Board Failures: The Travails Of Corporate Governance Without Enforcement
Board Failures is a series of columns examining board governance in India.
This year marks the twentieth anniversary of the earliest corporate governance initiative in India, namely the release in 1998 of a voluntary code for ‘Desirable Corporate Governance’ devised under the aegis of the Confederation of Indian Industry.
This code formed the bedrock of a flurry of activity on the governance scene in India. In the first decade since then, the Securities and Exchange Board of India devised mandatory corporate governance norms based on reports of various committees headed by industry leaders such as Kumar Mangalam Birla and NR Narayana Murthy. Thereafter, matters transitioned to the domain of the Ministry of Company Affairs that then incorporated corporate governance norms and, in particular, the role, responsibility and liability of the board of directors, into the Companies Act enacted in 2013. SEBI altered its framework to match that of the legislation. These measures, no doubt, ushered in a paradigm shift in Indian corporate governance, as the norms have become considerably more stringent over the years.
This, however, gives rise to a key puzzle.
Despite the constant evolution of corporate governance norms that have become rather robust, why does corporate India witness governance crises rather periodically?
Over the last two years, several high-profile crises erupted in well-known companies such as Tata Sons, Infosys, ICICI Bank and IL&FS, just to name a few, wherein the role of the board of directors has been called into question. One may be forgiven for harbouring the notion that the governance norms in India are an abject failure. But matters are more nuanced than that.
While the substantive law on corporate governance has evolved at a rapid pace, the legal enforcement of these norms has fallen short of the intended goals.
Soft And Hard Law
One method, employed in several countries, is to implement corporate governance norms through voluntary codes, which are essentially ‘soft’ law. Using the ‘comply-or-explain’ approach, companies must either comply with the codes or, alternatively, disclose and explain why they fail to comply. A reliance on market enforcement would suggest that investors would incorporate these disclosures into their decision-making process and punish companies for non-compliance by assigning a discount for poor corporate governance that would reflect in the market price of the stock.
While displaying some sporadic affinity towards such voluntary codes, the Indian regulators have mostly viewed them with suspicion. Conversely, India has relied heavily on ‘hard’ law, namely mandatory rules of corporate governance that seek to impose legal sanctions for non-compliance. This began through corporate governance norms contained in the listing agreement, which then transitioned to the Companies Act and SEBI’s listing regulations.
Arguably, such a mandatory approach to governance matters is apt for India, which has traditionally followed a top-down regulatory approach, and is thought to have a deterrent effect on delinquent managements and promoters.
Mandatory rules are optimal only when they are accompanied by robust enforcement mechanisms, both in the law as well as in action.
The lack of strong enforcement has possibly led to weaknesses in the governance framework.
On the one hand, public enforcement is considered the means by which civil or criminal penalties are imposed by the government, regulators or courts. In India, actions taken by the Ministry of Corporate Affairs and SEBI have been the mainstay of public enforcement. This can be a useful tool to ensure compliance with corporate governance norms and disclosure laws. Prescribing the conduct of management and boards of directors through such a mechanism would ensure that companies function in a manner that leads to investor protection. The focus is largely on the wrongdoers rather than the victims.
Even though public enforcement is the principal mechanism for implementing corporate governance in India, the track record of its utilisation paints a bleak picture.
There have hardly been any successful criminal convictions in any of the high-profile cases of corporate governance lapses even when they have involved blatant fraud.
Due to such impunity, the use of criminal law is bound to have limited deterrent effect against wrongdoing of managements and directors of companies. While the use of civil penalties has witnessed relatively stronger results, it has remained woefully inadequate in instilling improved governance standards.
Moreover, SEBI has used blunt force instruments such as debarring individuals from accessing the capital markets for a period of time, often on an ex parte basis, rather than more targeted actions. The most acute concern with public enforcement lies in the delays in regulatory action. For instance, while SEBI has passed orders in the decade-long Satyam scandal, the enforcement is far from reaching a logical conclusion given the possibilities of appeals that leads to uncertainty. That can hardly be any deterrence at all.
In the case of private enforcement, victims—who are generally minority investors in companies—have access to a menu of options to seek remedies for expropriation or abusive conduct suffered at the hands of managements or controlling shareholders. An action for oppression and mismanagement would enable a minority shareholder to seek remedy if the affairs of a company are carried out oppressively or in a manner prejudicial to the interests of the company or to public interest.
It is hard for minority shareholders to obtain a successful outcome in such actions, as they need to discharge a high burden of proving the requisite standard of wrongful conduct.
The Mistry group has relied upon the action for oppression and mismanagement as the primary prong of attack against the Tata group in the case involving Tata Sons but has failed to taste success so far.
Another action is a derivative suit brought about by the minority shareholders against wrongdoing directors on behalf the company. However, such shareholder derivative actions have been few and far between in the Indian context as they have to be brought before the regular civil courts that suffer from the usual delays and inefficiencies.
The last, and perhaps most potent—at least on paper—is the class action mechanism introduced under the Companies Act, 2013. Although it is wide in nature and confers considerable discretion to the National Company Law Tribunal to grant different types of remedies, the novelty of the provision leaves it with considerable uncertainty. There does not appear to be evidence of its successful use in any corporate governance lapses or other corporate wrongdoing, thereby making it premature to judge its effectiveness.
In all, while there are a number of private enforcement options available, they have seldom been used, and even rarely have they succeeded.
This leaves the victims of governance lapses without any recompense.
Consider a high-profile like Satyam. The holders of American depository receipts in the U.S. initiated a class action that compelled the company to settle by paying $125 million to the holders, and the auditors PwC to pay $25.5 million. In stark contrast, the Indian shareholders were unable to successfully bring an action for private enforcement before the Indian courts, and hence received no compensation at all despite suffering similar losses. The glaring inadequacies of private enforcement are on display through this episode.
Corporate governance in India is at crossroads. After having gone down the path of using ‘hard law’ in the form of mandatory rules, it suffers from a lack of effective enforcement. The logical path would be to create more avenues for the proper use of both public and private enforcement methods more effectively. The Ministry as well as SEBI ought to have a clear public enforcement strategy and execute it by deploying appropriate resources and capacity to that end. On the private enforcement front, existing bottlenecks can be removed by creative interpretation by the courts and tribunals. The other alternative would be to re-experiment with ‘soft law’ in the form of corporate governance codes, but it requires greater political will and momentum to effectuate such a drastic policy reversal.
Umakanth Varottil is an Associate Professor of Law at the National University of Singapore. He specialises in company law, corporate governance and mergers and acquisitions.
The views expressed here are those of the author and do not necessarily represent the views of BloombergQuint or its editorial team.