6.

Corporate Governance In India: Historical Perspective,

Governance Issues and Developments

• Historical Perspectives of Corporate Governance in India

• Pre-Independence Era : Colonial Period
• Post-Independence Era : Licence Raj Period

• Financial Crisis and Economic Liberalization of 1991

• Corporate Governance Developments in Post Liberalization

• Till Satyam Fraud - Early Developments

• Post Satyam Fraud – Modern day developments

 Pre Independence Era: Colonial Period

• Modern corporations of contemporary India owe their genesis to the

colonial period
• “managing agency system” forms the bedrock on which these
corporations evolved in the pre independence era
• “Managing agents or managing agencies” were the individuals or apex
firms t
• A legal contract with joint stock limited liability companies and
delegated the responsibility of managing it in lieu of return of certain
commission
• Managing agencies dominated business scenarios in India by virtue of
their power, control, and expertise
Pre Independence Era: Colonial Period

• Managing agency system attracted several mercantile families in India

• Able to mobilize their small capital in various ventures and quickly earn
profits without taking too much of risk.
• Tatas, Birlas, Poddars, Singhanias, Dalmias, and Ruias were among the
few noted managing agencies in India.
• The “nexus between the managing agency and the business family
established the structural basis for the family-controlled
conglomerates
• They have dominated the Indian economy since independence” and
form the core of the Indian corporate system
Functions Performed by Managing Agencies

Managing agents and agencies in colonized India served three

important corporate governance functions:

1. promoted new companies with their own capital and as the company
become successful, they would sell off most or all of the
shareholdings, but would still retain the control through managing
agency contracts.
2. acquired enough technical expertise and managerial experience to
handle the administration and management of the company.
3. performed the role of attracting new investors and arranging capital
for the company, especially in the period when the credit system was
still in its infancy.
 Governance Issues : Managing Agency System
• Managing agency system gave rise to an important governance issue
faced by corporations in today's context in the form of separation of
ownership and control.

• Managing agencies were able to control corporations even with low

equity base –

 by interlocking directorship on the board

 intercorporate investment, or
 through managing agency contracts.

• Their control rights sufficiently exceeded their ownership or cash flow

rights.

• Agency contract corporations entered with managing agencies favored

excessive power to these agencies allowing them to pursue
governance anomalies.
Governance Issues : Managing Agency System

• Managing agents quite blatantly violated the basic rights of the

shareholders, and

• sought consciously to exclude them from having any effective

voice in which firms were run.

• Managing agencies were able to tunnel money from a profitable

business expropriating shareholders, turning them into loss-
making to start a new venture.

• Interlocking directorship that could have served governance

purposes in contrast was central to the corporate malaise.
Regulatory and Institutional Framework

• Colonized India had well-developed corporate law, functioning stock

exchanges, relatively stable banking system, as part of the English
colony.

• The Indian Companies Act, was promulgated as early as 1866 and

revised in 1882 and 1913 that provided sound ground for the
functioning of both private and public companies.

• The banking system was also relatively stable, with most of the
banks being private.

• Laws were also placed to deal with the activities of trusts and banks.
India @ Independence Time

• India, at the time of independence, had a sizeable corporate sector

that contributed about 10% of the GDP (Goswami, 2002).

• The corporate laws, banking system, and stock exchanges, all were
relatively sound by the end of 1947.

• By independence, there were 800 listed firms on stock exchanges, so

equity culture was well developed among the Indian population.

• Managing the agency system provided its own advantages, but that
also along several governance issues and instances.

• India, therefore, at the time of decolonization, was having a relatively

good state of corporate governance and the economy
Post Independence Era: License Raj Period

• The era after independence till 1991, when liberalization started,

• marked by heavy regulation and ‘established a tightly controlled regime
covering almost all the aspects of corporate management.”

• The socialist accent of the country’s governance in the 1960s led to an era
of thicket regulation called “License Raj” in which only large companies
managed to survive.

• “Business house model” graduated over the managing agency system,

with the latter system finally dissolved in 1969 through an amendment in the
Companies Act, 1956.

• Leading managing agents of the pre-independence era, that were actively

engaged in promoting the business, by virtue of their position, provided
sound ground to become business conglomerates or “business houses” in
independent India.
License Raj Period : Key Regulations

• Industries (Development and Regulation) Act, 1951,

• mandated all existing and proposed industrial units to obtain
licenses for their operation and even for expanding their capacity

• Industrial Policy Resolution of 1956,

• granted the exclusive right to Government in 17 industries.

• Foreign Exchange Regulation Act and the Import and Export Control Act
of 1947
• imposed serious restrictions on foreign exchange and import and
export.
 License Raj Period : Rise of Mis-governance

• Import substituting industrialization (ISI) based government policy,

which was based on the “License Raj System” created a regime-
protected market

• bolstered excessive rent-seeking, corruption, and unethical

nexus between bureaucracy and business elites.

• Obligations of seeking a license for manufacturing products

• Domestic business was highly protected, insulated from foreign

competition

• Outcome of Policy Misgovernance

• uncompetitive markets with no incentive for efficient operations,
• a fertile ground for corporate misgovernance in post-colonized
India.
License Raj Period : Decline in Equity Financing

• Capital markets remained nascent and illiquid due to government

control and regulation

• Setting up the office of Controller of Capital Issues (CCI) regulated

the prices of stocks of companies.

• Determined equity prices for new issuances based on a preset

formula, by which issue prices were set very low

• No incentive for good corporate governance for higher market

valuation through equity

• The regulated capital market and limited private investment through

equity and restricted development of the capital market
License Raj Period : Rise in Debt Financing

• Focus during the period was on debt financing through government-

owned PFIs.

• ICICI, IDBI, and IFCI were established and 30 banks were

nationalized.

• LIC, UTI, and GIC were government-owned bodies that were

institutional investors.

• In the post-independence era, the entire financial system was

commanded by the Government, impounding several corporate
governance problems.
 License Raj Period : Governance Issues
• PFIs supplied credit to companies without having enough incentive to monitor
the management

• appraised based on the amount of credit sanctioned rather than the quality
of credit.
• Due to mismanagement, falsy credit policies, and greater instances of
overdue and fraud by industrial units, these suffered heavy losses

• Financial institutions having a substantial equity stake can instigate nominee

directors on the board for monitoring the management of the company.

• Nominee directors having no incentives remained passive observers, and acted

only as rubber stamps.

• The tradition of large borrowings from financial institutions led to a higher debt-
equity ratio, a ratio in excess of 2.5 to 1 was common during this regime.

• The promoters, with even small equity, controlled the corporations and easily
recouped their investment from the firm within one or two years of its instigation.
License Raj Period : Governance Issues

• Regulatory model had a mishmash of high taxes and low

valuations,

• No Incentive for companies and their promoters to show

higher profits and enhance shareholder value.

• Most of the promoters were involved

• self-dealing transactions and expropriating shareholder
rights,
• making the business unviable in the following years after
recovery of their initial investment.

• In post independence period- pervasive corporate mis-governance

• indirect state ownership with inept monitoring
• implementation of poor bankruptcy laws bolstered.
 License Raj Period : Institutional and Regulatory Framework

• Companies Act, 1956 and Securities Contract Regulation Act (SCRA),

1956 endowed the regulatory and legal framework for the operation of
companies.

• Corporate boards governed by the framework listed in sections 252 to 269,

-Very minimal in some regard as compared to the laws of the
developed countries.

• Very opaque in terms of disclosure and transparency norms,

• provided very little protection to minority shareholders.

• The Companies Act provided

• protection to shareholders only in cases of oppression and
mismanagement.
• not able to able to protect the right of minority shareholders in real
terms, who were more often than not defrauded by companies.
 License Raj Period : Institutional and Regulatory Framework

• The expropriation of minority shareholders’ rights was common,

• facilitated by lax oversight by nominee directors of financial institutions
• inadequate legal provisions.

• Inadequate laws let company promoters have friends and allies on the
board.

• Directors’ fee was regulated and board meetings were mere routine
exercises.

• Laws were inadequate to protect the rights of creditors.

• Governance structures were opaque as financial disclosure norms were

poor.

• Non-compliance with disclosure norms was common and not punished.

Financial Crisis and Economic Liberalization of 1991

• Corporate governance problems seeded by managing agency system in

colonized period got worse in India aggravated independence era - the License
Raj period

• Manifested by the emergence of the Government as an important owner,

• detrimental economic policies, licensing and high taxes
• dysfunctional supply and monitoring of capital by Government backed
PFIs, and
• partly by inadequacy in legislation, and its enforcement.

There was a huge fiscal deficit, low foreign exchange reserves, and a
large number of loss-making public sector undertakings

The pervasive corporate misgovernance prevalent in the License Raj Period,

seriously set back the entire economy leading to the economic crisis in the
early 1990s, forcing the country to carry economic liberalization
Financial Crisis and Economic Liberalization of 1991

• There was a huge fiscal deficit, low foreign exchange reserves,

and a large number of loss-making public sector undertakings

• The pervasive corporate misgovernance prevalent in the License Raj

Period, seriously set back the entire economy leading to the economic
crisis in the early 1990s, forcing the country to carry economic
liberalization

• The economic crisis of 1991, forced the Indian government to turn towards
the International Monetary Fund (IMF) and the World Bank to get out of
this crisis.

• Indian government carried several reform activities, such as

- opening up of the financial sector,

- reduced control on the import and its tariffs
- allowance foreign equity in certain sectors,
- dismantling the existing control regime
 Corporate Governance Reforms
• Harshad Mehta securities market scam of 1992, involving several banks with an
estimated loss to the tune of Rs 100 thousand crore

• Preferential share allotment scam(in 1993) involving unfair governance practices

of issuing preferential shares to promoters of the company at heavily discounted
prices - retail investors lost about Rs 5 thousand Cr

• Disappearing companies’ fraud (in 1993) - whereas 3911 companies vanished

after raising Rs 25 thousand Cr from the capital market even without starting
their business

• Radical transformations included the abolition of the office of CCI, and the
induction of a free market-pricing regime for security issues.

• “The Securities and Exchange Board of India (SEBI)” was established in 1992
pursuant to the enactment of the SEBI Act, 1992

• the objective of establishing a single window overseeing mechanism for all

aspects of securities market operations.
First Phase of Anglo-American based Corporate Governance Reforms

• Desirable Corporate Governance: A Code ( CII Code 1998)

• Kumar Manglam Birla Committee Report ( 1999)

• Clause 49 of Listing Agreement ( SEBI 2000)

• Chandra Committee Report ( 2002)

• Narayana Murthy Report ( 2003)

• Amended Clause 49 of Listing Agreement ( SEBI 2003)

• Irani Committee Report ( 2004)

• The Companies Bill ( 2009)

Desirable Corporate Governance: A Code (CII Code, 1998)

• The CII Code, a voluntary corporate governance code, emanated in April

1998 from the recommendations of the task force set up by the
Confederation of Indian Industry (CII) in 1996.

• The said code, based on the Anglo-American system of corporate

governance, contained detailed governance provisions for listed companies

• Focus on the relationship between the Board of directors of the company

and its shareholders.

• Code, however, being voluntary in its implementation, it did not prove to be

as audacious as envisaged
 Kumar Mangalam Birla Committee (Birla Report, 1999)

• Kumar Mangalam Birla Committee was constituted by the SEBI on April 7, 1999
to recommend on the introduction of a mandatory corporate governance code.

• Birla Committee’s recommendations were on the lines of the US corporate

governance framework, especially influenced by Blue Ribbon Committee
guidelines on independent directors.

• The report provided statutory directives relating to the structure and functioning
of corporate boards with provisions on the induction of “independent” directors
on the boards, as also the criterion by which such “independence” needs to be
assessed and disclosures to shareholders.

• The report suggested the incorporation of a separate section in the corporate

annual reports comprising of “Management Discussion & Analysis” as well as the
constitution of a Committee under the Chairmanship of a non-executive director
to look into shareholders’ grievances received by the company.

• Clause 49 of Listing Agreement ( SEBI 2000) - This clause constituted the first
formal statutory milestone in Indian corporate governance.
Naresh Chandra Committee (Chandra Report, 2002)

• Chandra Committee has established sequel to the enactment of the SOX Act in
the US after some profile scandals by the Government of India, Department of
Company Affairs

• to look into the reformation of the Companies Act, 1956 with a view to
strengthening the corporate governance provisions of the said Act.

• The said Committee made several recommendations primarily aimed at

streamlining provisions of the Act relating to auditors and auditing focusing on
• disqualification of auditors, rotation of audit partners, type of services an
auditor can render, disclosures in communications between the company
and its members.

• The recommendations of the Chandra Committee never found their way into the
statute book, but some were included in Clause 49 of the Listing Agreement on
the recommendations of the Murthy Report.
 Naryana Murthy Committee (Murthy Report, 2003)

• The SEBI in response to the constitution of the Chandra Committee by MCA, formed a
parallel Committee under the Chairmanship of Shri N R Narayanamurthy, in 2002.

• The Murthy Committee was constituted to advise on the adequacy and efficacy of the
provisions of Clause 49 of the Listing Agreement, and to suggest measures for
improvement of the prevailing corporate governance practices with a view to
“enhancing the transparency and integrity of the Indian stock markets”.

• (a) the strengthening of the definition of “independence” in the context of Board

members; (b) “nominee directors” i.e. directors nominated by financiers in pursuance of
loan agreements be not considered as “independent directors” and be subject to the
same responsibilities & liabilities as normal directors; © enhancing and redefining the
constitution and the role of “audit committees”; (d) protection of whistleblowers, etc.

• Amended Clause 49 of the Listing Agreement ( SEBI 2003) based on

recommendations of the Narayana Murthy Report

• All Listed Companies were required to comply with the provision of Clause 49 with
effect from 31st march, 2006 
 JJ Irani Committee (Irani Report 2005)

• The MCA constituted another Committee in December 2004 under the

Chairmanship of Shri J J Irani to make its presence felt.

• The mandate to the Committee was to revamp and reorganize the Companies Act,
1956 with a view to incorporate therein internationally acknowledged best practices
in this regard.

• The Irani Committee came up with several recommendations that were in conflict
with the extant Clause 49 of the Listing Agreement

a) providing for several exemptions based on the size and extent of public
ownership in a mandatory corporate governance framework
(b) the criteria for “independence” of “independent directors” is proposed to be
weakened significantly;
(c) the mandatory requirement of independent directors to constitute one-half of
the Board be weakened to one-third of the total members of the Board
(d) abolition of age limits for independent directors
 Companies Bill 2009

• Based on Irani Committee report and inputs received from the Expert Committee
& several other sources that included the Ministry of Law, the MCA set about the
task of a comprehensive revamping of the Companies Act, 1956

• Introduction of the Companies Bill, 2008 in the Lok Sabha on October 23, 2008 in
the 14th Lok Sabha. The Bill was subsequently referred to the Parliamentary
Standing Committee on Finance for examination and report.

• Before the said Committee could present its report, 14th Lok Sabha was dissolved
and the Companies Bill, 2008 lapsed under the provisions of clause (5) of Article
107 of the Constitution of India.
• In view of this, the Companies Bill, 2009 was introduced in Parliament on August
5, 2009, without any change in the earlier version of 2008 (Companies Bill, 2009)