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Corporate - Insight


Clause 49: Are we there yet?

Kshama V. Kaushik
Kaushik Dutta

Kshama V. Kaushik and Kaushik Dutta think that the Anglo-Saxon model of governance is unlikely to work and that an Asian way is needed

PERHAPS the most far-reaching legislation on corporate law in the history of the corporate world has been the Sarbanes-Oxley Act. The 2002 law was passed by an unprecedented majority — a quite unheard of convergence of political differences to fix errant corporate directors. The impact of this Act was felt across the world — from Dublin to Delhi.

SOX is a reactive piece of legislation — to the scandals that rocked America Inc that obliterated the wealth of the common man, reduced their life's savings and pensions to nothing. And all of this at the hands of unscrupulous corporate leaders and managers. The American CEO in 1984 was earning about 40 times that of an average worker. In 2004, it was about 400 times.

The history

Asked in court whether he was aware of the misstatements in the company's financial statements, which had fraudulently reported a large profit instead of a loss, the Enron CEO said that he was unaware of such an act as he had not signed the financial statements.

Under the US laws then, CEO was not required to sign the company's financial statements. But SOX made the CEO and the CFO responsible not only for the robustness of the financial statements but also for having an effective internal control over financial reporting.

In India, the Companies Act, 1956 lays the responsibility of financial statements on the board of directors. The board is also responsible for maintaining proper books of account which would give a true and fair view of the financial position and comply with the Accounting Standards. The principles of `truth and fairness' of the books of account embody the robustness of internal controls, the responsibility of which also lies with the board. The auditors under the Indian laws, since 1975 — nearly 30 years before SOX — were issuing an opinion on the internal controls over critical processes of a company.

In the absence of a legislation similar to Companies Act in India and the UK, a law like SOX was made in the US. Unfortunately, we seem to replicate significant parts of SOX, even where our laws have remedies for such misgivings.

The effort outlay

Since the Clause 49 amendment becomes effective on January 1, 2006, this means for the quarter ended March 31, 2006, a company would have to comply with the requirements of establishing risk management processes, internal controls, have appropriate number of independent directors, establish a code of conduct and issue a compliance report by April 15, 2006.

Internal controls are systems that act as checks and balances over the operation of an enterprise to preserve the sanctity of the transactions the company has with others and itself.

The controls need to be in operation for an entire year to be able to deliver robust year-end financial statements. To establish such controls for 90 days and test them for efficacy is inadequate.

According to AMR Research of Boston, US companies in compliance with their own internal control reporting will spend in 2005 about $6.1 billion to comply with SOX rules, a figure that includes everything from consultants' fees to technology.

Blythe J. McGarvie, a director of a number of Fortune 500 companies, gives the example of Pepsi Bottling spending over 34,000 hours in assessing the internal controls and their auditors spending 12,000 hours.

This is the magnitude of the outlay of effort.

In contrast, a few days before the deadline, we hear little buzz in India; there are faint rumours, laced with expectations, that the Clause 49 deadline will be deferred. Little has been done by companies to comply with it in letter or spirit. We legislate rules of governance but rarely comply with a conscience.

Independent directors

The mythical angels called independent directors now have the sole responsibility of keeping Corporate India in check. The CII and Prime Database have created a large database of individuals who qualify to be independent directors. Needless to say, such a database gets populated by all retired, retiring, out of work and aged professionals who probably did not make it to the board position of the companies they worked for. We seem to forget that a director holds a fiduciary responsibility and needs to be carefully chosen. You do not go through a public database to find a director for a listed company.

An independent director is an oxy-moron in a country where owning/promoting families have substantial ownership and control. Under the Companies Act, all directors need to be appointed and remunerated through resolutions approved by the shareholders. The family usually owns a majority or a substantial stake and wields overwhelming influence over such enterprises. No independent director would be appointed or remunerated sans the family's nod. Where would his interest lie? Rarely have we seen independent directors taking a vastly different view than the promoters. If they do, they usually end up voting with their feet. The recent Escorts case is an example when some independent directors stood up for what they believed was just and equitable and resigned, which reinforces the fait accompli faced by independent directors — either you are with us or against us.

Our insurance against mismanagement would not lie in definitions and rules of appointing independent directors but in the ethical calling and reputational risks some of these directors will have to protect themselves from.

Rules vs principles

The fundamental difference we have with SOX is on the sheer definition and the breadth of responsibilities under Sections 302 and 404 of SOX. Importantly, Section 404 is concerned only with internal controls over financial reporting, while Clause 49 requires certification on all internal controls.

A certification process necessarily is a compliance of a set of rules to deliver an opinion and in such a process one covers his risks by distributing responsibilities. Typically, this leads to a number of back-to-back certification with every individual in the chain signing off pieces of paper, whether or not the control processes would enable them to logically certify such processes.

Under Clause 49, the Indian CEO and CFO will have to certify on the efficacy of all aspects of internal controls — from manufacturing processes, sales approaches, legal compliance, human resource to financial, making this the most onerous certification process in the world. Pity the CFO, who would now need to build all the expertise to understand manufacturing processes in complex industries for such certification.

It is quite incomprehensible that in today's world of specialisation the CFO has to take all risks and liabilities of all control or take comfort in a myriad of back-to-back certificates. This defeats our basic foundation of being principles based.

It is beyond the call of duty of the CEO/CFO to take responsibility of all controls. This should clearly be reviewed as being too onerous.

The way forward

The vastness of the effort has already made the SEC defer the implementation of SOX certification for small-cap US and overseas companies listed in the US. The Securities and Exchange Board of India should stagger the implementation of Clause 49, as the small-cap companies are not in a position to comply with most of its requirements. They clearly need more time and guidance.

"One-size-fits-all" approach is detrimental to the corporates in India as this will result in a rush to comply with these requirements only on paper. Clearly, larger companies, especially those already listed in the US, such as Infosys and Satyam, are way ahead. The small companies with their meagre resources and budgets will find the going tough.

With SEBI yet to offer a guidance on the implementation and clarity on the rules of the Clause, it is left to individuals to interpret as they way deem fit.

In today's capital markets, `comparability of information' is the key and SEBI needs to do more to drive the unanimity and comparability of the approach.

It is easy to draft rules that are drawn from SOX and SEC but, then, one needs to be as proactive as the SEC in helping implement the rules. A need for clear guidance is the call for the day.

The cure for all corporate evil is seen to lie with the independent directors. In a culture like ours where obedience, respect for age and authority, and feudalism in varying colours play a huge role, raising dissent in a board and being heard is no mean task. This is not an issue only in an Indian context.

In Asia, from Japan to China to Dubai, the Anglo-Saxon model of governance is likely to fail. An Asian governance model would need to evolve from our deep-rooted family businesses, our bonds to families, our cultural strengths, which is unique to our world. This will take time but surely be an integral part of our corporate lives in the near future.

(Kaushik Dutta is Partner, PricewaterhouseCoopers, and Kshama V. Kaushik is a chartered accountant.)

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