‘Apply and Explain’ – An Alternative Model of Corporate Governance

[Manasvin Andra is a III year student at NALSAR University of Law, Hyderabad]

Corporate governance has emerged as one of India Inc.’s primary concerns since the time the Satyam scandal came to light. The incident – dubbed “India’s Enron” – has had a seismic effect on how businesses are regulated, and its effects have been felt most prominently in terms of how corporate governance norms are promulgated and enforced. Satyam resulted in India committing itself to a wholly mandatory approach to corporate governance, making it one of only a handful of countries to have adopted a ‘comply or else’ approach to the issue of how corporate governance is to be enforced.

Building on this in his illuminating article titled “Corporate Governance in India: The Transition from Code to Statute”, Professor Umakanth Varottil makes the argument that India has gone beyond the mandatory approach to implement what he refers to as the ‘ultra-mandatory’ approach. According to Prof. Varottil, India has taken the extreme step of embedding detailed elements of governance in its primary corporate legislation, as opposed to the general practice of laying down principles in corporate governance codes or listing rules issued by the stock exchanges. While the premise is that India is better off with a mandatory approach than the ‘comply or explain’ adopted by most European countries, Prof. Varottil argues that the ultra-mandatory approach is not conducive to the flexibility and dynamism that characterises the business world. As a result, he suggests that the ultra-mandatory approach be discarded in favour of a mandatory approach, where detailed rules regarding corporate governance are left either to subordinate legislation or to regulations made by the securities regulator.

The present project aims to demonstrate how India can make the aforementioned transition, by introducing an alternative – and transitory – model of corporate governance termed ‘apply and explain’ into the Indian legal system. The model is based on requiring companies to outline how they have applied the norms being followed, and has the potential to increase compliance rates with respect to corporate governance rules.

The Deficiencies of the Comply or Explain Model

According to Prof. Varottil, the peculiar features of the Indian corporate landscape makes the ‘comply or else’ model the most suitable structure to enforce corporate governance norms in India. This argument is based on four grounds, which are stated to be the distinguishing factors between countries that are equipped to employ the ‘comply or explain’ model and those that are not.

The first factor is the reliance of the corporate sector on government regulation, with both the legislature and judiciary influencing how companies operate and govern their internal functions. Second, the absence of a large body of institutional investors has precluded the emergence of voluntary codes of governance, as they do not exert real influence over the manner in which companies are run. The third factor is the prevalence of concentrated ownership structures and the corresponding issue of limited shareholder activism, which reduces the likelihood of companies making voluntary disclosures. Lastly, Indian institutions have failed to engender a culture of voluntary compliance, which has resulted in compliance rates generally remaining low. Given this situation, it is argued that it would be unreasonable to expect firms to voluntarily follow governance codes, leading Prof. Varottil to suggest that the ‘comply or else’ model is the model that is best placed to enforce corporate governance norms in India.

The factors mentioned above set out a strong case for a mandatory approach to corporate governance. However, there exist drawbacks to this approach, which should prompt a reconsideration of the efficacy of the mandatory model. These deficiencies primarily relate to the lack of effective enforcement of norms and, more importantly, to the costs and benefits of an enabling – as against an ultra-mandatory – corporate governance framework.

Enforcement of corporate governance norms in India leaves much to be desired, as stronger legal frameworks and stringent penalties have failed to stem the flow of corporate misdeeds. A primary reason for this is that public enforcement is hindered by significant procedural delays, particularly when the judiciary is brought into the picture. The time taken to act against corporate misdemeanours offsets the advantages conferred by laws and regulations passed by the government as companies expect to go scot-free given the aforementioned delays.

Further, the ineffectiveness of regulators and the government in clamping down on noncompliance is a key reason for the weak enforcement of corporate governance norms in India. Regulatory deference to industry views and opinions has resulted in government relaxing rules rather than helping companies implement them and foster greater compliance with the norms. The advantages of timely enforcement are obvious in that it fosters compliance among companies, as laws and rules are no longer matters to be negotiated but mandates that must be enforced. Ultimately, the ultra-mandatory approach has led to the presence of stronger rules; however, lack of enforcement has resulted in minimal adherence rendering the model largely ineffective.

As opposed to this, an enabling framework has the benefit of improving enforcement by reducing the burden faced by the judiciary and the regulator, as the more onerous requirements can be dropped from the primary legislation and enacted as rules by the concerned regulators. Rather than relax the requirements along the lines of industry responses, the government can assist the corporate sector in following corporate governance norms, which will have a snowballing effect as companies are pushed in the direction of greater compliance. Assisting entities in achieving compliance removes the need to penalise them when they are non-compliant, thereby reducing the burden on the judiciary and ensuring that only the egregious violators are brought to the courts. These are benefits that will accrue under a mandatory as opposed to an ultra-mandatory model, which is the primary factor necessitating a transition from the latter to the former.

Utilising ‘Apply and Explain’ in India

The ‘apply and explain’ model finds its origins in the King IV Report on Corporate Governance for South Africa, and marks a move away from the ‘apply or explain’ approach that was previously in use. ‘Apply and explain’ assumes that companies are already in compliance with the principles and it requires them further to explain how they achieve their targets. The intention is to move beyond a simple “tick box” approach to corporate governance, and to task companies with showing precisely how practices achieve compliance with the designated principles. Essentially, entities are asked to take a proactive approach to corporate governance, and are required to deliberate on how their actions help the organisation achieve its goals.

To this end, the King IV Report provides a framework of sixteen principles, along with recommended practices to assist in the achievement of each principle. The idea is to prevent companies from getting away with “mindless” compliance, and instead to explain how their actions moved the organisation closer to achieving each goal. This is geared towards changing the perception of corporate governance as simply the “cost of doing business”, which strikes at the heart of corporate governance as it reduces the idea to a set of mechanical actions with little regard for whether the desired goals were achieved. Consequently, the Report frames good governance as the exercise of ethical and effective leadership by the governing body, which should ideally result in the achievement of outcomes such as an ethical culture, performance and value creation, effective control and legitimacy.

The ‘apply and explain’ model provides the most effective method of transitioning from an ultra-mandatory to a mandatory approach, in view of the unique factors that characterise India’s corporate sector. This is because governance reform has mainly focused on independent directors and better protection for minority shareholders in the face of concentrated ownership structures, which are difficulties that can be ameliorated by the ‘apply and explain’ model. This works in two ways: first, by giving minority shareholders and institutional investors – who are largely passive in the Indian context – a better window into the internal workings of companies, and second, by bolstering enforcement as regulators and the government get a clear picture of how companies are complying with the relevant rules.

As Prof. Varottil notes, activism on the part of shareholders and institutional investors is on an upward trend in India; however, it is unlikely to have much of an impact in the face of concentrated shareholding that typifies the Indian corporate landscape. Companies do not encourage disclosures given their ability to generate private information and benefits, though the situation has changed since the enactment of the Companies Act, 2013. Despite this, compliance largely remains a tick box exercise for most entities, with minority shareholders given a cursory treatment by companies to ensure that do not run afoul of the law. Simply following the procedure instead of engaging with the spirit of the law cannot be said to amount to compliance at all, which is the primary problem plaguing corporate governance in India.

It is here that the ‘apply and explain’ model comes in handy as, by forcing companies to explain how their strategies brought them closer to achieving the organisation’s objectives, the company – and by extension the controlling shareholders – are held accountable for their actions. Since the disclosures and explanations are placed in the public domain, minority shareholders are exposed to how the companies achieve their objectives, which makes it easier to identify and act against any discrepancies that may arise.

Such a model also helps independent directors perform their duties in a more effective manner, given that their primary role is to ensure that the interests of minority shareholders are protected and not adversely affected. Since independent directors sit on the board, which is responsible for making disclosures under the ‘apply and explain’ model, they can act by themselves to hold promoters and management to account, on the basis of explanations provided to them by the board itself. Therefore, the ‘apply and explain’ model will provide a fillip to corporate governance practices in India, as it will improve transparency in terms of the internal workings of companies.

Secondly, the quality of companies’ explanations under the model will be indicative of whether norms are being understood and applied correctly, which ought to simplify the process of moving from an ultra-mandatory to a mandatory approach. This is because the ultra-mandatory approach appears to be based on a distrust of businesses and the industry as a whole, especially considering that it was enacted in the aftermath of the Satyam scandal. By requiring companies to explain their approach towards the achievement of corporate governance goals, government and the regulators will be in a position to evaluate whether companies are complying with the spirit of the law. On this basis, the more onerous norms can be removed from the Companies Act, 2013 i.e. the primary legislation. This ensures that while corporate governance remains in the form of law rather than a voluntary code, a more enabling framework is substituted in place of the ultra-mandatory model that currently holds the field.

Conclusion

As Prof. Varottil observes, the rigidity of a corporate governance regime that uses primary legislation to deal with basic corporate governance norms “generates excessive costs without the concomitant benefits”, and India needs to move a more enabling regime if it is to effectively enforce essential rules and regulations. As shown above, the ‘apply and explain’ approach offers the most optimal model in this regard, as it provides a way for the government to roll back the more onerous aspects of the Companies Act, 2013 without risking the collapse of the entire corporate governance structure.

Manasvin Andra

About the author

Add comment

Subscribe to Blog via Email

Enter your email address to subscribe to this blog and receive notifications of new posts by email.

Recent Posts

Topics

Recent Comments

Archives

web analytics