Category: Business Process Outsourcing

Obviously, this means that the business requires not only a
competent leader heading the finance function, but also a competitive leader to
lead the business activities. The finance organisation is uniquely positioned to
direct some of the uncomfortable activities that the current regulatory and
external stakeholders expect because otherwise no one will do them.

The same situation is faced on managing investors’
expectations. The capital markets around the world are coming closer and the
investors’ expectations are becoming almost similar from a business in the USA
and the one from India. The investors, if are giving higher multiple to your
company than a similar one in the USA or Europe, they have to be convinced about
the reason for such higher valuation of your business.

This brings the growth story. In IT industry, or now I would
now name it as Knowledge Industry (KI), the 30% growth story is impressive all
along to the global FIs, but to sustain these growth numbers at a billion $ +
top lines is a different challenge that no CFOs in India had faced before. The
CFOs are expected to create these values.

While doing that role, internally, the CFO has to maintain an
effective rhythm in the business thru participation in business planning and
review sessions. During this process, the CFO has to expose the areas of
underperformance in the business to ensure that overall growth and value do not
have a drag. This requires a lot of political and tactical skills. Weeding out
the dead log from the organisation in the current era is very critical and
crucial for survival of the organisation and the CFO has a lot of value to add
in this area.

Another way to judge the quality of output is to encourage people to participate in awards. Say, Institute of Chartered Accountants’ award for best-presented annual report. Such competitions provide an urge to improve quality of the output like annual report of the company.

Highest integrity of each finance team member is also one of the critical factors to achieve competitive edge. In the current environment, it is important that there should be zero tolerance for non-compliance. Controls are not only needed in substance but also in form. For example, if you have internal review meetings, the minutes of the same need to be recorded and circulated, action items must be tracked and completed to ensure that all the adequate controls are in place and are followed adequately.

No surprises:

This is the dream that every CFO has and wants to achieve. Business and markets give you enough surprises. What you hate to have is more surprises coming from your own organisation, from auditors and from the audit committee. Thus constant liaison with auditors and the audit committee has no substitute. Every non-business as usual (BAU) matter must be informed to these entities immediately to avoid last minute surprises to either side. This ensures a healthy relationship between all the stakeholders !

Internally, anticipating issues before they arise is essential. The CFO must have a list of peculiar transactions that may give rise to any non-BAU issues. Such issues need to be attacked on a war footing in time to avoid the quarter-end surprises. If you have number of subs in multiple countries reporting their numbers in different currencies and GAAPs, your responsibility goes up multifold as each of such sub, its GAAP and reporting currency has many surprises stored at the time of consolidation. The interpretation of GAAP provisions and their respective treatments in books can vary so much that quarter-end consolidation can become truly a nightmare! This requires a tight forecasting schedule and ability of the business to forecast accurately. In spite of spending hours on calls with the business people on forecast numbers, outlooks and budgets almost every week, there is a huge scope for a surprise and one has to have a plan to deal with such situations wisely and sometimes bravely. Revenue recognition or impairment of intangibles or compensated leave provision are some of the areas that can give last-minute surprises in US GAAP. Foreign Exchange Accounting has its inheritant element of surprise on the last date of a quarter. The CFO has to learn to pass thru these situations.

Complex life:
While the CFO is busy adding value to business and creating competitive advantage to the business and avoiding surprises, the ever-changing laws and demanding auditors and audit committees (especially those coming under laws like SOX !) makes life of the CFO and his organisation more complex. Indian companies are going global, and preparing accounts with different reporting currencies, different GAAPs, consolidations under Indian GAAP and also mostly US GAAP, and lastly every quarter with ‘deadlines’, Most of my CFO friends truly experience the meaning of ‘Dead’ line! Truly, life has become too complex.

I think it is time to question what is the value of publishing the quarterly numbers. Modern businesses are too complex to be evaluated on just one-quarter numbers and get in to enormous discussions on QoQ and YoY numbers, LTM numbers and so on. Other than audit firms and TV business channels and media, no one (especially investors/shareholders) stands benefited! It loses quality and adds complexity of numbers at the heavy cost of health of finance/accounts organisation of each listed company. Further, we add to our complexity by giving guidance for the next quarter and try to achieve it or beat it with no regards to global market dynamics (not capital markets) of our own Industry.

I think all of us bring of the same fraternity should make a serious attempt, to see that we get a stable set of GAAP rules which do not have multiple interpretations, leave some space for the CFOs’ integrity and discretion, rather than asking auditors to interpret GAAP rules (AS) (as if they are Vedas and only the auditors have right to interpret them! !); stop this quarterly business and make it half-yearly and move as early to IFRS to have common rules for global subs and consolidations of accounts. There are number of areas where the same transaction gets treated differently in different parts of the world. Even OECD countries do not have common understanding of the accounting treatment of similar transactions. Compensated leave, intagibles, ESOP accounting are some of such areas. IFRS, I believe, will bring these complexities and confusions to an end. In the USA, number of multinationals have found a solution otherwise! They have started publishing ‘Non-GAAP’ numbers with a management statement that these numbers are not audited but the management feels that they represent ‘true picture’ of the business !

The problem that I see is, in all this intellectual exercises and professional egos, all of us have forgotten that the main purpose of the reporting is to elucidate the current shareholders and prospective investors about the affairs of the company and allow them to have more educated judgment on the future performance of the company they have invested in or want to invest. In the bargain, not only have we made our lives complicated, but also made these numbers almost indecipherable to all stakeholders.

I feel, this is not impossible, though difficult.What we need is to put brains of professional accountants, CFOs, and regulators together to see how we ultimately help to create a value for our business, how we bring competitive advantage to our business without making life unnecessarily complex by bringing some common standards and compatible accounting practices that give all global stakeholders some same and meaningful information at reasonable intervals. I can only hope, we will reach there one day and it may not be just Utopia!

Industry is in need of complex specialised services and is
being forced to look elsewhere and this is becoming a matter of concern. The
growth of the BPO/KPO sector providing global services, has brought in massive
use of technology to deliver services and over a period of time created a large
pool of talent, unheard of anywhere else. In the short run, this has led to a
severe shortage of talent and large increases in compensation, creating room for
other professionals to run in. Professional practice is suffering with over 85%
of new members joining industry and large-scale flow of talent out of the
system. This, along with the increased demand from industry would lead to
consolidation of practices and reshape the profession. Small enterprises are
deprived of the services of CAs, impeding their growth, calling for new policy
responses. Welcome to the 21st century.

CAs are also becoming CEOs of local and transnational
enterprises, creating role models of the future.

The Chartered Accountant is India’s best known and most
widely respected professional. It represents years of business studies, work
experience, and the highest standards of professional ethics and objectivity.
But it is based on the model of yesterday and needs to reshape to meet the needs
of tomorrow. It should not be a profession of historic glory, but rather should
write its own history in this new era.

The first and perhaps the most significant trend is the all
pervasive impact of information technology. IT changes not merely the methods by
which financial information is produced, but can significantly influence the
content of that information, its form and its frequency of presentation, as also
the role of the auditor.

Information technology makes it possible for information to
be produced, analysed and collated very fast and this will generate demands for
financial information to be prepared and presented to shareholders on an
on-line, real-time basis. The annual general-purpose financial statement as now
produced in the form of the annual report may well disappear. In fact we are
very fast reaching the stage where, as a cynic when referring to the annual
report put it, “Analysts do not need it and shareholders don’t read it”.
Electronic filing of myriad statutory reports with regulatory authorities will
also become the order of the day and audit firms will have to increasingly
embrace automation in their auditing processes totally to handle this.

There will be a fundamental shift in the objective of audit.
Arithmetical accuracy of data generated through electronic systems will be taken
for granted and emphasis will shift to the validity of the input data and the
meaningful evaluation of the outputs generated. Higher level skills will
therefore be needed to make the resultant value judgments.

The development of the eXtensible Business Reporting Language
(XBRL) will be greatly accelerated. XBRL assigns a tag to each individual data
item in financial information containing contextual information such as
accounting period, company name, currency of use, etc. This makes it possible to
identify, extract, exchange, manipulate and report data quickly and easily. XBRL
will revolutionise financial reporting by making it possible for anyone who
wants to use financial information to analyse it, re-use it and exchange it in
any desired form. This can improve the transparency of financial statements and
returns filed with regulatory authorities and XBRL filings will become
mandatory. Already in the UK, XBRL filings have been made mandatory for all
corporate tax returns by 2011.

Significant progress has already been made in the development
of XBRL software throughout the world. The International Accounting Standards
Committee Foundation has developed IFRS-GP and software has been developed to
tag companies’ reported data and to validate the accuracy of self-tags for SEC
filings in the US. In India also, the project for XBRL development has been
assigned to a sub-committee of SEBI’s Standing Committee on Disclosure and
Accounting Standards (SCODA).

A second significant trend which can be identified is the
impact of globalisation in general and the development of international
standards of accounting and auditing in particular. India’s emergence as one of
the fastest growing members of the world economy carries with it the necessity
that it should rapidly align its financial systems with international practices.
Adoption of international accounting standards by 2011, as announced, is an
essential step in that direction. However, there are certain
aspects of this decision which need to be considered.

First, there is the oft-repeated complaint that accounting
standards are increasingly becoming too academic and divorced from practical
considerations. It is said that because of this approach, financial outputs are
often at odds with economic reality. It is also claimed that accounting
standards are becoming more complex. That there is merit in this claim is
obvious from the fact that the International Accounting Standards Board (IASB)
itself has recognised the need for reducing complexity in some standards. Thus,
it has recently issued a discussion paper on ‘Reducing complexity in reporting
financial instruments’. This paper argues that the many ways of measuring
financial instruments may be one main cause of complexity and while the
long-term goal should be measuring all types of financial information in the
same way, there will have to be an intermediate approach which must (a) provide
relevant and easily understood information; (b) be consistent with the long-term
measurement objective of fair value; (c) increase the number of financial
instruments measured at fair value; (d) not increase complexity, and (e) be
significant enough to justify the costs of the change.

Second, there is the growing debate between principle-based standards as proposed by IASB and rule-based standards as in US-GAAP. Both carry certain risks. The SEC in the U.S. argues that principle-based standards carry the risk of poor judgments which could be second-guessed by hindsight, whereas rule-based standards provide clarity and ensure risk. However the Enron, Worldcom, etc. debacles clearly show that rule-based standards are not free from risk as they can be easily circum-vented. The more -fundamental objection to rule-based standards, however, is their unsuitability as a basis for international standards. Rule-based standards are derived in the context of the environment in which they are developed and a rule which is appropriate in one jurisdiction may be wholly inappropriate in another jurisdiction with a different environment. In order to develop a single international standard, IASB and FASB are progressing along the road of convergence of IFRS with US-GAAP, but there is increasing concern that what may finally emerge willbe principle-based standards with rules.

But by far the most important  area of concern  is the growing trend towards ‘fair-value’ accounting in international standards. As a long-term goal, the concept of ‘fair-value’ accounting is unexceptional. It significantly enhances the role of financial information as a tool for making investment decisions and it obviates the ‘movement’ errors which occur when the values of assets and liabilities change over a period of time. However, there are significant difficulties in determining fair value and when fair value is based on estimation and guesswork, ‘measurement’ errors can occur.

IASB has in November 2006 issued a discussion paper titled ‘Fair Value Measurement’ which incorporates a definition of fair value as “the price that would be received to sell an asset or transfer a liability in an orderly transaction between market participants at the measurement date”. This borrows the definition used in a standard issued by FASB two months earlier, but the important difference is that whereas the term ‘fair value’ is used restrictively in US-GAAP to cover financial instruments and business combinations, it is used more extensively in IFRS to cover most assets and liabilities.

The big problem is that in practice, and certainly in developing countries like India, there often does not exist a market in which orderly transactions can take place between participants. Therefore ‘fair value’ will have to be estimated by the preparers of financial information and these values would be subject to the significant risk of ‘measurement’ errors, both deliberate and in good faith. Auditors also could become more dependent on managements’ judgment and as Warren Buffet has so aptly put it, marking to market could well become marking to myth.

Globalisation also will have an impact on the regulatory framework of the auditing profession. In the U.S., the Public Company Accounting Oversight Board (PCAOB) established under the Sarbanes-Oxley Act is required to exercise oversight over overseas audit firms which audit U.S. listed companies or their subsidiaries wherever located. PCAOB teams have already started examination of audit firms in India. In a recent interview, the Head of Audit Regulation of the European Commission has said that the Commission is consulting on how to deal with auditors from non-EU jurisdictions – ‘third countries’ – who audit third-country entities listed in EU regulated markets. The question is whether third-country auditors should be subject to registration requirements and over-sight by EU member states or whether reliance could be placed on the third-country audit registration and oversight authorities. Clearly in making that decision, an important consideration will be the level of public oversight in the regulation of the profession and pressure will mount for this oversight to be by a public regulator and not by the Institute.

A third significant trend which can affect the profession is the growing importance of corporate governance and its impact on the role of audit. The failure of major corporations like Enr on , Worldcom, etc. in the U.S., Royal Ahold in the Netherlands, Parmalet in Italy, etc. has highlighted the fact that corporate responsibility is the central issue which business needs to address. While this has resulted in a spate of regulatory pronouncements and statutes whereby policy makers seek assurance that business delivers sustainable and responsible outcomes, it also demands that business policies are supported by accurate and reliable information and the systems, processes and strategies that produce that information and that there is independent assurance in this area. This is a growing concern which will provide both future risk and opportunity for the profession and also re-define  the role of audit.

An auditor has two roles, first, to provide assurance regarding the reliability of financial information as the basis of investment decisions, and second, to give an opinion on the stewardship performance of the management. Traditionally the profession has given prominence to the first role and largely ignored the second. However in the changed environment, the roles will reverse. Auditors will be required to increasingly give assurance to shareholders on the ‘stewardship’ aspect rather than on the ‘decision usefulness’ aspect. This will mean that shareholders will want greater information and assurance on the risks and uncertainties that affect numbers in the financial statements arising from subjective judgments by management regarding revenue and cost recognition. Therefore, emphasis will shift from an opinion merely on the true and fair aspects of financial statements to value judgments on the existence and adequacy of controls and the relationship between finance and risk.

Risk management willbecome a major area of concern for managements and consequently for the auditor. He will need to examine and evaluate the methods by which managements identify risk, and devise and administer methods by which risks are controlled, managed and reported. He will no longer be able to avoid responsibility for failure to detect high-level collusive fraud and will need to devise new approaches to deal with it. He will need to be more pro-active, that is, identify work which is needed and do it before being asked to and will need to ensure that the work he does is relevant and valuable to the client. Managements will also have to accept greater Corporate Social Responsibility (CSR) including in areas of sustainable growth and the auditor will need to audit and monitor these initiatives. All of this will mean that auditors will have to possess wider skills, greatly increase their productivity and create multi-disciplinary firms.

A final trend which we need to recognise is the impact of restructuring in the profession. There are two major themes which will inevitably change the structure of the profession. The first is the growing process of consolidation within the profession, and the second, the continued ability of the profession to attract talent.

The decade which has ended has seen a process of consolidation within the profession whereby the Big-8 have become the Big-4 and a second level of international firms have grown significantly in size. In this process, smaller firms have found it difficult to continue independent existence and have scrambled to join the international firms. The growing dominance of these big international firms and particularly the Big-4 has raised concerns of regulators in many countries. In a recent survey of the investor community in the UK, 25% of the respondents were concerned that the lack of competition could be risking audit quality. However, a third of the same respondents also said that if there was a switch away from a Big-4 firm, they would review their investment decisions.

There have been demands for regulation to restrict this dominance, but clearly that is not the answer. The solution appears to be for second-tier firms to consolidate into larger entities and offer meaningful competition to the Big-4. To create this ‘reputational competition’ they need a better understanding of what constitutes a ‘great firm’. It has been claimed that the outstanding characteristics of a great firm are :- (a) significant sustainable profitable growth; (b) the right type of client base providing the right type of work at the right fees; and (c) the ability to attract and retain quality people. It is also claimed that to acquire these characteristics, these consolidated second-tier firms will need to address certain fundamental issues, namely, (a) the need for a well-planned strategy for the future; (b)    acquisition  and retention  of high-quality staff; (c)    leadership at all levels within the firm; (d) concentration on service lines in which the firm excels and avoidance of service lines where it does not; and (e) understanding client expectations and surpassing them.

An equally important aspect is a change in mindset. The profession must give up its dependence on work where it has a protective position and must no longer expect work as a matter of right. Rather it must be willing to sustain its business development through competition, both within and without the profession. Only then will it force itself to take steps to acquire a ‘reputational’ advantage through a track record of first-rate work.

The most crucial factor which will affect the profession’s future will however be its ability to attract and retain talent. With globalisation and a fast growing economy, one of the major constraints for the economy will be the shortage of talent and the resultant competition for it. Institutes in other countries have already addressed this issue and taken proactive action. Thus in the UK, the English Institute introduced some time back a system whereby training for an associate who is not in practice is extended to employers in several countries, including a proposed extension to India. In March 2006, it launched the Pathway Programme which enables professionals with other accountancy qualifications and five years experience also to obtain an associate qualification after passing an ‘examination of experience’. Finally, it has modified its examinations syllabus to enable entrants to take the examination in phases. Many other Institutes may follow this example and the ‘articleship’ system as we know it may no longer remain as the only vehicle for entry into the profession and audit experience may soon become an optional requirement.

If the profession has to address adequately the challenges created by the trends we have identified, the two key drivers which will be needed in the coming decade will be quality and integrity.

The Financial Reporting Council in the UK recently published a paper on ‘Promoting Audit Quality’ and a framework which admirably summarises the key drivers of audit quality. These are (a) culture within the firm; (b) skills and personal qualities of – 1 partners and staff; (c) effectiveness of the audit process; (d) reliability and usefulness of audit reporting; and (e) ability to respond to factors outside the control of auditors affecting audit quality.

Confidence in the auditor’s integrity is fundamental to his work. To inspire this confidence, he must be seen to be honest, truthful and fair, compliant with the concept of social responsibility, open and concerned with the interests of all stakeholders and demonstrative of taking corrective action where necessary. Integrity has to be underpinned by moral values and demonstration of scepticism, per-severance and ability to withstand pressure in the face of opposition.

As I look back over the last fifty years, I share a feeling of satisfaction that I have been part of a profession which has grown so fast and with so much success. It has done so because it has recognised early and been able to adapt better and faster than many other professions to the changing aspects of business and to exploit the opportunities which this changing aspect has offered. I have no doubt that in the coming decade, we will continue to remain the most dynamic seekers of new business opportunities if we continue to exhibit the qualities which have made this possible, namely, continually updated skills, integrity, social responsibility and strong regulation which protects the ‘brand equity’ of the Chartered Accountant.

The ultimate test of the role of a professional is the
standing and the respect he commands and the value which people put on the way
he handles matters and not the number of matters he handles. In England,
previously they had amateurs and professionals playing the game of cricket and
the annual match at Lords used to be called ‘Gentlemen v. Players’, the
amateurs being the gentlemen. The captain of the English team would invariably
be a cricketer who qualified as an amateur (gentleman). (Len Hutton, later Sir
Leonard Hutton, was the first exception just about the time that the Society
started functioning.) This is no longer so. The annual match is discontinued.
One wonders whether this is because the gentleman has gone out of the game! In
my view a professional attains his ultimate role if he qualifies as a gentleman
professional and not just a successful or prominent professional.

In one way of looking at it, the qualities which a
professional must possess to discharge his role with distinction have remained
the same over time. After all, the Ten Commandments do not change from time to
time. They are enduring and of universal application. Nevertheless times are
changing — the 20 : 20 culture has replaced the flavour of a test match in
popular thinking. So also the general concept of a professional has undergone a
change. Advertising by a professional was, and is taboo in India. However, it is
rampant in the United States of America where one may find at a department store
handouts which one can pick up about the achievements of a lawyer and I presume
also of an accountant. At some international airports one finds posters or
hoardings with a photograph of the leading professional in a professional firm
who has achieved success and prominence in his field. Even in the UK today,
barristers are permitted to bring to the notice of the public their speciality
of practice but not a reference to cases won by them. The rule against
advertising in India is so strict that Rule 36 of the Code of Conduct framed by
the Bar Council of India specifically provides that the stationery of a lawyer
should not indicate that he is or has been a President or a member of the Bar
Council or any association or that he has been associated with any person or
organisation or any particular cause or matter or that he specialises in any
type of work or that he has been a judge or an advocate-general. Strictly
speaking therefore, the letterhead cannot state ‘formerly a judge of . . .’ The
Chartered Accountant is subject to equally stringent condition against
advertising. The classic view is that the client must seek out the professional
and not that the latter fishes for clients.

The other malaise is the publicity which professionals seek
by constantly voicing their views in the press in response to mobile requests.
The views are often based on newspaper reports or TV announcements without
having actually seen in black and white what they comment upon. This is, of
course, less reprehensible than the case of the politician who recommends
banning of a publication which he admits in a blase manner that he has not
read !

A prevalent practice today is for a professional to make
presentations to would be clients to show his particular expertise and sometimes
with a view to the client retaining him or his firm at the expense of the
professional currently working for him. This to me appears unsavoury. Of course,
the other point of view is that the client is a customer and it is proper that
he be made aware of the alternatives available just as a businessman advertises
the superior quality of his products.

It is urged in defence that a new entrant in the profession cannot get known unless he is permitted some degree of advertisement. Insofar as the presentations are concerned, the truth is that it is not the new and junior member who indulges in them, but the well-established and seasoned professional even though he does not have to fish for clients! Insofar as the junior and new entrant is concerned, there are several avenues open to him to get himself known. He can write articles in the professional as well as in the lay press, he can accept speaking engagements and he may even take up an assignment as a lecturer, all of which will give his image an exposure. This is particularly applicable to professionals practising in the ( fields of accountancy, law, management, etc. Indeed, the Society is a great place for a new entrant to have his voice heard. The Society as well as several other professional bodies encourage new and budding professionals by offering them speaking and writing engagements. In life there is always a right and a wrong way of doing things.

It is also to be borne in mind that a professional is not in the business of selling goods. Sethi J. observed in Saxena v. Sharma, 2000 7 SCC 264,  “The professional obligations of a lawyer are to be distinguished from the business commitments followed by the trading community.” Vivian Bose J. in the case of Mr. G, a Senior Advocate of the Su-preme Court, AIR 1954 SC 557, pithily observed that the restraints which a lawyer is subjected to are a part of the price he pays for the privilege of belonging to a close and exclusive club, their integrity, dignity and honour shall be above the breath of scandal. There is a very important, firm and distinct line between a business and a profession, a line which unfortunately gets blurred as time passes. Some observations of the Supreme Court – would appear to make this line vanish. In Barendra Prasad Ray v. ITO, 129 ITR 295, the Supreme _ Court equated a business connection as also covering a professional connection. To the same effect is the observation of Rowlatt J. in Christopher Barkar & Sons v. IRe, (1919) 2 KB 222 wherein he observed that “All professions are businesses, but all businesses are not professions.” The observations have to be read in context and bearing in mind the issue involved. For example, in the Supreme Court case the issue was whether an Indian solicitor had a business connection with the barrister engaged by him. It would indeed be a sad day if no distinction is visible between a businessman and a professional. What distinguishes a profession from a business is that a profession has a code of conduct to which its members are subject and breach whereof would result in a disciplinary action. However, no written code of conduct could possibly cover all contingencies. Ultimately, the question to be asked is whether the conduct in question is that of a true gentleman. Often adherence to the unwritten code of conduct is more important because the written code is there for all to see. As very pithily observed in an old film ‘Seven Brides for Seven Brothers’, one has to honour an unwritten contract because the written contract can always be enforced.

Bose J. stated in AIR 1954 SC 557 that a professional “is expected at all times to comport himself in a manner befitting his status as ‘an officer and a gentleman.’ In the Army it is a military offence to do otherwise … though no notice would be taken of ungentlemanly conduct under the ordinary law of the land and none in the case of a civilian. So here, he (the advocate) is bound to conduct himself in a manner befitting the high and honourable profession to whose privileges he has been admitted; and if he departs from the high standards which that profession has set for itself and demands of him in professional matters, he is liable to disciplinary action.” It is for this reason that S. 21(3) of the Chartered Accountants Act, 1949 imposes a punishment not only for professional but also for ‘other’ misconduct.

In business, the driving force is money. That ought not to be the case in a profession.  In the Preamble to the Standards  of Professional  Conduct  and Etiquette formulated  by the Bar Council of India and reported in the journal  section  of 68 Bom.  L.R. 72 it is stated “An advocate shall, at all times, comport himself in a manner befitting his status as an officer of the Court, a privileged member of the communitp, and a gentleman, bearing in mind that what may be lawful and moral for a person who is not a member of the Bar, or for a member of the Bar in his non-professional capacity may still be improper for an advocate. Without prejudice to the generality of the foregoing obligation, an advocate shall fearlessly uphold the interests of his client, and in his conduct conform to the rules hereinafter mentioned both in letter and in spirit. The rules hereinafter mentioned contain canons of conduct and etiquette adopted as general guides, yet the specific mention thereof shall not be con-strued as a denial of the existence of others equally imperative though not specifically mentioned.”
 
What applies to a lawyer equally applies to any other professional. The introduction to the publication on code of conduct issued by the Institute of Chartered Accountants of India sets out that the overriding motto has to be pride of service in preference to personal gain.

An illustration which may bring out the difference that there should be in the approach of a professional and of a businessman is provided by what should be their respective reactions to the fact that a particular act or transaction which has scope to yield monetary gain may be visited with a penalty if held to be impermissible. The businessman may ask what is the extent of the penalty and if factoring in the quantum thereof would still make the transaction acceptable from the business point of view, then he may take the penalty in his stride. On the other hand, the professional would (should 7) say that a penalty would imply a breach of the law and an act which imposes a penalty must be avoided even though financially viable. My views may, of course, be regarded by the new and not so new entrants to the profession as archaic, but then I have been brought up in a culture where it was considered improper for Counsel to carry visiting cards and certainly not proper to distribute them to all and sundry at professional meetings. Today, this is regarded as essential ‘networking.’ Indeed, in some large and well-known firms abroad and perhaps in India also, the senior-most partner essentially confines his activities to client nursing and client development rather than client attendance. The worth of a partner is judged by the money he pulls in and not the quality of his work.

By saying that in the 21st century money is the measure of success, I do not mean that a profes-sional must not charge what he feels is his proper remuneration for the time spent by him and the effort put in by him over a period of years in attaining excellence. After all, he devotes his time and there is no mechanism by which the time ordained to him in this world can be extended. At the same time if a matter deserves his attention, he should not refuse the assignment because the client is not in a position to pay his fee or that he only accepts work from corporate clients.

Most unfortunately,  it is not wholly unknown that the professional may tell a client or accept the sug-gestion of a client to raise his fees or perhaps even gross up the fees for the component thereof which is to be used to bribe on behalf of the client. The client assumes the role of an ‘innocent abroad’ as his accounts only show the payment of a profes-sional fee. I may be pardoned for saying that it is like a businessman who retains an assassin to get rid of a competitor and does not pull the trigger himself. Of course, this ‘refinement’ does not have to be practised where the client or the professional has access to the other type of money !

It is also unfortunate that sometimes in India one reads in magazines interviews with professionals where they flaunt the success achieved by them in handling certain cases, even revealing the names of the clients. Confidentiality of the client’s affairs is equally important in the 21st or even in the 25th century as in the earlier times.

Today, the aspect of a contingent fee has assumed importance. The rules governing the American Bar clearly permit the charge of a contingent fee i.e., a fee based on success. In India, this is not per-mitted both to the chartered accountant and the lawyer. One must, of course, recognise that the charge of a contingent fee does serve a purpose as it enables an indigent person to avail of professional services without himself being out of pocket. The main reason for discouraging the levy of a contingent fee is that it gives to the professional a personal interest in the litigation which may lead to his not being fair to the Court, Tribunal or Authority before whom he appears or to his adversary. This breeds the class of ambulance lawyers – who chase an ambulance to offer their services to the injured in an accident or to the heirs of the deceased! As in all things in life, one has to balance two competing viewpoints. Old-fashioned as I am, I would vote for ‘no contingent fee,’ which is also the view clearly expounded by the Supreme Court of India in AIR 1954 SC 557 referred to above.

Over the last 15 years, a sea change has taken place in the quantum of the professional fee charged. This is in line with the globalisation of the Indian economy because foreign professionals charge a fee infinitely more than do their Indian counterparts. It is not as if the calibre of the foreign professional is any superior to that of the Indian. One result of this is that the problem of ‘kick back’ has unfortunately increased. The kickback could be to the employee of a corporation or an employee in a professional firm or even to a partner in a professional firm. This is undoubtedly unethical. It is however, not just a recent development as even in the old days it was not unknown that budding I counsels shared their fee with the managing clerk in an attorney’s office, who had the disposing power over a brief. An interesting issue is posed by Clause (2) of Part I in the First Schedule to the Chartered Accountants Act, 1949 which enumer-ates as a misconduct the payment directly or indirectly of any share or commission in the fees or profits of a chartered accountant to any person other than a member of the Institute. Obviously, the permissive payment is to a member of the Institute who does professional work for the chartered accountant. I do not know whether as worded it would permit payment of a simple kick-back to a member of the Institute! I am sure, it would not as it would come within the all-embracing principle of conduct not becoming a professional (Chartered Accountant). I may only add that though the fees charged have multiplied, the professional must not overlook that there are several cases where free counsel and work is necessary.

In order to fulfil his role of being a good professional, the person must maintain his total independence. If the professional is on the Board of Directors of a company, he should not perform professional services for the company as one does not know when there may be a conflict of interest in his role as a professional and his role as a director of the company who has to look after the interest of the shareholders. In the USA, strict rules of the Sarbanes Oxley Legislation are meticulously applied. Insofar as the legal profession is concerned, Rule 8 of the Code of Conduct prescribed by the Bar Council of India provides that a lawyer who is a director shall not appear for the company of which he is a director. Unfortunately, these rules are sometimes flouted even by the highest. Sometimes they are skirted by putting forward a dummy professional as being in charge!

There is a misconception in the mind of the lay public that a professional ought not to accept an assignment on behalf of a person who in public perception is perceived to be guilty of the charge levied against him. This is totally wrong. The function of a professional is to put forward without mis-representation of facts the case of his client. The professional is supposed to be better suited by training to articulate his client’s view. He should not bend to the public diktat not to appear for a particular person. The person may have a perfectly good defence though at first blush it may seem improbable. The only exception where he may decline to appear is where there is some conscientious objection to his canvassing a particular point of view and not because he feels the client is guilty of the misdemeanour he is charged with, unless, of course, the client has confessed to the profes-sional his wrongdoing. In our system it is for the judge to adjudicate.

One must also distinguish between a professional person’s argument in a matter and his opinion.
The opinion has to be what he feels is the correct position on facts and in law. His arguments  have to be what  is most  advantageous   to his client without factual misrepresentation.  He cannot be a judge and decline to urge a point which he feels may not be acceptable.  On the  other  hand,  his opinion  has to be what it is stated to be, namely, his view of the correct position in law on the given facts. The ultimate tribute is when, say, an officer says that  the  assessee  should  obtain  an opinion from XYZ as his opinion  will really be what  he believes to be true.

A very important professional development in the r 20th century insofar as India is concerned is the advent of foreign professional firms. As per present regulations, neither in the field of chartered accountancy nor of law can a foreign professional, who does not have the necessary Indian qualification or a foreign qualification recognised by the concerned apex body, practise in the field of chartered accountancy or law. The view is that to practise a profession does not merely mean ap-pearance in the Court or before an authority, but also performing any function which the said pro-fessional can perform. The writer feels that the right of a foreign professional to practise should be completely on a reciprocal basis. If the Indian professional can practise in that foreign country, then the professional of that country should be allowed to practise in India under the same terms and conditions. With the opening up of the economy, this is an issue which has assumed considerable importance. Here again one sometimes regrettably sees a surrogate practice being carried on. A fallout of increasing globalisation is that if a foreign company has an Indian associate, the audit of the associate company sooner or later gets transferred to the associate concern of the foreign company’s auditor. The homebred auditor is replaced not because he is less efficient or wanting in professional attainment, but because he does not have the necessary ‘connection.’ This is an unfortunate development per se. The defence, of course, is that this practice encourages uniformity of audit approach.

There is only one further aspect of the matter which requires to be considered. What are the special skills which the 21st century dictates for the professional? The first one which comes to mind is that one must train one’s memory to remember the relevant case law and facts. When one is arguing a matter before an authority and a question is put, it is in that split second that the professional must be able to provide the answer. This is particularly so when arguing before the Tribunal or a Court. Such response is possible if he has trained his memory to recall at pleasure the relevant case law on the subject. It is the 21st century computer mania which is a strong deterrent to the cultivation of a memory. Why should I strain myself when the information is available on the click of a button? A similar situation is reflected in the inability of the present generation to total mentally three sets of figures. The calculator is a great crutch. The other attribute which is required to be developed is the ability to put the argument in a succinct form. Gone are the days when judges had time at their disposal to hear lengthy arguments. One has to hit the target in the shortest possible time. Above all, one has to develop intuition and a sense of the moment. With the increasing workload one must know what to look for and what to ignore. As an auditor, a Chartered Accountant should learn by instinct to determine which aspects of a client’s accounts require particular scrutiny. Again a speedy reaction to a question is often called for. A client rings up with a question and expects a prompt response. One should be careful not to commit oneself if one is not sure of the position as later the response given by him may be held against the professional if it turns out to be inaccurate. Particular care has, therefore, to be taken in furnishing opinions, specially in writing, as years later what has been opined may be referred to and commented upon adversely. This is the reason why furnishing a written opinion is so much more difficult than arguing a matter. It is also more time-consuming than preparing for an appeal. Above all in the present era of tension and fast living, the professional must develop a sense of detachment and humour. He should not get carried away by ful-some praise showered on him. He must remember that it is only as long as he delivers that the client will hanker after him.

It is a wise man who said that if you want to find out how important you are, take a bucket and fill it with water, put your hand in it up to your elbow, pull it out and the ‘hole’ that remains is the measure of how you will be missed. You may splash all you please when you enter, but stop and you will find in a minute that it looks just the same as before!

I have, in this article, confined myself to the professions of accountancy and law as these are matters of prime interest to readers of this magazine. However, there is the profession of medicine which perhaps affects all of us intimately in our personal life. (Classically the three learned professions are the professions of divinity, law and medicine.) The doctor is the last resort when it is a matter of life and death. It appears to me to be unfortunate that today in the medical field there is over-specialisation. For every limb in the human body there is a specialist and sometimes he looks at the matter only from his point of view and not from a holistic point of view. Very soon we may have a specialist for the thumb or the little finger! Today pathological and mechanical tests have overtaken the innate diagnostic skill which the physician of old possessed. Of course, this is an offshoot of mal-practice litigation fears – fears to some extent fuelled by members of the legal profession. The great role of the doctor is that he administers to human beings and not to corporates as do high-flying members of the other two professions and this is also reflected in their respective professional fees !

In the ultimate analysis in determining whether a professional has fulfilled his role, one has to determine what he has contributed to the profession. His individual brilliance is undoubtedly to be complimented, but what is to be admired is how he passes on the knowledge which he acquired to another and trains him to enrich the profession. Unlike in the case of a businessman, a professional himself trains his article clerks, or juniors, as the case may be, to be independent and there is nothing so satisfying for the true professional as to see those whom he has trained shine in the profession and preferably even outshine him! The profession gives us much and the only way one can repay the debt is by putting others in the field. To be labelled a successful professional is not necessarily a compliment, but to be called a true professional is !

Financial leverage is an important aspect in outbound tax
planning and the planning is typically aimed at effective use (deductibility) of
interest on debt incurred (whether third-party or internal) in conjunction with
a transaction. It may also be possible to claim deduction for interest in more
than one tax jurisdiction through judicious planning.

This can be illustrated as below :

In the above illustration, it may be possible to claim a
deduction for the interest in India and also in Country B. Further, if tax
consolidation is possible in Country B, then interest costs of the Buy Company
can be offset against the profits of the Target Company. At best, the home
country would only be able to retain a withholding tax on interest payments,
which may again be mitigated or reduced through proper treaty planning.

The expression ‘thin capitalisation’ is commonly used to
describe a situation where the proportion of debt to equity exceeds certain
limits. Thin capitalisation legislation is a tool used by tax authorities to
prevent what they regard as a leakage of tax revenues as a consequence of the
way in which a corporation is financed. Financing a resident corporation with
debt is considerably more efficient from a tax point of view than financing with
equity. The difference in tax treatment is an incentive to provide capital to
the corporation in the form of debt instead of equity. If there are no thin
capitalisation rules, it is relatively easy for a non-resident to advance funds
to a resident corporation in a way that is characterised as debt, so that the
payments on the debt are deductible as interest payments. This is true for
controlling shareholders in particular, because they are probably indifferent to
the form in which their investment is structured, and thus are likely to be
guided by tax considerations when structuring the legal form of their
investment.

The object of Thin Capitalisation Regulations is to prevent the use of excessive ‘in-house’ loans which would be detrimental to the revenue of home country (where the borrower is resident), by reason of the fact that profits would effectively be shifted to the foreign lender, as the interest payments would be tax deductible in the home country.

Countries, through Thin Capitalisation Regulations ensure that the deductions for interest on debt owed to connected parties, is allowable in the home country as a deduction in the hands of the borrower, only if within the permissible limits. While financial leverage has, on its own standing, its own value, this is definitely impaired when interest is not deductible either wholly or partially.

Overview of the Thin Capitalisation Regulations in some key jurisdictions:

A wide variety of methods are used to deal with thin capitalisation in various countries. These approaches range from complex legislation to no specific thin capitalisation legislation at all.

Within this range {our general approaches may be distinguished: (1) the fixed ratio approach (2) the subjective approach (3) application of rules concerning hidden profit distributions; and (4) the ‘no rules’ approach.

The emphasis on the above factors or combinations of factors often varies from country to country. Measures taken by countries to limit excessive debt financing by shareholders are either based on specific legislation or administrative rules or on practice.

Under the ‘fixed ratio’ approach, if the debtor company’s total debt exceeds a certain proportion of its equity capital, the interest on the loan or the interest on the excess of the loan over the approved proportion is automatically disallowed and/or treated as a dividend. The ratio may be used as a safe-haven rule. In this backdrop it should be noted that countries which use the fixed ratio approach usually have specific thin capitalisation legislation.

The basis of the ‘subjective’ approach is to look at the terms and nature of the contribution and the circumstances in which the financing has been made and to decide, in the light of all facts and circumstances, whether the real nature of the contribution is debt or equity. Some countries using the subjective approach have specific legislation. Other countries use more general rules if these are available, such as general anti-avoidance legislation, provisions on ‘abuse of law’, provisions on substance over form. There are also countries that apply ‘hidden profit distribution’ rules to reclassify interest as dividends. In some of these countries the hidden profit distribution rules are applied along , with specific rules which limit the deduction of interest on loans from shareholders. The general principles of transfer pricing rules may also playa role in this respect. The underlying idea is that if the loan exceeds what would have been lent in an arm’s-length situation, the lender must be considered to have an interest in the profitability of the enterprise and the loan, or any amount in excess of the arm’s-length amount, must be seen as being designed to procure share in the profits.

This article provides an overview of the the Thin -‘” Capitalisation Regulations in five major world economies: France, Germany, the Netherlands, the United Kingdom (UK) and the United States (US).

While some countries, like France, have detailed regulations, others like the UK, do not specify a debt: equity ratio, but merely give the right to the Inland Revenue to challenge the interest deductions keeping in view the arm’s-length principle.

France:

Deductibility of Interest – an overview:

New Thin Capitalisation Regulations were introduced for the financial year beginning on or after January 1, 2007. Related party interest falling within the scope of the new Regulations is tax-deductible only to the extent that it meets two tests, which are applicable on a standlone basis at the level of each borrowing company, as opposed to a consolidated basis.

These tests are the Arm’s-Length Test and the Thin Capitalisation Test.

Conditions for disallowance:

Under the Arm’s-Length Test, the interest rate is capped to the higher of the following two rates:

• The average annual interest rate on loans granted by financial institutions that carry a floating rate and that have a minimum term of two year; and

• The interest rate at which the French Company ould have borrowed from any unrelated financial institution (for example, a bank) in similar circumstances.

The portion of interest that exceeds the higher of the above thresholds is not tax-deductible and must be added back to the French Company’s taxable income for the relevant financial year.

Under the Thin Capitalisation Test, the deductibility of interest may be restricted, even if the conditions specified under the Arm’s-Length Test have been met with.

Here, the interest paid in excess of the following three thresholds is not tax-deductible:
 
The Thin Capitalisation Regulations now stand combined with the General Interest Limitation rules.
 
•    The debt-to-equity  ratio threshold,  which is calculated in accordance with the following for- The Business Tax Reform (2008), introduced a new mula (The amount of interest that meets the concept for restriction of the interest deduction. The Arm’s-Length Test x 150% of the net equity of restriction applies regardless of whether the inter-the borrower at either the beginning or end of est is paid to a related party or an unrelated lender, the financial year. The total indebtedness of the such as a bank. French borrowing company resulting from borrowing from related companies);

•    The earning threshold, which equals 25% of the adjusted current income. The adjusted current income is the operation profit before deducting the following items: tax; related-party interest; depreciation and amortisation; and certain spe-cific lease rents;

• The interest income threshold, which equals interest received by the French Company from related companies.

If the interest that is considered to be tax-deductible under the Arm’s-Length Test exceeds all three of the above thresholds, the portion of the interest that exceeds all three of the above thresholds is not tax-deductible, unless the excess amount of interest lower than Euro 150,000.The nondeductible portion of interest is added back to the taxable income of the borrowing entity. However, it can be carried forward for deduction in subsequent financial years. A 5% reduction applies each year to the balance of the interest carried forward to future financial years beginning with the second subsequent financial year .

Exemptions:
The above thresholds that limit the deductibility of interest do not apply if the French borrowing company can demonstrate that the consolidated debt-to-equity ratio of its group is higher than the consolidated debt-to-equity ratio of the French borrowing Company on a standalone basis (based on its statutory accounts). In determining the consolidated debt-to-equity ratio of the group, French and non-French affiliated companies and consolidated net equity and consolidated group indebtedness (excluding inter-company debt) must be taken into account.

Germany:
Deductibility of Interest – An overview:
The Thin Capitalisation Regulations now stand combined with the General Interest Limitation rules.

The Business Tax Reform (2008), introduced a new concept for restriction of the interest deduction. The restriction applies regardless of whether the interest is paid to a related party or an unrelated lender, such as a bank.

This new Regulation, which is effective for tax years beginning after 25 May 2007 and ending on after 1 January 2008, applies to companies resident in Germany, companies residing abroad but maintaining a permanent establishment in Germany and partnerships with German branch.

Conditions for disallowance:
The new rule disallows’ excess net interest expense,’ which is defined as the excess of interest expenses over interest income if such excess exceeds 30% of the earnings before (net) interest, tax, depreciation and amortisation (EBITDA).

Exemptions:
The limitation rule does not apply if any of the following conditions is satisfied:

•    The net interest expense is less than Euro 1 million;

•    The Company is not a member of a consolidated group (a group of companies that can be consolidated under International Financial Re-porting Standards);

•    The equity ratio of the German subgroup is equal to or higher than the equity ratio for the group as a whole, as shown on the balance sheet of the preceding fiscal year (so-called ‘escape clause’). A ‘group’ is defined as a group of entities that could be consolidated under IFRS, regardless of whether a consolidation has been actually carried out. The escape clause does not apply if any entity in the worldwide group has received loans from a related party not included in the group and if the interest paid on such debt exceeds 10% of the net interest expense.

The Netherlands:

Deductibility  of Interest –    An overview:

Since 1 January 2004, when the Thin Capitalisation Regulations first came into effect, there have been several amendments, such as broadening the definition of debt.

In general, in the Netherlands, interest expenses (and other costs) with respect to related party loans (or deemed related party loans) may be partly or completely disallowed if the taxpayer is part of a group, as defined under Dutch generally accepted accounting principles (GAAP /international financial reporting standards (IFRS). Further, even if an external debt is formally granted by a third party but is in fact owed to a related party, the Thin Capitalisation Regulations apply.

Conditions for disallowance:

The Regulations provide two ratios to determine the amount of excess debt.

Under the first ratio, which is a fixed ratio, the average fiscal debt may not exceed more than three times the Company’s average fiscal equity plus Euro 500,000. For the purpose of this ratio, debt is defined as the balance of the company’s loan receivables and loan payables. The balance sheet for tax purposes is used to determine the average debt and equity.

The second ratio is  the group ratio. When the Company files its corporate tax return, it may elect to apply for the group ratio. Under this alternative, the Company may look at the commercial consolidated debt-to-equity ratio of the (international) group of which it is a member. If the Company’s commercial debt-to-equity ratio does not exceed the debt-to-equity ratio of the group, the tax deduction for interest on related-party loans is allowed.

In certain circumstances, The Dutch Supreme Court has also in its judgements re-characterised loans as informal capital contributions.

The deduction of interest paid including related costs and currency exchange results, by a Dutch company on a related-party loan is disallowed to the extent that the loan relates to one of the following transactions:

•    Dividend distributions or repayments of capital by the taxpayer or by a related company or
a related  individual  resident  in the Netherlands;

•    Capital contributions by a taxpayer, by a related Dutch company or by a related individual resident in the Netherlands into a related company; or

•    The acquisition or extension of an interest by the taxpayer, by a related individual resident in the Netherlands in a company that is related to the taxpayer after this acquisition or extension.

Exemptions:

This interest deduction limitation does not apply  if either of the  following conditions are  satisfied:

•    The loan and the related transaction are primarily based on business considerations;

•    At the level of the creditor, the interest on the loan is subject to a tax on income or profits that results in a levy of at least 10% on a tax base determined under Dutch standards, disregarding the patent and group interest boxes (which offer certain tax concessions. However, effective from 1 January 2008, even if the income is subject to tax of at least 10% at the level of the creditor, interest payments are not deductible if the tax authorities can demonstrate it to be likely that the loan or the related transaction is not primarily based on business considerations. The measure described in the preceding sentence applies to loans that were in existence on 1 January 2008, with no grandfathering.

The United States:

Deductibility of Interest – An overview:
The US has thin capitalisation principles under which the Internal Revenue Service (IRS) may attempt to limit the deduction for interest expenses if a US corporation is thinly capitalised. In such case, funds loaned to it by a related party may be recharacterised by the IRS as equity. As a result, the corporation’s deduction for interest expense may be considered distributions to the related party and be subject to withholding tax.

Conditions for disallowance:
It can be said that the US adopts a facts-and-circumstances approach in determining whether or not a US corporation is thinly capitalised and whether an instrument should be treated as equity or debt.

While no fixed rules exist, a debt-to-equity ratio of 3 : 1 or less is usually acceptable to the IRS, provided the US corporation can adequately service the debt without the help of related parties.

However, a deduction is disallowed for certain ‘disqualified’ interest paid on loans made or guaranteed by related foreign parties that are not subject to U.S. tax on the interest received. This disallowed interest may be carried forward to future years and allowed as a deduction.

In addition under the US Treasury Regulations, interest expense accrued on a loan from a related foreign lender must be actually paid before the US borrower can deduct the interest expense.

Exemptions:
No interest deduction is disallowed under the above provision if the payer corporation’s debt-to-equity ratio does not exceed 1.5. If the debt-to-equity ratio exceeds this amount, the deduction of any ‘excess interest expense’ of the payer is deferred.

The United Kingdom:

 As mentioned earlier, the Regulations in the UK are broad based rather than specific. In other words, UK’s transfer pricing measures apply to the provision of finance (as well as to trading income and expenses). As a result, Companies are required to self assess their tax liability on financing transactions using the arm’s length principle. Consequently, the Inland Revenue may challenge interest deductions on the grounds that, based on all of the circumstances, the loan would not have been made at all, or that the amount loaned or the interest rate would have been less, if the lender was an unrelated third party acting at arm’s length.

European Union (EU) aspects of Thin Capitalisation Rules:

In the case of EU countries, the tax environment is subject to significant external influence in the form of the Ee Treaty and decisions of the European Court of Justice (ECJ). The ECJ decision in the Lankhorst-Hohorst has revived discussions on the compatibility of thin capitalisation rules with the non-discrimination principle of the EC Treaty. The ECJ held in that case that the German thin capitalisation rules which applied only to non-resident companies violated the freedom of establishment provision contained in Article 43 of the EC Treaty. A number of EU countries have thereafter decided to amend their thin capitalisation rules and extent their applicability to resident companies as well.

Thus, in any tax planning exercise involving a financial leverage, Thin Capitalisation Regulations must be taken into cognisance, especially if one of the objectives of such an exercise is to minimise the Global Effective Tax Rate.

While in most of the countries in the world, the top
executives are trying to survive their jobs and positions and while this is the
first time when maximum CEOs are hated by their shareholders, the independent
Directors are trying to run away from their current position. One of the reports
of Economic Times says that, since Satyam scandal and Nagarjuna case, “there are
over 500 independent directors in India who have resigned from their respective
positions on the Board citing reasons ranging from ill-health to work
pressures”. The resignation of one director or a succession of them,
particularly of independent directors, may indicate something untoward in terms
of corporate governance or commercial developments. Investors should be made
aware of these changes. There is almost a situation of fear-psychosis amongst
almost all Boards where Directors who hardly spend any time and who are hardly
paid anything are expected to perform much more with all the responsibilities
and liabilities of the CEO or an executive director. This is not to suggest that
there is something untoward in every Indian company where independent directors
have resigned in the past. That would be too rash a conclusion to draw. It could
also be the fear of potential liability. Independent directors are often
understandably fearful about this issue for two reasons :

I think the first category of companies are not finding it
difficult to get the independent directors as they are looking for true trouble
shooters and expert professionals to come on the Board whereby reputation of
both, the company and the director, will be elevated by such person coming on
the Board. Such directors are well remunerated and spend reasonable time in the
committees and the Board meetings, asking all odd questions and seeking
clarifications to ensure that the company does not knowingly take any decision
against the interest of any of the stake holders. There is a misconception that
independent directors are sitting on the Board only to take care of the minority
shareholders’ interest. Legally that may not be the correct position.
Independent directors are expected to use their experience and professional
skills to take care of the interest of all the stakeholders, i.e.
shareholders, suppliers, customers, employees, regulators and the society at
large. Thus decisions like payment of dividend need not be looked at if they
benefit majority or minority shareholders but need to be verified with general
principles of the dividend payments, cash outflows, payout ratios, etc.

The second categories of companies generally appoint their ‘own’, ‘known’, ‘friendly’ independent directors. These directors are expected to create least resistance in the Board meeting on any proposal that promoter may bring in. If the family or group does not hold majority stake in the company, they are more careful while appointing independent directors. Though. the law prescribes the criteria of independent directors, such promoters like to have supportive board members rather than trouble-shooters. Thus, though these companies seemingly comply with the Board composition requirements, the independent directors may not act independently as expected by law and regulators. The paperwork of the board may be kept compliant with all the laws and regulations but in spirit, the Board may not be performing their expected duties. The public shareholders need to be more vigilant while investing in such companies.

The third category is more interesting. As per earlier SEBI observation, maximum non compliant companies to clause 49 so far as Board composition is concerned, were PSUs. The enormous delays in appointing independent directors by respective Government departments or ministries on PSU Boards were quite glaring. Here the independent directors are ‘nominated’ by Government who also happens to be the majority shareholder of the Company. How can one be sure that such directors nominated by the majority shareholders can act as independent directors? This particular point was raised at a few forums in front of Government officials but is never satisfactorily answered to my knowledge.

SEBI as the custodian of the shareholders’ interest, appointed various committees to advise on the Corporate Governance. Kumarmangalam Birla Committee (1999), Naresh Chandra Committee (2002), Narayan Murthy Committee (2003). Every report added a few more suggestions on Board composition, Board Remuneration, Board meeting Pro-cedure, disclosure of Directors’ interests, code of conduct for the Board and definition of independent directors. However, the law has sufficient scope for the improvement based on practical difficulties. While all the committee reports have the same objective of improving corporate governance, what needs to change is the mindset of the promoters and the independent directors. Legally one may’ qualify’ as independent director but what is important is if such person indeed acts independently and asks right probing questions. I think, currently importance is given more to ‘form’ than ‘substance’ and that has its own repercussions. On one side the independent directors of Satyam get clean chit while those who were members of the Board of Nagarjuna in 1999 get arrested in 2009 !

Liabilities of the Board Members:

Every law needs to have punishments and liabilities prescribed to ensure that the law is complied with. The economies in United States of America thrived due to various reasons, but one of them was promoters and owners had limited liability. This allowed them to take risks in the business. Some failed but many flourished. Post Enron, the laws like SOX put the limited liability concept to an end. The CEO and CFO of the company now are personally liable for various things. More than the actual liability, the fact that one is vulnerable to such draconian fines and/ or arrests has literally made senior management paranoid about day to day business of the business that they run. No business can progress when the Board, CEO and CFOs are running business in paranoia. In India, we are entering similar scenario after the non executive Board members were arrested in 2009 for something to the best of their recollection happened in 1999 or prior to that. Satyam is another example. While the law and regu-lators moved very quickly against the culprits, the fraud was disclosed by the confession letter from one of the promoters. Till then, even the Board, the regulators and the auditors and senior management of the company and the market analysts, who tear your numbers every quarter, had not doubted that the company had serious problems to the extent of Rs.7000 crores. On the other hand, the company was growing normally and receiving corporate governance awards! I think both these instances have put many independent directors in dilemma. I have seen the changed atmosphere in the Board meetings post Satyam. The questions that are asked to the Auditors are as basic as if they verified Bank Statements! This fear is forcing many independent directors to resign from their position.

In the recent past, independent directors were perceived as playing a passive role in the company. The recent resignation phenomenon may not be because the directors suspect any messy stuff in the company but god forbids, if there are skeletons in the cupboard, your reputation is at stake. The job of the Directors is truly becoming difficult. For mere Rs.20,000 sitting fees per quarter, it may not be worth making one vulnerable to bad publicity, financial fines and may be arrest. In reality, as independent director, one spends a few hours in the quarter in the Board room. The audit committee spends a few more hours with CFO and Auditors and goes through what is presented to them. With their experience, they can ensure that there does not seem any apparent wrong in the numbers and there is no ground not to believe the numbers based on variances and QoQ and YoY analysis. In the current recessionary conditions, many directors may suspect that the managements and promoters may have more tempting reasons to take extra business risks and do any unacceptable adjustments in the numbers. Such  distrust might have made many sitting directors very uncomfortable. These circumstances taken together might have led to a situation where companies are finding very difficult to get independent directors on the board.

Having said that, the past track-record of directors being held liable for actions of the company favours independent directors. In an influential series of studies carried out across several countries (though not including India), it was found that the risk of liability on independent directors is far lower than what commentators and directors themselves believe. Even in a litigious society such as the U.S., it was shown that there were only a handful of cases where directors in fact had to make payments (and these include the high profile Enron and WorldCom settlements). The researchers show that these were cases where there was a ‘perfect storm’ scenario (e.g. where the company was in bankruptcy, the D&O insurance was inadequate, and so on), unlikely to occur in most circumstances. However, independent directors are indeed concerned not about direct financialliability but the time, cost, lost opportunity and reputational risk that accompany the mere initiation of legal action against them, even if that action does not succeed in the end. In the past the financial liabilities under company law were insig-nificant and in most of the cases, matters used to get settled between company secretary and the regulators without directors even being aware of it. However, now fear of arrest/imprisonment has really put a lot of scare in the minds of people. For example, the Chairman of the Audit Committee can be arrested for not attending the AGM. Empirical study may not reveal alarming examples in India in the past but the current instances make one feels vulnerable. On February 1 of this year the cn has made the representation to the Parliamentary Standing Committee on the subject suggesting that the liabilities of independent directors should be handled in a different way than that of the executive directors or non independent directors as independent directors are not involved in the day-to-day working of the company. Unless personally involved, there should not be any criminal liability attached to independent director.

Peculiar Indian  scenario:

In a few international studies, India was found culturally in a unique situation. I am sure countries like Japan also would fall under similar situation. The study observed that in most of the cases in India, Chairman/Chairperson of the Board is a very senior (both by age, stature or experience) and hence it is not considered prudent to question the Chairman in the meeting on any matter. This kind of culture restricts the independence of a director. If you are an independent director, and if you feel the decision that is sought by the Board is not in the interest of the stakeholders, you must raise the point and question the decision. In the process of Board discussion, you may get convinced or you may convince the board. But having no discussion as a part of the culture is very harmful for the corporate governance process in the company.

A similar situation is observed in the PSUs as well. If the independent director, appointed by the Government is a person junior to the Chairman (which is normally the case), he or she does not contradict or question the Chairman of the Board. His or her organisational hierarchy comes in the way and prevents him/her from questioning the Chairman in the Board meeting.

I have seen in some cases where such directors discussing a situation what they call ‘off line’. However, such practices are not healthy from corporate governance point of view. Such discussions also do not get recorded in the minutes of the Board and hence are forgotten about later. I feel, once you are sitting on the Board, you are personally responsible for all the acts of the Board and one must act to the best of his or her ability to ensure that healthy, transparent and useful discussions take place in the Board irrespective of your positions outside the Board.

Going  forward:

I think, globally, we have same issue on independent directors. The mind set of the person getting appointed as director must be of one to act without fear or favor. If in your professional capacity, you feel the company is not acting in the interest of the stakeholders, you must question such actions and ensure that they are recorded in the minutes. We may not overcome the problem overnight but to slowly get over this issue, I have following quick suggestions-:
 
1. Independent Directors must be appointed/ nominated by a separate meeting of the minority shareholders, not representing the majority investors. A separate meeting of such minority shareholders must be conveyed prior to the AGM to nominate such independent directors and AGM should formally appoint such independent directors. The majority shareholders should not play any role in such appointments directly or indirectly. Any vacancy of the Board seat between two AGMs may be filled in by other independent directors continuing on the Board like Additional Director.

2. To ensure that the independent directors spend adequate time, they must be compensated well. Mere sitting fees of Rs.20,000 is obviously not enough. Such fees can be capped based on profits of the company or can be a fixed sum.

3. Independent Directors should not get any options. Having options, generally may affect their independent status.

4. Chairmen of the committees must be a rotating position. At least in three years, a new member must be appointed as chairman of Audit /Compensation committee. Such provision would help a board to get new and fresh views.

5. Liability of independent directors should be distinguished from the executive directors and non independent directors. No criminal liability should be attached to independent director for the acts of the company or other executive directors unless the independent director has personally committed a willful criminal act. This obviates the situation where independent directors can not be arrested unless personally and willfully involved in a criminal act.

I feel, the above changes will bring some sanctity in the process and intent of having independent directors on the board.

Post Satyam, it is not only necessary that culprits are punished quickly but also the process is cleansed to achieve intended results that regains investors’ confidence in Indian Companies.