12 October 2017

The Kotak panel on corporate governance should separate best practices from mandatory provisions

I have an op-ed piece in today's The Economic Times where I argue that implementing the Kotak Committee report on Corporate Governance should be proceeded with extreme caution and most recommendations should be implemented as best practices rather than new legal provisions. The piece is linked here.  The full article is also reproduced below:

You would be forgiven for thinking this is a parallel universe. A core private sector committee instituted by the Securities and Exchange Board of India (Sebi) is advocating stringent new corporate governance norms. And, bureaucrats are opposing it on grounds of ease of doing business.

For that reason, in a blind test, the Kotak Committee report on corporate governance could easily pass as drafted entirely by career regulators. The committee seeks to order a firm control over corporate India, which has often careened off its ideal highway. A fiat — or positivist law, in jurisprudence jargon — relies on the command followed by sanction in the event of disobedience. By contrast, best practices set non-mandatory targets, which have the benefit of flexibility.

This distinction is very different from the ‘rule-based vs principle-based’ debate many have engaged in over the last decade. The clearest example of the former is the listing regulations of Sebi. The best example of the latter is the ‘comply-or-explain’ provisions relating to Corporate Social Responsibility (CSR).

Before discussing the report, it is useful to remember that the influence of the board in driving a company is limited, even in the fragmented ownership model of the US and Britain. And this is not based on some ‘left-leaning’ opinion, but on a detailed study by that flag-bearer of capitalist thought, McKinsey. Only 10 per cent of directors surveyed felt that they fully understood the industry dynamics in which their company operated. Similarly, what is seen as a slam dunk in the report — that a split role between chairman and managing director (MD) is the best board structure — is based on the premise that there ought to be an alternate power centre.

However, the reality is more complex. There are companies where a chairman ought to also be the MD, as it requires an army-like commandand-control structure. Additionally, both leading corporate battles and corporate governance battles in the last year revolved around two power centres. This caused problems in functioning of the companies involved. So, there is significant downside to a split role.

Similarly, it isn’t clear whether mandating a woman director on the board alone is good enough. The woman director should, according to the norms, be an independent director (ID), under 70, and be paid, broadly, a minimum of Rs 50,000 for each meeting. Such level of detail is too intrusive.

In the Bored Room
Combined with incorporating these into a sanction-based law, this would mean a company and its directors not following any of the ‘ands’ would, in theory, be in violation of the law with collective and individual liability. The contrast couldn’t be more stark with the fact recently reported in ET that 40 per cent of the listed companies are not even in compliance with the womanon-board provision.
Ideally, some of the provisions should indeed have the force and mandate of law followed by penal consequences for their violation. These include having an independent director for the quorum of board meetings, limiting the directorship and committee memberships, introduction of declaration of true independence, introduction of the concept of lead ID with specific enabling roles, enhanced scrutiny of material subsidiary’s fund utilisation, enhanced monitoring of group companies, enhanced scrutiny and disclosure of related-party transactions, introducing transparency in ownership of global depositary receipts in Indian companies, full disclosure of credit rating assigned to securities, various enhanced disclosures and bringing chartered accountants under the purview of Sebi.

Some of the provisions, which require to be segregated into a ‘complyor-explain’ code of conduct include increasing the minimum size of the board to six from three, introducing a matrix of competence for directors, having a minimum number of five board and audit committee meetings from the earlier four, introducing an annual update programme for directors, a formal meeting between non-executive directors and senior management, splitting the chairman’s role from the managing director’s, formal training of IDs every five years, enhancing the role of the Nomination and Remuneration committee and the Stakeholder Relationship Committee, and introduction of a stewardship code.

Essentially, the segregation is based on whether violating the provisions should be met with a penalty of Rs 1 crore and a jail sentence of up to 10 years. Additionally, not every listed company is necessarily complex, requiring the same standards. For less complex companies, a single rigid rule would harm their ease of doing business.

However, even for those companies, setting best practices would set a good standard for corporate hygiene, so long as it is not immediately to be met with serious penalty. Many of the recommendations would also cause private companies to remain private, because the next Mark Zuckerberg of India is not likely to hand over control to a group of admittedly non-expert outsiders.

Inconvenient Directors
Some of the items discussed should be not be implemented as presented. These include putting a minimum compensation for IDs, or maximum compensation for executive directors, amendments to insider trading norms (which require a complete relook, rather than amending a part) and promoter reclassification (which also requires a complete relook).

Finally, the items missing from the report are the significant learnings from the Tata and Infosys governance fiascos and could have been specifically introduced. For instance, enhanced protection from removal of ‘inconvenient’ IDs.


11 August 2017

Shell Shocked - courtesy SEBI

I have a piece in the Business Standard in the all too familiar case of the 331 'shell' companies - passed by SEBI. I argue why the order should not have been passed. The article is linked here (paywalled) and the full text is as below.


We know from the Securities and Exchange Board of India (Sebi) circular that the Ministry of Corporate Affairs (MCA) forwarded a list of 331 companies (presumably listed ones from a larger list) to the market regulator on June 9, 2017 to take necessary action. On August 7, Sebi forwarded this list to the exchanges. We know that Sebi has not reviewed this list because the two numbers are identical — 331. Sebi has asked the exchanges to take the following action: To halt trading in the companies except once a month. Price traded can only go down and not up. People will need to pay 200 per cent of the agreed price and the extra amount to remain blocked for five months. The directors and promoters of these companies can buy shares only after exchange permission and cannot sell shares. The exchange to appoint auditors and forensic auditors to assess these companies. If found not to have proper “credentials”, exchanges should initiate delisting those companies.
Now this looks like harsh but swift and just action against presumable money launderers without giving them time to scoot. Only it’s not. So why is the order wrong?

First, it is clear from the Sebi circular that the MCA itself “suspects” these to be shell companies and in bureaucratese, the ministry had asked the market regulator to take “necessary action”. That really is code for, “we don’t know if being a shell company is a problem, but if it violates securities laws, you know best what action, if any, to take”, and also “we aren’t even sure these are shell companies”. Sebi has misread that routine letter to mean let’s behead these companies immediately.

Second, there appears no law in India which says being a “shell company” is an offence or violation of any law, leave alone the securities law. The Companies Act prescribes striking off a company where it has not been in operation for over two years after giving notice to the company and an exception to that provision is in fact listed companies. Besides striking the name of a company is not a penal provision, but more of a clean-up of defunct companies.

Third, many companies indeed shut their operations because their business is no longer viable. Anyone who has visited mid-town Mumbai has seen first hand, the hundreds of acres of textile land, which remained idle from the 1980s till they discovered value in the 2000s as commercial office plots. In other words, there are many listed companies which are no longer operating, but may have valuable assets which are owned by it. These companies are neither criminal in nature nor are they presumptively violating any laws, so long as they comply with their disclosure and listing norms among other laws.

Fourth, the outsourcing of regulatory work is also somewhat troubling. The MCA had some information, which we now know is not even fully accurate, of companies which suffered from the crime of being “shelly”. Its letter to Sebi with the names has been converted into a final order of the market regulator to be executed by the outsourced agency of exchanges. They in turn have been asked to outsource investigation to private auditors and forensic auditors. This is not only problematic because of privatisation of core regulatory function of investigation, but also because they have provided a provision for further enhancement of penalty if they cannot “verif[y]..the credentials/fundamentals” without reference to the regulator. Note again that the enhanced penalty is supposed to be imposed not for any violation of the law but for the high crime of not having credentials/fundamentals.

Fifth, Sebi has found a way to penalise companies, but has not provided for an exit from the harsh provisions. Say for some reason, the so called shell companies can immediately prove that they are not shell companies, or the shell companies can show that they are not operating companies but not committing any illegalities, the exchanges cannot give those companies a free pass out of the penalty provisions described. There is similarly, no provision or hearing provided before Sebi for any of the 331 companies. Principles of natural justice even at the most rudimentary level require a post decisional hearing.

Sixth, the whole concept of harsh enforcement action, not by quasi judicial action, but by a circular is an unacceptable mode of action. Sebi is trying to interpret a recent Supreme Court ruling which holds that non-quasi judicial circulars cannot be challenged in SAT, but only by way of writ in a high court. In fact, Sebi presented this argument before SAT. Labeling an enforcement order, with a virtual economic death penalty for the company and its million plus investors, with the word “circular” on top cannot make it immune to an appeal.

Seventh, as we discovered after this circular was unraveled on exchange websites on the morning of August 8, several of the companies were not only not shell companies but were active, highly profitable, fully compliant with laws and listing regulations with marquee investors and even working on prestigious government awarded projects like the Mumbai Metro.

Finally, Sebi has completely ignored the interests of millions of investors who have been impoverished overnight because of its shotgun actions.

Sebi has a fabulous top team, including intelligentsia from the industry, at the helm. It is time Sebi realises that processes are important and cannot be short-changed in its attempt to obtain rough and ready mass enforcement action against what it believes are companies choking up regulatory bandwidth. Indeed, India does suffer from hundreds maybe thousands of dubious listed companies which may frequently commit one mischief after another. But there has to be a better way to achieve its objective. This way is just too unjust and hurts many people who have failed and even more, people who invested in such companies.

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01 June 2017

Too many regulations are ruining CSR

Reuben Abraham of IDFC Institute and I have a piece today in the Mint. The opinion piece is linked here and reproduced below:


The overly prescriptive set of what is and what is not CSR is grounded in the government’s mistrust of companies

The Companies Act, 2013, introduced a well-intentioned section requiring companies to spend on corporate social responsibility (CSR) initiatives. The section is applicable to large companies measured by net worth, turnover, or profits. We argue that while the intent was to keep the provision principle-based and flexible, the leakage between intent of the law, its drafting, its delegated interpretation, and its final execution by the company on the ground gives rise to concerns that it does not realize what it set out to accomplish.
Clearly, the object of introducing the section was to promote corporate philanthropy to ensure that growth remains inclusive. With increasing divergence between the richest and the poorest, the political need for companies to address public welfare is evident and admirable.
The simplicity of a principle-based approach is clear in the Act itself, which requires 2% of profits to be spent based on a policy set out by the CSR committee of the boards of large companies. Any spending below the minimum needs to be explained in the annual directors’ report in a “comply or explain” regime.
This seems to suggest that a company, through its CSR committee, is free to decide what is appropriate by way of the amount to be spent and how and where to spend. In the event the amount is below the required threshold, the directors need to explain why.
For the “where to spend” question, the view of the committee is final and no one can question the discretion of the board or the committee. Though the statutory provision appears simple, flexible and left to the judgement of the corporate board, it’s not.
Indeed, the way the ministry of corporate affairs has injected complexity and second-guessing contradicts the very foundation of what the section sought to achieve. A schedule, a notification, a circular, two general circulars and frequently asked questions (FAQs) distort the simple flexibility of the section. These notifications and circulars are exceedingly prescriptive in places. Here are a few examples.
One-off events like marathons, awards or charitable contributions are not considered CSR-compliant.
An average marathon generates over a million kilometres of health-inducing running just on marathon day and probably tens of millions of kilometres in the previous few days of training, contributing significantly to preventive health. But this is not CSR.
A compliance award function may introduce significantly higher levels of compliance with the law across not just the awardees but across thousands of listed companies that seek such awards in the future. But it is not certified CSR.
There is more. Charitable contributions for helping the disabled will change the lives of millions of affected people, but are not considered CSR-compliant.
Many large companies have substantially contributed to training law enforcement agents, for example in cyber security, where the public sector’s knowledge is limited. That is not CSR either, even though it significantly enhances the financial and economic security of the country.
Neither is any form of capacity building in government, which is inexplicable in a country hobbled by lack of state capacity.
The Companies Act, 2013, introduced a well-intentioned section requiring companies to spend on corporate social responsibility (CSR) initiatives. The section is applicable to large companies measured by net worth, turnover, or profits. We argue that while the intent was to keep the provision principle-based and flexible, the leakage between intent of the law, its drafting, its delegated interpretation, and its final execution by the company on the ground gives rise to concerns that it does not realize what it set out to accomplish.
Clearly, the object of introducing the section was to promote corporate philanthropy to ensure that growth remains inclusive. With increasing divergence between the richest and the poorest, the political need for companies to address public welfare is evident and admirable.
The simplicity of a principle-based approach is clear in the Act itself, which requires 2% of profits to be spent based on a policy set out by the CSR committee of the boards of large companies. Any spending below the minimum needs to be explained in the annual directors’ report in a “comply or explain” regime.
This seems to suggest that a company, through its CSR committee, is free to decide what is appropriate by way of the amount to be spent and how and where to spend.
In the event the amount is below the required threshold, the directors need to explain why.
For the “where to spend” question, the view of the committee is final and no one can question the discretion of the board or the committee.
Though the statutory provision appears simple, flexible and left to the judgement of the corporate board, it’s not.
Indeed, the way the ministry of corporate affairs has injected complexity and second-guessing contradicts the very foundation of what the section sought to achieve. A schedule, a notification, a circular, two general circulars and frequently asked questions (FAQs) distort the simple flexibility of the section. These notifications and circulars are exceedingly prescriptive in places. Here are a few examples.
One-off events like marathons, awards or charitable contributions are not considered CSR-compliant.
An average marathon generates over a million kilometres of health-inducing running just on marathon day and probably tens of millions of kilometres in the previous few days of training, contributing significantly to preventive health. But this is not CSR.
A compliance award function may introduce significantly higher levels of compliance with the law across not just the awardees but across thousands of listed companies that seek such awards in the future. But it is not certified CSR.
There is more. Charitable contributions for helping the disabled will change the lives of millions of affected people, but are not considered CSR-compliant.
Many large companies have substantially contributed to training law enforcement agents, for example in cyber security, where the public sector’s knowledge is limited. That is not CSR either, even though it significantly enhances the financial and economic security of the country.
Neither is any form of capacity building in government, which is inexplicable in a country hobbled by lack of state capacity.
India is urbanizing fast, and will witness the largest migration worldwide into urban centres over the next 20-30 years, an eventuality it is not fully prepared for. Yet “sustainable urban development” and contributions to enhance urban public transport systems are not CSR-compliant, even though our chaotic and polluted cities could use all the help they can get. The specific inclusion of “sustainable” urbanization begs the question whether “unsustainable” urban development is somehow compliant?
In spite of the exhortation to interpret the laws liberally, the fact is it’s hard for a compliance department to certify such a liberal interpretation, especially if it’s at odds with Schedule VII.
It’s also worth noting that interventions that are likely to have the greatest positive externalities (state capacity, urban development, etc.) are specifically prevented.
The overly prescriptive set of what is and what is not CSR is grounded in mistrust (based on a variety of delegated explanatory circulars) rather than in trust (as prescribed in the section). This mistrust is best seen in the non-inclusion of research, perhaps because of a fear that commercial research and development activities will be passed off under CSR.
However, this puts the world of ideas, fundamental research, design, training, etc., which will likely provide the greatest bang per rupee spent, out of reach of the world of CSR.
The best way forward is to delete all circulars, general circulars, notifications, FAQs and truncate the schedule to two or three principles. The rest should be left to corporate disclosures, which can be more detailed, as to where the company has chosen to utilize its money and let the company deserve the public accolades or shame based on its choices.
A US supreme court justice, Louis Brandeis, said appropriately, that sunlight is the best disinfectant and a lamp-post the best policeman. It’s time to trust the firms and even more importantly the people who will judge those firms.
Reuben Abraham and Sandeep Parekh are, respectively, the CEO of IDFC Institute and managing partner of Finsec Law Advisors.

23 May 2017

"Managing Your Legal Organisation" is out with a short interview of mine by Ramit Singh of @MagicLawyers. It's a good compendium and all profits go to charity - available on Amazon.in

31 March 2017

SEBI needs to loosen up and keep its eye on investor interest using economics - 'Poke me'

I have a piece published online in Economic Times. In a new format, this piece invites your comments on the op-ed. It will be reproduced on the edit page of the Saturday edition of the newspaper with a pick of readers' best comments. So please add your comments at this link. Comments reproduced in the paper will be the ones that support or oppose the views expressed intelligently. Please add comment on the main site of ET not here if you would like to be considered for publication. Please find below the full piece:

"Last month, Ajay Tyagi took over as the new Securities and Exchange Board of India (Sebi) chairman. He will have priorities. But for starters, one hopes he will support more innovation. As with other things, there is a tradeoff between innovation and risk. If capital requirement in banks is increased from 5% to 100%, there will never be bank failures. But such an outcome will be disastrous for the economy. There should be more experimentation in the financial market space, particularly in the exchange space. For too long, we have chosen safety over innovation. The pendulum needs to swing more towards freer markets which are well regulated, the preamble to the SEBI Act itself mentions development of the markets as a goal of SEBI. 

There ought to be more evidence-based policy decisions on market microstructure, and more open debate on concerns related to high frequency trading. Two low hanging fruits include eliminating the 15% cap on shareholding of exchanges and introduce, like RBI, a 15 year roadmap to dilute shareholding. This will foster new exchanges and more competition. The second low hanging fruit is allowing alternate exchanges which will provide innovation to the marketplace and create new markets. The larger exchanges are not interested in this space as it requires some handholding of smaller companies and there is a need for such alternate exchanges. The US has over 40 of them. This is possible even within the current statutory provisions and current capital requirements.

Secondly, many of the securities businesses today have capital requirements where there is no need for capital. Examples include networth requirements for portfolio managers and mutual fund managers. This is anti-competitive and plainly hurts smart people and investors. It gives a message that India is more comfortable with robber barons than with IIM graduates starting a securities business. Businesses which should require smarts rather than deep pockets should require the right entry norms. Certain securities businesses do indeed require capital, like clearing corporations, but imposing it on mutual fund managers is anti-competitive and invites the wrong kind of people in the business, besides raising costs for investors who must ultimately bear the costs of pointless deployment of capital.

Third, while SEBI has been very effective in curtailing mischief by intermediaries, it has not been successful with problems which require more bandwidth, like enforcement against listed companies and financial shenanigans by persons conducting Ponzi schemes. Similarly, there has been virtually no action against mis-selling and broking fraud, where brokers empty out accounts of new clients by constant trading in derivatives and other inappropriate products. This issue has gained epidemic proportions and needs to be addressed with suitable enforcement action making such practices financially ruinous. SEBI inspections should seek information which indicates this practice.

Fourth, in line with regulatory action against miscreants, SEBI needs to take a softer approach against honest mistakes. Given the complexities of the regulations, many professionals in companies are sometimes left confused, and there are bound to be honest mistakes. SEBI needs to take a lighter touch approach to such mistakes or merely issue warnings. Recent statutory amendments also help the regulator in taking a rational approach. SEBI also needs to put a restraint on interim orders. Use of emergency powers may be required at times, but SEBI’s use of interim ex parte orders is disturbing as it beheads a person before the trial has even begun. SEBI then has years to relax, while the person is executed daily through economic harm.

Fifth, and most radical, there is a need to revisit the quota system for initial public offerings. By offering retail investors a special ‘quota’ in an IPO, investors are lured into a highly risky equity product with a dangled carrot of 'free money'. Nothing could be further from the truth. Investing in IPOs could be highly profitable, but it could also wipe away 80% of an investor’s saving in just two weeks. This is not a product for retail, and certainly not a product which should be luring retail participation. Freeing up the market to ordinary market forces without quotas would reduce the moral hazard and imperfections like IPO frauds substantially and eliminate subsidies to punters. SEBI’s eyes should be on investor interest, not on guaranteeing returns to flippers who want free money in 2 weeks. SEBI needs to use economics and ‘nudges’ rather than fight them.

Sixth, excellent progress has been made in the corporate debt market over the past ten years. Corporate debt markets should be allowed to innovate more and corporate debt markets should not be set up as replicas of equity markets (they are different animals and need different food). Ironically, the best policy is encouraging more off exchange trades, including electronic trades, which will create liquidity and expand the markets. This is so, because debt instruments, unlike equity, are traded infrequently and in very large transactions, sometimes in thousands of crores. Attempting to move that to an anonymous order matching platform is bound to fail as large trades push the market price beyond what is acceptable to any buyer or seller. Any mandatory push would in fact shrink the market. Alternate debt exchanges are one possibility and SEBI has had an applicant for that.


Finally, there is need for simplicity and constancy in regulations. I find many of the securities laws are spread over circulars, which are vague and ever-changing. It is not clear how ordinary companies can keep track with daily changes and excessive complexity of regulations. Complexity is the enemy of compliance. And confusion guarantees innocent violations on the one hand and crooks to breed on the other."