Companies Act 2013

Corporate governance and risk management

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  • Composition of the board/ non-executive directors

    What the Companies Act 2013 states:

    Both under the 2013 Act and RC49, directors are categorized into two classes, viz., executive directors (ED) and non- executive directors. Non-executive directors are further sub- categorized into independent directors (ID) and others (NED).4Whilst the 2013 Act recognizes the concept of ED, ID and NED,it prescribes minimum requirement only in respect of ID. For the balance composition, a company is free to choose between ED and NED. In contrast, RC49 requires that the board of directors of a listed company should have an optimum combination of executive and non-executive directors. It also requires that minimum 50% of the board should comprise of non-executive directors, which include both IDs and NEDs.

    Neither the 2013 Act nor the Directors’ Appointment Rules nor RC49 contain any specific information about functions, roles and responsibilities of NED. With regard to liability of NED, the2013 Act states that NED, not being a promoter or KMP ofthe company, will be held liable, only in respect of such acts of omission or commission by a company which had occurred with his knowledge, attributable through board processes, and with his consent or connivance or where he had not acted diligently. RC49 contains such a clause for ID, but not for NEDs.

    EY insights

    From a practical perspective, unlike an ID, an NED is not expected to be independent of the company and its promoters/ shareholders, etc. At the same time, an NED does not form part of the executive management team.

    In accordance with the Higgs Report published by the British government in 2003, NEDs are expected to play key role in the following areas:

    • Strategy: NEDs should constructively challenge and contribute to the development of strategy.
    • Performance: NEDs should scrutinise and monitor the performance of management.
    • Risk: NEDs should satisfy themselves that financial information is accurate and that financial controls and systems of risk management are robust and defensible.
    • People: NEDs are responsible for determining appropriate levels of remuneration of executive directors and have a prime role in appointing and where necessary removing senior management, and in succession planning.
  • Woman director

    What the Companies Act 2013 states:

    The 2013 Act requires prescribed class of companies to have at least one woman director on the board. In accordance with the Act, existing companies meeting the prescribed criteria need to comply with the requirement within one-year.

    The final rules contain criteria for appointment of woman director which is similar to what was proposed under the draft rules. See table below.

    Table 6: Criteria for appointment of woman director

    Company

    Directors’ Appointment Rules

    Draft Rules

    Listed companies

    All companies

    All companies

    Non-listed public companies meeting either of the following two criteria

    Paid-up share capital

    `100 crores or more

    `100 crores or more

    Turnover

    `300 crores or more

    `300 crores or more

    Under the draft rules, non-listed public companies, which met the prescribed criteria, were given three year timeframe to comply with the requirement. This time limit has been removed from the Directors’ Appointment Rules.

    The Directors’ Appointment Rules also require the following:

    • A newly incorporated company, which meets the prescribed criteria, needs to appoint a woman director within six months from the date of its incorporation.
    • The board needs to fill-up any intermittent vacancy of woman director at the earliest but no later than the immediate next board meeting or three months from the date of such vacancy, whichever is later.

    RC49 also requires all listed companies to have atleast one woman director on the board. RC49 is applicable from 1 October 2014 and does not allow any transitional provision to meet this requirement. This suggests that all listed companies will need to have atleast one woman director on their board, on or before 1 October 2014. However, non-listed publiccompanies meeting the prescribed criteria will need to appoint woman director within one year from the date of enactment of the 2013 Act, i.e., they need to appoint woman director by 31 March 2015.

    EY insights

    In accordance with the Directors’ Appointment Rules one of the criteria for appointment of woman director in non-listed public companies is that the company has paid–up share capital of `100 crore or more. For this purpose, will the paid- up share capital include non-convertible preference shares also? Will the securities premium received on issue of shares also be included in the paid-up share capital?

    Section 2(64) of the 2013 Act defines the term “paid-up share capital” to mean “such aggregate amount of money creditedas paid-up as is equivalent to the amount received as paid-up in respect of shares issued and also includes any amount credited as paid-up in respect of shares of the company, but does not include any other amount received in respect of such shares, by whatever name called.” (Emphasis added) (Emphasis added)

    In accordance with section 2(84) of the 2013 Act, share means a share in the share capital of a company and includes stock.In accordance with section 43, share capital of a company can be of two kinds, viz., equity share capital and preference share capital. It does not differentiate between convertible and non- convertible preference shares. Moreover, the definition of “total share capital,” given in the Definition Rules, to include paid-up equity share capital and convertible preference share capitalis relevant only for the definition of terms subsidiary company and associate company. The same definition cannot be used for any other purpose.

    Hence, we believe that for the appointment of woman director, paid-up share capital includes paid-up equity share capital and paid-up preference share capital, whether convertible or not. Also, from the words highlighted in section 2(64), it appears that paid-up share capital includes only amount receivedtoward face value of shares. Amount received toward securities premium is not included in the paid-up share capital. Also, the share application money pending allotment is not included in the paid-up share capital.

    An explanation to the criteria for appointment of woman director states that “for the purposes of this rule, it is hereby clarified that the paid-up share capital or turnover, as the case may be, as on the last date of latest audited financial statements will be taken into account.” In this regard, the following issues need to be considered:

    • Let us assume that a company is getting its quarterly financial statements, prepared in accordance with AS25 (either full or condensed), audited. Does it require the company to consider the paid-up share capital or turnover, as the case may be, in quarterly financial statements to decide whether applicability criteria aremet?
    • In the case of annual financial statements, there is always some time-lag between the year-end and the date on which audited financial statements are available. Should the company continue using previous year financial statements in the interim?

    Section 2(40) of the 2013 Act defines the term ‘financial statements’ to include, among other matters, balance sheet as at the end of the financial year, P&L for the financial year and cash flow statement for the financial year. This suggests that audited financial statements for the completed financial year should be considered to decide the applicability. Further, we believe that a company should use only Indian GAAP financial statements for this purpose.

    The use of the word “latest audited financial statements” indicates that till the time audited financial statements for the immediately preceding financial year are ready and available, a company may continue using the earlier period financial statement to determine if the applicability criteriaare met. Thus, a company could delay the appointment of the woman director by delaying the issuance of audited financial statements within the prescribed time limits in the 2013 Act.

    Interestingly, neither the 2013 Act nor the rules give any time limit to comply with the requirement for appointment of woman director if the company meets the prescribed criteria at a later date, i.e., the date subsequent to the commencement of the2013 Act. To illustrate, let us assume that on 1 April 2014, ABC Limited (non-listed public company) did not meet the prescribed criteria for appointment of woman director. Two years later, these criteria are met. In such cases, no time limit is given for complying with this requirement. It appears that ABC may need to appoint a woman director immediately.

  • Independent directors

    What the Companies Act 2013 states:

    The 2013 Act states that every listed company will have at least one-third of total number of directors as independent directors, with any fraction to be rounded off as one. In addition, the 2013 Act empowers the Central Government to prescribe minimum number of independent directors for other class of public companies.

    In accordance with the Gazette Copy of the 2013 Act, existing companies meeting the prescribed criteria need to comply with the requirement within one-year5.

    The draft rules stated that public companies covered under the prescribed class should have at least one-third of the total number of its directors as independent directors. In the Directors’ Appointment Rules, minimum number of directors for non-listed publiccompanies meeting prescribed criteria has been changed to 2, irrespective of the board size. Also, the criteria for appointment of independent directors have changed in the Directors’ Appointment Rules. See table 7 below.

    Table 7: Criteria for appointment of independent directors

    Particulars

    Directors’ Appointment Rules

    Draft rules

    All listed companies

     

     

    No. of independent directors

    1/3rd of board size

    1/3rd of board size

     

     

     

    Non-listed public companies

     

     

    No. of directors

    Two

    1/3rd of board size

    Criteria – either of the following

     

     

    Paid-up share capital

    `10 crores or more

    `100 crores or more

    Turnover

    `100 crores or more

    `300 crores or more

    Aggregate outstanding loans, debentures and deposits

    Exceeding `50 crores

    Exceeding `200 crores

    The Directors’ Appointment Rules also require the following:

    • Any class of companies, for which a higher number of independent directors has been specified in the law for the time being in force, will comply with the requirements specified in the law.
    • If a company covered under this rule is required to appoint higher number of independent directors due to the composition of its audit committee, such higher number of independent directors will apply to the company.
    • The board needs to fill-up any intermittent vacancy of an independent director at the earliest but not later than the immediate next Board meeting or three months from the date of such vacancy, whichever is later.

    The Directors’ Appointment Rules rules also state that a non- listed public company, which ceases to fulfil any of the three conditions laid down in the rule for three consecutive years, will not be required to comply with these provisions until such time as it meets any of the conditions.

    The Directors’ Appointment Rules rules also state that director, if any, appointed by the small shareholders will be treated as independent director provided that such director meets the criteria for being independent director and gives requisite declaration.

    Revised clause 49

    RC49 requires that where the Chairman of the board is anon-executive director, at least one-third of the board should comprise independent directors. In case the Chairman is an executive director, at least half of the board should comprise independent directors. Since the requirement under RC49is stricter, a listed company will need to comply with RC49 requirements. Some other key differences between the 2013Act and RC49 are given below:

    • Board of subsidiary companies: RC49 requires that the board of all material non-listed Indian subsidiaries of a listed parent company will have at least one independentdirector from the board of the parent company. There is no such requirement under the 2013 Act.
    • Meaning: Meaning of the term “independent director” given in RC49 contains most of the attributes prescribed in the 2013 Act. RC49, however, contains the following additional criteria:
      • ) The person should not be a material supplier, service provider or customer or a lessor or lessee of the company
      • The person should not be less than 21 years of age
    • Nominee directors: Both under the 2013 Act and RC49, nominee director is not treated as an independent director.
    • Stock options: Both under the 2013 Act and RC49, an independent director is not entitled to any stock option in the company. However, neither the 2013 Act nor RC49 provide any clarity as to how a company should deal with stock options granted in the past and outstanding at the date of enactment. One argument is that a company may need to cancel/forfeit these options immediately. It may be appropriate for the MCA/SEBI to clarify this matter.
    • Limit on number of directorship: RC 49 requires that a person can serve as an ID in not more than 7 listed companies. If the person is whole-time director in any other listed company, then he can serve as an ID in not more than 3 listed companies. The 2013 Act does not contain any separate restriction on number of directorship for IDs. However, it is pertinent to note that the 2013 Actrestricts the number of directorship for an individual to 20. Out of total 20 companies, number of public companiesin which a person can be appointed as a director cannotexceed 10.
    • Tenure and rotation requirement: Under the 2013 Act, an independent director holds office for a term up to 5 consecutive years on the board of a company. He is eligible for reappointment on passing of a special resolution by the company. However, no independent director can hold office for more than 2 consecutive terms of five years each. Under the 2013 Act, this provision will apply prospectively. An independent director that completes two terms will be eligible for appointment after the expiry of three yearsof ceasing to become an independent director; provided during that period of three years, he remains independent with respect to that company.

      RC49 also contains similar provision for independent directors’ rotation, except that rotation requirement is not entirely prospective. RC49 states that a person, who has already served as an ID for five or more years in a company as on 1 October 2014, will be eligible for appointment, on completion of present term, for one more term of up tofive years. Since the requirement under RC49 is stricter, a listed company needs to comply with the same.
    • Limitation of liability: RC49 states that an independent director will be held liable, only in respect of such acts of omission or commission by a company which had occurred with his knowledge, attributable through board processes, and with his consent or connivance or where he had not acted diligently with respect of the provisions contained in the Listing Agreement. The 2013 Act also contains similar protection clause.
  • Audit Committee

    What the Companies Act 2013 states:

    The 2013 Act requires each listed company and such other class of companies, as may be prescribed, to constitute the Audit Committee. In the Board Rules, thresholds for constitution of the committee have been made more stringent vis-à-vis the draft rules (see table 8 below). These changes in the criteria will require more companies to constitute the Audit Committee.

    Table 8: Criteria for constitution of the Audit Committee

    Company

    Board Rules

    Draft Rules

    Listed companies

    All companies

    All companies

    Non-listed public companies meeting either of the following criteria

    Paid-up share capital

    `10 crores or more

    `100 crores or more

    Turnover

    `100 crores or more

    No such criterion

    Aggregate outstanding loans, or borrowings, or debentures or deposits

    `50 crores or more

    `200 crores or more

    Due to the use of the word “or” in the third criterion for non- listed public companies, there seems to be a confusion whether a company needs to consider loans separately, debentures separately and deposits separately or they should be considered in totality. In our view, from the use of the word “aggregate,”it is clear that all of them have to be considered together. To illustrate, a non-listed public company, which has outstanding bank loan of `20 crores, outstanding debentures of `23 crores and outstanding deposits of `12 crores, has met third criterion under the Board Rules. Hence, it needs to constitute the Audit Committee.

    Revised clause 49

    RC49 requires all listed companies to constitute the Audit Committee. Given below is an overview of differences relating to the Audit Committee between the 2013 Act and RC49:

    • Under the 2013 Act, an audit committee comprises of minimum of three directors with independent directors forming a majority. RC49 requires the audit committee to comprise of minimum three directors with two-third members being independent directors.
    • The 2013 Act requires that majority of audit committee members including its chairperson should have an ability to read and understand the financial statement. In contrast, RC49 requires that all members should be financially literate and at least one member should have accounting or related financial management expertise.
    • RC49 requires that the Chairman of the Audit Committee should be an independent director. It also requires the Chairman of the Audit committee to attend the AGM to answer shareholder queries. No such requirement exists under the 2013 Act.
  • Nomination and Remuneration Committee

    What the Companies Act 2013 states:

    Both the 2013 Act and RC49 require all listed companies to constitute NRC. The 2013 Act empowers the Central Government to prescribe additional class of companies, which need to constitute NRC. In the Board Rules, thresholds for constitution of NRC have been made more stringent vis-à-vis the draft rules (see table 9 below). These changes in the criteria will require more companies to constitute NRC.

    Company

    Board Rules

    Draft Rules

    RC49

    Listed companies

    All companies

    All companies

    All companies

    Non-listed public companies meeting either of the following criteria

     

    Paid-up share capital

    `10 crores or more

    `100 crores or more

    NA

    Turnover

    `100 crores or more

    No such criterion

    NA

    Aggregate outstanding loans, or borrowings, or debentures or deposits

    `50 crores or more

    `200 crores or more

    NA

    Both the 2013 Act and RC49 requires that NRC will comprise of three or more non-executive directors, out of this, atleast one- half should be independent directors. RC49 specifically requires that the Chairman of NRC should be an independent director; however, there is no such requirement under the 2013 Act.

    The 2013 Act allows the chairperson of the company (whether executive or non-executive) to be appointed as a member of the NRC. However, the person cannot chair NRC. RC49 does not give such an option.

  • Subsidiary companies

    What the Companies Act 2013 states:

    With regard to corporate governance of subsidiary companies, RC49 contains the following specific requirements:

    • The board of a material non-listed Indian subsidiary of a listed parent company will have at least one independent director from the board of the parent company.
    • The Audit Committee of the listed parent company will also review the financial statements, in particular, the investments made by the non-listed subsidiary company.
    • The minutes of the board meetings of the non-listed subsidiary company will be placed at the board meeting of the listed parent company. The management shouldperiodically bring to the attention of the board of the listed parent company, a statement of all significant transactions and arrangements entered into by the non-listed subsidiary company.
    • The company will formulate a policy for determining “material” subsidiaries and such policy will be disclosed to the stock exchanges and in the Annual Report.
    • A company will not dispose of shares in its material subsidiary which will reduce its shareholding (either on its own or together with other subsidiaries) to less than 50%or cease the exercise of control over the subsidiary without passing a special resolution in its general meeting.
    • Selling, disposing and leasing of assets amounting tomore than 20% of the assets of the material subsidiary will require prior approval of shareholders by way of the special resolution

    Similar requirements do not exist under the 2013 Act.

  • Internal audit

    What the Companies Act 2013 states:

    The 2013 Act requires such class or classes of companies, as may be prescribed, to appoint an internal auditor to conduct internal audit of the functions and activities of the company. The draft as well Accounts Rules require all listed companies to appoint internal auditor. In the Accounts Rules, the threshold for appointment of internal auditor by non-listed public companies has changed. Under the Accounts Rules, private companies meeting prescribed criteria are also required to appoint internal auditor. This was not required under the draft rules. Table10 provides comparison of the two criteria.

    Table 10: Criteria to appoint internal auditor

    Particulars

    Accounts Rules

    Draft rules

    Listed companies

    All companies

    All companies

    Non-listed public companies meeting either of the following criteria

    Paid up Share capital during the preceding financial year

    `50 crores or more

    `10 crores or more

    Turnover during the preceding financial year

    `200 crores or more

    No such criteria

    Outstanding loan/ borrowing from bank or public financial institutions at any time during the preceding financial year

    `100 crores or more

    `25 crores or more

    Outstanding deposits at any time during the preceding financial year

    `25 crores or more

    `25 crores or more

    Private companies meeting either of the following criteria

    Turnover during the preceding financial year

    `200 crores or more

    No private company was covered.

    Outstanding loan/ borrowing from bank or public financial institutions at any time during the preceding financial year

    `100 crores or more

    The Accounts Rules also require the below:

    • An existing company, which meets the prescribed criteria, will comply with the requirements within six months from the commencement of this section.
    • The Audit Committee or the Board, in consultation with the internal auditor, will formulate the scope, functioning, periodicity and methodology for conducting internal audit.

    EY insights

    A perusal of the 2013 Act read with the Accounts Rules indicates that a company may either engage external agency or have internal resources to conduct internal audit. Further, a firm not registered with the ICAI may also be appointed as internal auditor.

  • SFIO

    Role of SFIO with respect to Companies Act 2013

    The Government of India has set up the Serious Fraud Investigation Office (SFIO) in the Ministry of Company Affairs (MCA) with effect from July 1, 2003 with an objective to undertake the investigations under the provisions of the Companies Act, 1956 for corporate frauds.

    The magnitude and the complexity are the key aspects involved in any corporate frauds. If such frauds are not dealt or investigated with relevant expertise may have serious ramifications on the economy nationally & globally in general and the stake holders in particular. Keeping this aspect in mind, Serious Fraud Investigation Office (SFIO) has been authorized to draw up the services of experts and expertise in various fields including accountancy, forensic auditing, taxation, information technology, capital markets, financial transactions, etc with a view to fulfilling the assigned task.

    As per the information given on SFIO website, total 878 cases of corporate frauds are pending before the courts of law, out of which 796 cases are under Company Law and 82 cases under the provisions of Indian Penal Code.

    Despite the SFIO came in to existence over 10 years ago, it did not have the enough teeth to deal with the fraudsters. However, the Companies Act 2013, which came in to existence on 29th August, 2013 is more stringent and conferred more powers to SFIO to deal effectively the fraud cases and people indulged in fraudulent activities.

    The new act has empowered SFIO to carry out arrests, raids and seizure in respect of certain offences of the act which attract the punishment for fraud. The decision to give legal and statutory powers to the SFIO by including appropriate provisions in the new Companies Act 2013 is with the objective of strengthening them and to enable it to initiate investigations on its own, further investigation report of SFIO filed with the Court for framing of charges shall be treated as a report filed by a Police Officer, will help bringing SFIO at par with any other law enforcement agencies.

    Further, as per the clause 212, on the intimation of special resolution passed by the company, SFIO can investigate into the affairs of the company or on the receipt of a report of the Registrar or inspector or in the public interest or on request from any Department of the Central Government or a State Government.

    This empowerment of SFIO will surely act as deterrent against the companies indulged in fraudulent activities and in turn will help in building the confidence of the stake holders.

3 For the purposes of this publication, other non-executive directors, i.e., non-executive directors, other than independent directors, are referred to as “NED.”

4MCA website: http://www.mca.gov.in/Ministry/pdf/CompaniesAct2013.pdf, assessed 6 April 2014.