CORPORATE LAW IN INDIA – PROMOTING EASE OF DOING BUSINESS WITHOUT DILUTING STAKEHOLDER INTERESTS

INTRODUCTION

The sheer size
of corporates combined with the volatile stock markets has made corporate
performance the barometer of a country’s economic sentiment, and India is no
exception to this. In the last three decades, continuous measures to deregulate
the corporate sector were driven by the desire to attract investments to
accelerate economic growth. This was interrupted by new regulatory measures
introduced to prevent corporate scandals that erupted periodically from
recurrence. Seen through this lens, it appears that deregulation, which now
goes by the phrase promoting ‘Ease of Doing Business’ and protecting
stakeholders’ interests are contradictory as evidenced by the periodic swings
in the regulatory environment from promoting Ease of Doing Business to
protecting Stakeholders’ Interests and back.

This article
seeks to examine the validity of a perceived conflict between promoting Ease of
Doing Business and protecting Stakeholders’ Interests and explores potential
avenues to reconcile the two by taking a historical view. It is structured in
four parts:

Promoting
business and protecting stakeholders’ interests in the pre-corporate era;

Promoting
business and protecting stakeholders’ interests in the corporate era;

Indian
regulatory initiatives in the 21^st century; and

Reconciling
Ease of Doing Business with Protecting Stakeholders’ interests in the corporate
world.

Part 1: Promoting Business and Protecting
Stakeholders’ Interests in the pre-corporate era

Despite
appearing contradictory, in the transport sector the progress in braking technology
was a key prerequisite for quicker and faster transport of goods and people.
Likewise, protecting stakeholders’ interest is a prerequisite to promote
economic activity in a society. This can be seen in the evolution of the three
key commercial concepts that boosted economic growth, namely, (i) Recognition
of private property, (ii) Use of commercial lending and borrowing, and (iii)
Advent of corporate entities for conducting business.

Table 1: Commercial concepts that promoted
economic activity

The first
impetus to economic growth came with private property. Recognition of private
property resulted in ownership without possession by penalising theft and
robbery which can negate the owners’ rights. This enabled individuals to
undertake economic activities on a larger scale and with a longer gestation
period by assuring them that the rewards of their labour will be secured for
their own benefits. It resulted in human societies shifting from hunting and
gathering to agriculture where there is a time lag of a few days to weeks or
months between ploughing and harvesting of crops, which promoted production in
excess of consumption required by the individuals or their families. At a later
stage, this protection against theft and robbery promoted trade by assuring
travelling merchants the safety of their goods when they moved it from place of
production to places of consumption.

In the digital
economy of the 21^st century, as the nature of assets changed, recognition
of private property is visible in the clamour for protection of Intellectual
Property (IP) that comes from technology companies and Startups who invest
their efforts in creating it. As a result, economies that protected IPs like
the USA and Europe have had accelerated economic growth and other economies
have since emulated them by enacting enforceable IP laws to promote local IP
creation.

The second impetus to economic growth came
from the use of credit for commercial activities which pulled in future demand
into the present time. For long periods in human history, lending and borrowing
were in the realm of social activity, where an individual or a household in
short supply would borrow their daily necessities from their neighbours. In the
social realm, the quantity borrowed and the quantity returned were the same. As
the goods borrowed changed from items of daily necessities to seeds for farming
and goods / money for trade, the concept of interest emerged. The borrowers
induced the lenders to part with their valuables by promising them a share of
their gains. Being a voluntary act motivated by profit, the lenders wanted an
assurance that the borrowers would honour their promise.

Given the
substantial benefits that accrue to the society, in the early stages regulators
created deterrents like bonded labour and imprisonment for the defaulting
borrowers. In later stages it took the form of enacting insolvency and
bankruptcy laws like the Insolvency and Bankruptcy Code that India enacted in
2016 which empowers lenders to enforce the promise made by the borrowers by
taking control of their assets.

Progress in enacting and enforcing the
Intellectual Property laws and enabling quick recovery of loans shows the
primary role played by private property and commercial lending in accelerating
economic activity. This rule of law is a primary prerequisite for economic
development and growth. At the next level, economic activity can be further
accelerated by ensuring good governance which has two components – political
governance and corporate governance, which is reflected in the social and moral
ethos of society even though its roots can be traced back to regulatory
enactments.

Part 2: Promoting business and protecting
stakeholders’ interests in the corporate era

By combining the three concepts of joint
ownership, limited liability and transferability of shares in one commercial
entity, which is the joint stock companies, the foundation was laid for rapid
and sustained economic progress. This new entity enabled collaboration among
large numbers of investors to undertake projects of longer gestation periods,
which would have been unimaginable without joint stock companies. This boon,
however, is not without reservations as it comes with significant drawbacks
that are visible in the periodic corporate scandals that have erupted across
the globe due to misuse of the limited liability provision combined with the
separation of ownership from operational controls.

Corporate scandals seen in the last five
centuries can be traced to one of these three elements – (a) indiscreet use of
corporate assets, (b) diversion of corporate assets for personal use, or (c)
misuse of corporate business information for personal gains. These concerns are
not new and were expressed when the first company was created. However, these
concerns were overlooked as the economic benefit from these companies was
substantial. The very first joint stock company was formed in the year 1553 in
London to find a trade route to China through the North Seas, although it ended
up finding a profitable trade opportunity with Russia. It sought to address
these concerns by prescribing three basic qualifications of ‘sad, discreet and
honest’ for their directors who held operational control of the company. While
discreet and honest are self-explanatory, the word ‘sad’ is derived from the
word ‘sated or satisfied’, to denote a satisfied individual who would take care
of the interest of minority shareholders and other stakeholders without
diluting it for his own personal interests.

Table
2: Major regulatory initiatives in corporate law

The last five centuries of corporate history
have not come up with any new concepts to redress the concerns of minority
shareholders and stakeholders but has only seen refinement and fine-tuning in
implementing the three qualities of ‘sad, discreet and honest’ that were
defined in the year 1553. Thus, we have seen movement from

–   Sad or Satisfied Directors to Independent
Directors who are entrusted with the job of protecting minority shareholders
and other stakeholders,

–   Discreet to fair disclosures to prevent
benefits accruing to individuals with inside information by regulating insider
trading, and

–   Honest to Related Party Transactions at arm’s
length pricing to prevent individuals with control from misusing their powers
for their personal benefit in transactions with the company.

While these concepts are clear in principle
to protect stakeholders’ interests, it is in their implementation that
challenges arise. Despite the refinements made in the last five centuries, the
outcome is not as desired. As a result, we see a constant battle between
promoting Ease of Doing Business and protecting Stakeholders Interest, as seen
from the regulatory developments in India over the last two decades.

Part 3: Indian regulatory scene in the 21^st century

The statutory endorsement of the Securities
and Exchange Board of India (SEBI) in 1992, the entity that was set up in 1988,
is a key element in the economic liberalisation process of the Indian economy.
Modelled on the SEC in the USA, it replaced the Controller of Capital Issues as
the regulator of new issues for raising funds from the public by companies.
Moving from a formula-based pricing to a market-based pricing mechanism, SEBI
led the movement to promote and enforce good corporate governance in India as
it seeks to protect stock market investors by preventing corporate scandals.
Following the path set by SEC, SEBI too embraced the principle of empowering
investors by providing them with the information required to make informed and
educated decisions. Hence, since its inception SEBI has mandated and nudged
companies to provide additional information or mandated more frequent
information sharing as the means to achieve better quality corporate
governance.

Table
3: Key Indian regulator initiatives in the 21st
century

In the last two
decades, strengthening corporate governance or protecting stakeholder interests
has resulted in the prescription of multiple rules and procedures which
include, among others, to define an independent director, the minimum role of
the audit committee, elaborate systems for approving related party transactions
and complex processes for preventing insider trading to the detriment of other
investors. While these measures are well intended, historically they have not
served the purpose of preventing corporate scandals leading to erosion of
corporate shareholder value. Further, in the face of economic downturn or stock
market collapse, to stimulate economic activity many of the stringent controls
and systems mandated are diluted, despite knowing the adverse impact on
stakeholder interests.

Part 4: Reconciling
Ease of Doing Business with protecting Stakeholder Interests

Ease of Doing Business is associated with
nil or reduced regulatory costs, efforts and time required to take and
implement any decision. On the other hand, protecting stakeholder interests
involves placing restraints on certain decisions or specifying some
pre-conditions for it. The key challenge in reconciling Ease of Doing Business
with protecting stakeholder interests is in designing restraints on actions
that protect stakeholder interests without translating into additional costs,
efforts or time required to complete the actions.

In achieving such a reconciliation,
technology, especially electronic messaging and e-voting should be liberally
used to convert representative democracy, as manifest in decision-making by the
board of directors, to participatory democracy of shareholder decision-making.
Further, in this digital era of cashless economy and compulsory
de-materialisation of shares mandated for all public companies, use of
electronic records should be prescribed for record-keeping by companies.

A brief analysis of the restraints that are
in place to protect stakeholder interests in the corporate law as it exists
today is listed here along with the changes proposed for protecting stakeholder
interest while at the same time promoting Ease of Doing Business.

Certification
of company’s reports: Certain reports that are
prepared by the company and shared with stakeholders are required to be
certified by specified professionals or professional agencies to assure
stakeholders of their veracity and fairness. These are reports like:

•    Annual Accounts by statutory
  auditors,

•    Corporate Governance report
  by practising company secretaries,

•    Statutory compliances
  certificates by practising company secretaries, and

•    Mandatory credit rating for
  issuing debt instruments.

Despite many instances where independent
professionals have failed in providing the required assurance, third party
certification is an effective means of assurance to all stakeholders. Measures
like limiting an auditor’s tenure through rotation, preventing the auditors
from providing consulting or advisory services that can dilute their
independence seek to prevent, if not reduce, the instances of failure. In this
regard, the initiative in the UK of getting the auditors to separate their
consulting business from audit firms needs to be closely watched to determine
its effectiveness for India to adopt the same.

Presence of
independent directors: The concept of independent
directors was introduced in the corporate board rooms to protect the interests
of minority shareholders and other stakeholders from misuse of executive powers
by the promoters and executive management. This was especially the case with
respect to their role in approving related party transactions and staffing the
audit committees to prevent misreporting.

As seen in the last few decades, the role of
independent directors in preventing corporate scandals has had mixed results.
In a few cases, independent directors were ineffective and in a few other
instances, they have resigned at the first sign of trouble when their presence
was most needed.

Given this ineffectiveness, it is worth
considering whether all related party transactions should be put up for
approval of the shareholders. With the exemption for small value transactions
in place, defined with reference to the size of the company or an absolute
value, whichever is lower, for all other transactions shareholder approval
through e-voting should be considered as a cost-effective and efficient system,
with the Board’s role restricted to ensuring that accurate and adequate information
is provided to the shareholders for their decision-making. Given the dominance
of promoters in the ownership of companies, on specific issues like related
party transactions voting by majority of non-promoter shareholders present and
voting should be considered.

Pre-approval from a designated authority –
the regulatory cost and effort increases at higher levels of the hierarchy and
diminishes as the levels decrease. Further, the cost is related to the number
of occasions where the approval is sought to be obtained or the specified
intervals within which these meetings should be held. Different levels at which
approvals are required in the descending order of hierarchy and costs involved
are listed below:

From MCA for unlisted companies and / or SEBI
in case of listed companies,

From shareholders in a duly convened
meeting or postal ballot,

From the Board in a duly conveyed
meeting,

From the Board through a circular
resolution.

In certain exceptional cases like mergers or
demergers, approval from stakeholders like creditors and lenders is mandated to
ensure their interests are protected in restructuring the entity on which they
took their exposure, as its underlying value could change.

In the 19^th century, proxy was an
effective means introduced to permit shareholders who were unable to attend
meetings in person. Given the technological advancement in the 21^st
century, e-voting could be mandated for companies of all sizes to enable larger
participation of shareholders in decision-making. Over time, as shareholders
get used to e-voting, the proxy system can be dispensed with.

Further, the one-time Covid-19 relaxation
provided for conducting shareholder meetings in electronic mode be converted
into a permanent provision in the Act to enable greater shareholder
participation.

Providing advance notice – The regulatory specification that translates to time involved in
taking a decision based on the minimum time prescribed for undertaking an
activity.

Illustrations:

Shareholder meetings – 21 days’ advance
notice, plus, based on convention, 2 days’ postal time considered for delivery,

Board meetings – 7 days’ advance notice for
convening board meeting.

Given the widespread use of emails for
communication, combined with the need for investors to have PAN and / or
Aadhaar cards as part of their KYC, the time for providing advance notice can
be reduced to seven days in case of both board meetings and shareholder
meetings, thereby enabling faster decision-making. The current provision for
holding shareholder meetings at shorter notice requires consent from 95% of the
members. In companies with lesser number of members, inability to contact even
one or two shareholders to get their consent will render this provision
ineffective.

Filing of
returns with public authorities (MCA / Stock Exchanges): The regulatory requirements specifying filing multiple returns with
the public authorities can be classified into two broad categories:

Event-based returns – Returns that are required to be filed only on the occurrence of
certain activities / transactions such as appointment or resignation of
directors, fund-raising;

Calendar-based returns: – Returns that are to be filed at periodic intervals reporting the
activity that occurred during that period, including filing of nil return or
reiteration of the status as on a given date such as annual filing of KYC form
for directors or half-yearly filing of MSME form;

Ease of
Doing Business – Can
be promoted by reducing the cost and time for regulatory compliance by ensuring
event-based return filings to public authorities like MCA and SEBI are only for actions that require their prior
approval. For all other returns that only notify actions already taken,
these returns be clubbed into a quarterly or annual return to be filed, thereby
reducing the compliance burden.

Maintenance
of internal records as evidence: This includes
maintenance of registers for certain activities and minutes of shareholder and
board meetings that are required as evidence for future records or use in case
of disputes.

Initially encourage and subsequently mandate
companies to maintain all internal minutes and registers in electronic records
that are tamperproof, with audit trails for entries made; these can be retained
for long periods of time. Provision can also be made for stakeholders concerned
to have 24/7×365 days access to these records. This concept is in line with the
requirements for all public companies to have their shares in dematerialised
form. In the medium to long run, this will ensure elimination of disputes
related to incorrect records or absence of records.

The Covid-19 pandemic in March, 2020 by
imposing significant restrictions on the normal way of life has provided an
opening for digital technology to change our lives forever. In the governance
and compliance field, while exemptions are being provided on a transactional
basis, can we use this opportunity to make a transformational change in protecting
stakeholder value and at the same time promote Ease of Doing Business by
embracing technology?