New CSR Rules: The Risks Of Greater Rigidity
The new CSR rules move the needle from what has largely been a comply-or-explain approach to a mandatory requirement.
One of the significant problems with corporate social responsibility is that the concept can take on different incarnations depending on who you ask. At one end of the spectrum, it embodies good corporate citizenship by which companies must carry out their business activities to pursue broader goals to enhance stakeholder interests in addition to maximising profits. This approach embraces voluntary action on the part of companies. At the other end, CSR compels companies to direct a portion of their profits towards causes prescribed by law. Such a statutorily stipulated approach likens it to corporate philanthropy and, in its severest form, taxation. The CSR regime in India began with a voluntary approach, which transitioned into a quasi-mandatory philanthropic approach under the Companies Act, 2013. With changes now proposed to the Companies Act, CSR in India faces the prospect of attaining the full mandatory status that is akin to taxation. This may have the effect of upending the concept of CSR as it is globally understood and likely carry unintended consequences for Indian companies.
Voluntary, Statutory, Mandatory
The issue of whether CSR ought to be voluntary or mandatory exercised the minds of the legislators during the enactment of the Companies Act, 2013. Initial reports indicated that proposals leaned towards a mandatory approach. However, considerable backlash ensued, in particular from industry groups, and a detailed consultative process led to a carefully constructed compromise expressed in Section 135 of the Act. The statutory provision stated that large companies are required to spend at least two percent of their average net profit made during the three immediately preceding financial years in pursuance of their CSR policies towards identified activities.
While this compromise position is often mistakenly referred to as a mandatory requirement, it is far from that as it is embedded in the principle of 'comply-or-explain'. While the language of the spending requirement appears similar to an obligation to spend the above-mentioned amount towards CSR activities, the language is softened by a proviso stating that if a company fails to comply with such a spending requirement, the board must disclose the reasons therefor.
In that sense, while spending is not mandatory, disclosure is. It is only the failure to make appropriate disclosures that would invite penal consequences.
In the last five years that the statutory CSR requirement has been in force in India, its functioning evoked mixed responses. Although there has been an overall uptick in CSR spending by Indian companies, it is also clear that a large number of companies have not met the two percent spending requirement. While that is not necessarily a legal violation, the question then relates to the levels and standards of disclosures containing reasons for non-spending. Even here, there is considerable variation with some companies making detailed and specific disclosures, with others relying on boilerplate and less meaningful disclosures. In these circumstances, the Government has continuously reviewed the implementation of the CSR law and made necessary adjustments. However, the first significant reorientation to the CSR provision comes in the form of a proposal in the Companies (Amendment) Bill, 2019, which both houses of Parliament have now approved.
Forcing The Hand
Under this dispensation, companies that are required to undertake CSR spending have no choice but to set aside two percent of the profits towards the activity. The amendment provides that if a company has unspent CSR amounts in any financial year, it must transfer such amounts within six months of the end of such financial year to certain specified government funds, including the Prime Minister’s Relief Fund or other funds for socio-economic development and relief and welfare of certain categories of the population. The only latitude given to companies is that if they have already allocated unspent CSR funds to specific projects, they must transfer such funds into an escrow account known as the “Unspent Corporate Social Responsibility Account” for a period of three years, after which remaining amounts must be transferred to the government-specified funds. More importantly, any failure to comply with the above transfer requirements will result in significant penal consequences on both the company as well as officers in default, who may even suffer a jail term.
There is something to be said about the manner in which the legislative reform is being effected. At a superficial level, there is an appearance that the change relates to a simple question of implementation on how unspent funds in a financial year can be dealt with, namely whether it is possible to carry them forward for future years. This issue arose because companies carried forward unspent amounts to future years and disclosed the same when a CSR project spanned across multiple financial years. However, the government seems concerned that this method can lead to companies under-complying, even though there is no legal mandate to spend that amount, and instead, disclosing reasons for non-spending.
Delving deeper, this introduces a mandatory requirement for CSR spending through the back-door. Before this amendment, companies have had two choices: either spend two percent of the profits towards CSR, or disclose a failure to do so. With the present amendment, those choices undergo a change: either spend 2 percent of the profits towards CSR within a defined timeframe, or turnover those profits into a Government-run fund. This amendment will now require all qualifying companies, without exception, to spend the specified part of their profits towards CSR.
This moves the needle from what has largely been a comply-or-explain approach to a mandatory requirement.
Several questions arise.
Three Problems With The New Approach
First, the erstwhile approach carried many concerns as it equated CSR with corporate philanthropy, with its dedicated focus on how companies spent their profits rather than the broader question of whether they acted responsibly. By eliminating the possibility that companies can spend less than the prescribed amount, CSR in the Indian context equates with taxation. Under the comply-or-explain approach, companies may account for several factors while undertaking CSR in a manner that benefits their immediate stakeholders. Companies themselves make choices on the projects that are appropriate to fund, and the extent of funding. The new pressure to hand over profits to government-managed funds transfers the decision-making to the political and bureaucratic actors.
While this will impel the better-governed companies to work within the framework to maximise spending on CSR that benefits their own stakeholders, others might be inclined to simply delegate that decision to the government, in a manner that is characteristic of taxation.
Second, the three-year time limit the new law imposes will beget short-termism. It will compel companies to contemplate CSR projects in bite-sized three-year periods and eschew those that benefit in the longer term. The legislation considerably attenuates the scope of the companies in managing their CSR spending responsibilities.
Third, given that the amendments bring about a substantial shift in the attitude towards CSR in India, there ought to have been a more robust consultation process of the type that resulted in the compromise position reflected in the comply-or-explain approach initially introduced in the Companies Act, 2013. If that position encountered problems in implementation due to poor disclosures and questions such as how unspent funds must be dealt with, it would have been prudent to address those issues directly. Instead, we have an instantaneously switch to a mandated CSR spending requirement that bears no exceptions and one that invokes severe criminal sanctions for non-compliance.
In all, the Companies Act, 2013 has been a game-changer as it has pioneered a statutory stipulation for CSR in a manner that is far more stakeholder-oriented than other jurisdictions. However, the move towards mandatory spending requirements that necessitate payment into government-operated funds will have the effect of substantially altering the original philosophy behind CSR and encouraging mechanical compliance—and that too under the shadow of potential incarceration for failure—that does little to alter innate corporate behaviour.
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.