MANDATED CSR AND IMPRISONMENT: A FIT CASE FOR RECONSIDERATION

Corporate Social Responsibility (CSR) is in
the news with the passing of the Companies Amendment Act, 2019 because it has
made lapses in complying with CSR spends an offence subject to imprisonment for
a maximum period of three years¹. The penal provision for
imprisonment replaces the earlier requirement to comply with CSR spends or
explain the reason why a company had not spent the mandated amount on CSR. This
change was brought in after witnessing five years’ track record of implementing
mandated CSR. Hence it is appropriate that we evaluate and take stock of the
idea behind Mandated CSR in the backdrop of India Inc’s track record on
implementing CSR spends in the last five years and evaluate the fairness of the
current punishment accorded for lapses in CSR spends in the overall context of
the penal provisions prescribed under the Companies Act, 2013.

India is the first and probably only country
till date to mandate CSR spends by large corporates. It was part of the
Companies Act, 2013 which was enacted to replace the 1956 Act and was seen as a
major measure to promote ease of doing business and corporate activity that
would accelerate the pace of India’s economic growth. Probably to balance the
inequality created by private sector-led economic growth, the new Act required
large companies, defined by their net-worth, turnover or profits beyond the
defined threshold level, to spend 2% of the average profits of the last three
years on specific activities identified in schedule VII of the Act.

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1   135 (5)
The Board of every company referred to in sub-section (1), shall ensure
that the company spends, in every financial year, at least two per cent of the
average net profits of the company made during the three immediately preceding
financial years, or where the company has not completed the period of three
financial years since its incorporation, during such immediately preceding
financial years, in pursuance of its Corporate Social Responsibility Policy:

Provided that the
company shall give preference to the local area and areas around it where it
operates, for spending the amount earmarked for Corporate Social Responsibility
activities:

Provided further
that if the company fails to spend such amount, the Board shall, in its report
made under clause (o) of sub-section (3) of section 134, specify
the reasons for not spending the amount and, unless the unspent amount relates
to any ongoing project referred to in sub-section (6), transfer such
unspent amount to a Fund specified in Schedule VII, within a period of six
months of the expiry of the financial year.

Explanation—For the
purposes of this section “net profit” shall not include such sums as may be
prescribed and shall be calculated in accordance with the provisions of section
198.

(6) Any amount remaining
unspent under sub-section (5), pursuant to any ongoing project,
fulfilling such conditions as may be prescribed, undertaken by a company in
pursuance of its Corporate Social Responsibility Policy, shall be transferred
by the company within a period of thirty days from the end of the financial
year to a special account to be opened by the company in that behalf for that
financial year in any scheduled bank to be called the Unspent Corporate Social
Responsibility Account, and such amount shall be spent by the company in
pursuance of its obligation towards the Corporate Social Responsibility Policy
within a period of three financial years from the date of such transfer,
failing which, the company shall transfer the same to a fund specified in
schedule VII, within a period of thirty days from the date of completion of the
third financial year.

(7) If a company
contravenes the provisions of sub-section (5) or sub-section (6),
the company shall be punishable with fine which shall not be less than fifty
thousand rupees but which may extend to twenty-five lakh rupees and every officer of such company who is in default
shall be punishable with imprisonment for a term which may extend to three
years or with fine which shall not be less than fifty thousand rupees but
which may extend to five lakh rupees, or with both.

CSR RATIONALE – THE THREE VIEWPOINTS

The concept of CSR emerged in economies
where there was exclusive focus on corporate business responsibility. In
contrast, in social democratic societies in Northern Europe, especially the
Nordic countries, the concept of CSR is quite nascent and is focused more on
sustainability and innovations as the basic social security needs of health,
education and old-age relief are provided by the state. Even in continental
Europe, in countries like France and Germany, where some form of state
socialism prevails, CSR has limited appeal. Companies in the private sector of
these economies implement labour laws which are quite comprehensive and pay
their taxes which fund social security programmes for the rest of the society.

The idea of CSR has flourished only in
liberal market economies such as the United States where the private sector
dominates healthcare and education, catering only to the needs of the society
that can afford to use their service. The reason for this is not too difficult
to fathom. The primary business responsibility of a company in these economies
is restricted to earning a profit by conducting its affairs legally and the
social security system in place is not comprehensive enough to cover all the
vulnerable sections of the society. Further, some of these social concerns were
not addressed by the government despite the visible and pressing needs as it
was seen by some to infringe on the personal freedom of individuals, or seen by
some others to be discretionary for which tax-payers’ money should not be used.

Over time, three distinct views emerged to
justify CSR in these liberal economies. Initially, CSR spending was seen as an
optional marketing expense, essential for building a corporate brand and
goodwill among the public at large who were seen as potential customers or
employees in the long run. In the second stage, the pressure to spend on CSR
increased in companies operating in certain sectors like mining and energy that
used natural resources and caused noticeable pollution / environmental hazards.

But then a new rationale emerged, with CSR
being seen through the lens of the social contract theory. Using this theory,
CSR spending was justified as the fee paid by the polluting firms to society in
return for their right to carry on business. This view seems to have gained
credibility as firms with high CSR spends were found in highly polluting
sectors, or sectors with large negative externalities, such as mining, tobacco
and oil exploration.

Around the end of the second millennium, a
third view emerged. It was an interesting viewpoint, where CSR was seen as
businesses serving the base of the pyramid. This idea gained traction in
parallel with the idea of social enterprises gaining visibility, especially in
areas like micro-finance. Depending upon whom you talk to and which part of the
world you are in, all the three views can be heard.

MANDATED CSR – A
PRO-CON ANALYSIS

The idea of mandated CSR introduced by the
Companies Act, 2013 emerged in the backdrop of the prevailing concepts of CSR
expenditure seen as brand investment or as a social contract with the society
to compensate for the negative effects of business, or as catering to the needs
of the base of the pyramid, or as a variant of social enterprise. In this
context, mandated CSR was a new idea not found elsewhere in the world. Shorn of
its voluntary ‘mask’, mandated CSR is a form of taxation, where the tax,
instead of being paid to the exchequer, was now in the hands of the taxpayer to
be spent on pre-defined purposes. Instead of a legal process coercing the
company to spend with the threat of penalty for defaults in spending, the 2013
mandate used the principle of social pressure of ‘Comply or Explain’, a
technique using social standing and reputation as leverage to get companies to
spend on CSR.

Advocates of the mandated CSR approach
hailed it for three specific reasons:

(i) Companies would be more effective than
government in spending the money as they would bring in the speed and
efficiency of the corporate world in the selection, implementation and
monitoring of the CSR spends. Especially on the monitoring front, there was
huge expectation of corporate experience bringing in new techniques and methods
of monitoring that would help the social sector.

(ii) Absence of the bureaucracy and
discretion available in the corporate world would enable innovative projects to
be taken up in the social sector funded by the corporates. Once these projects
succeeded, they could be used by the government for scaling up and reaching
larger segments of the society.

(iii) Companies would cater to the needs of
specially deserving segments of the population and meet the specific needs of
their location that may not be visible to the larger government machinery.

Opponents of the mandated CSR school, in
addition to questioning the ‘corporate efficiency’ theory, also raised the
issue of intent where some corporates instead of allocating incremental budgets
for CSR spends may be reclassifying their current spends or placing a social
envelop for their business spends on marketing and pre-recruitment training
expenses to meet the mandate. Further, they also questioned the desire of
corporates to spend time and effort in building the competency required to
manage social projects.

While both sides had their merits, only the
track record of India Inc. in CSR spends could settle the issue one way or the
other. So what does the five-year track record of India Inc. show?

INDIA INC.’S CSR
PERFORMANCE – THE TRACK RECORD

In the first year of mandated CSR, if we
take Nifty 50 as representative of India Inc., the performance reflected
teething troubles as is to be expected of any new enactment, especially one
that involves discretionary spends. Against a mandated spend of Rs. 5,046
crores, reflecting 2% of the profits of the Nifty 50 companies, the actual
spend was at 79%, amounting to Rs. 3,989 crores². Two of the Nifty
50 entities, State Bank of India and Bank of Baroda, are not regulated by the
Companies Act, 2013 and hence were not required to specify their mandated
spends on CSR.

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2   CimplyFive’s India Secretarial Practice 2015,
Nifty 50 Annual Report Analysis, December 2015

Of the remaining 48 companies, 16 spent in
excess of the mandate, including three companies where the mandated spends on
CSR was negative due to lack of profits. The remaining 32 companies had a
shortfall in their spends, with 30 of them explaining the reason for their
inability to spend. Only two companies offered no explanation for not spending
the required amount on CSR. A further analysis revealed that 12 companies had
stated that being the first year, they were not able to spend as they were
building their capacity to spend.

Table 1: Comparison of CSR spends by Nifty 50
Companies in the first two years of mandate

In the second
year of implementation, we see a marked improvement in CSR spends compared to
the first year as depicted in Table 1. The mandated amount of CSR spends
increased by 8.5% to Rs. 5,478 crores and the amount spent on CSR activities
increased by 27% to Rs. 5,082 crores. Even the amount spent as percentage of
the mandate increased from 79% to 93%, an increase of 14%.³  Companies not spending the mandated amount
too decreased from 32 to 25 and only one company did not disclose the reason
for not spending the mandated amount.

The steady improvement in compliance becomes
more evident when we look at the last two years. In 2017-18, the CSR spend as a
percentage of mandate was 98⁴ 
and in the last financial year 2018-19, the spend as a percentage of
mandate was at 104. However, the number of companies with shortfall in CSR
spends in 2018-19 at ten remained at the same level as in 2017-18.

The performance of India Inc., as
represented by the Nifty 50 companies in the five-year period, reflects that
the objective of CSR mandate in getting companies to spend on social activities
is achieved as evidenced by Nifty 50 companies, as they spent 104% of the
mandated amount.

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3   CimplyFive’s India Secretarial Practice 2016,
Nifty 50 Annual Reports Analysis, November 2016

4   CimplyFive’s India Secretarial Practice 2018,
A Study of Nifty 50 Companies, March 2019

Table 2: CSR spends of the Nifty 50 Companies
in last two years

The Indian experience of using ‘comply or
explain’ is at par with the international experience seen in Europe where it
takes three to four years for a new regulation to be widely adopted and
implemented. While the experience of Indian corporates outside the Nifty 50
companies could be different, there is no data that is analysed and presented
to show that. Given this analysis, was there a need to change the penal
provision to enforce CSR spends by Indian corporates to the extreme level of
imprisoning the officers in default for a maximum period of three years? How
does this punishment compare with penalties for other defaults in company law?

PENALTY IN CORPORATE
LAW

Conceptually, punishment or penalty can have
two distinct objectives:

(a) Compensatory, i.e., to punish the
wrongdoers by taking away from them the benefit accruing to them from their
wrongdoing. Most often this is in the form of monetary penalties; or

(b) Deterrent and preventive, i.e., act as a
disincentive to the wrongdoer and all other potential wrongdoers by imposing a cost on them that is prohibitive and dissuades them from
committing the wrong. Since the objective is to be a deterrent and preventive,
this takes the form of monetary penalties, where the amount recovered is more
than the benefit obtained by the wrongdoer and / or limiting the personal
freedom of the wrongdoer, i.e., imprisonment.

The Companies Act, 2013, consisting of 470
sections, has penalties both in the nature of compensatory and
deterrent-cum-preventive measures. The Act has 101 sections with monetary
penalties for non-compliance and 56 sections that have imprisonment as penalty
combined with fine, as monetary penalty.⁵  While monetary penalties can be levied on
either the company or the officers in default, imprisonment is a penalty
applied only to the officers in default.

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5   CimplyFive’s Report on the Cost of Compliance
and Penalty for Non-compliance under the Companies Act, 2013, December 2017

Analysing the penalty provisions that
provide for imprisonment in the Companies Act, 2013 we can classify them into
six distinct categories based on their value as a deterrent, as detailed in
Table 3:

Table 3: Classification of penalty provisions
for imprisonment based on their value as a deterrent

Seen in this backdrop, lapses in complying
with the CSR requirements on spending / transferring the amount to specified
accounts with imprisonment up to three years equates it to a category IV
offence, which is higher than tampering with the minutes of meetings of the
company.

Further, an analysis of Nifty 50 companies
that have short-spent on the mandated amount reveals that in some companies,
the Profit After Tax may not be backed by Operating Cash flows providing them
the liquidity to spend. At the Nifty 50 level, Operating Cash flows at Rs. 3,13,638 crores
are 90% of Profit After Tax at Rs. 3,48,751 crores. For certain companies that
have short-spent on CSR, Operating Cash flow as a percentage of Profit After
Tax drops to 16. Given this anomaly of Operating Cash flows being lower than
Profit After Tax in many companies due to their business model of selling on
credit or having a long working capital cycle, the penal provision of
imprisonment for non-compliance which could be the result of a business reality
needs a review.

Given the fact that charity cannot be
mandated or legislated, this mandate to prescribe imprisonment for lapses in
CSR spends, which the world over is optional for corporates, needs to be
seriously reconsidered. The regulators, by swiftly
amending the law to remove this aberration, would visibly signal a conducive
corporate environment to promote economic growth and employment generation.

PS: After this article was written but
before publication, the government has responded to implement the report of
high-level committee on CSR which has recommended that violations should be
treated as civil offences and made liable to monetary fines.

This is a welcome step and will go a long
way in the Indian companies feeling the responsive nature of the regulator to
critical feedback.