small publicly traded companies lack the resources to implement an effective control system. The requirements of the Companies Act of 2013 are broader than those prescribed by the SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015, and cover both financial and non-financial controls, increasing the challenge for small listed companies in this regard.
So post-reforms, how effective and independent are Indian boards now?
The new regulatory framework, which codifies their duties, accountability, and responsibilities, has significantly altered the role of directors. According to surveys conducted by independent organisations, the following changes have occurred:
The overall effectiveness of the board has improved with few exceptions. The codification of duties has made directors more concerned with compliance. Following the reforms, the boards reassessed their priorities and became more involved in financial management. Boards' strategy functions have been subsumed to some extent by the increased compliance functions that they must perform.
Companies and their boards have benefited from the diversity and complementary skill sets and experience of post-reform directors. Larger corporations have brought in diverse skills and become more effective.
So post-reforms, how good are our processes, controls and risk management systems?
The Parliamentary Standing Committee emphasized the importance of encouraging self-regulation through internal mechanisms or procedures. It expanded the board's reporting responsibilities to include aspects of internal financial controls, risk management, and compliance.
Improvements in internal controls can be seen across the board. Financial reporting and related processes in large publicly traded and unlisted companies have improved significantly. Because of limited resources, small publicly traded companies have not seen optimal gains, allowing only incremental steps to strengthen their processes.
Boards seek greater assurance from statutory/internal auditors to provide assurance on the adequacy and operational effectiveness of internal financial controls, escalating time and costs. This emphasis on internal controls as a result of increased liabilities has increased the cost of doing business, which many argue outweighs the benefits. Enhanced regulations, accountability, and onerous liabilities imposed on boards as a result of controls and processes have blurred distinctions between board and executive functions, resulting in micromanagement at times. While Boards' focus on compliance has limited time spent on strategic planning, it has significantly increased shareholder and investor confidence in financial reporting.