Corporate Governance in India and the Suitability of Legal Transplants

[By Shuchi Agrawal

The author is a student at the Jindal Global Law School.

Corporate governance refers to the mechanisms which are used to regulate and govern a corporation. The model of corporate governance adopted, determines the scope of powers that are wielded by different actors, in order to facilitate the smooth functioning of a company. The U.S. and U.K. follow an outsider model of corporate governance, which is based on the separation of control and ownership, as the shareholders have limited interest in the management of the company. Meanwhile, India follows the insider model, which is characterized by the presence of cohesive groups of ‘insiders’ who have a long term affiliation with the company. Usually, the controlling shareholders are a business family or the State. The presence of such controlling shareholders helps concentrate ownership and may lead to greater benefit for the dominant shareholder at the expense of the minority shareholders. Thus, this may result in an agency conflict between the controlling shareholders and the minority shareholders.

However, despite the differences between the shareholding patterns in India and, the U.S. and U.K., legal transplants have been heavily employed in formulating the corporate governance policies in India. This has been done without considering the historic, cultural and economic differences between the concerned jurisdictions and has resulted in the establishment of a regime that is severely ill-equipped to prevent unethical or fraudulent activity within corporations, in India.

Considerations while Introducing Legal Transplants

Legal transplants’ are legal models and regulations which are exported from an alien jurisdiction into a receiving one. Due to the historic imbalance of power between nations, legal transplants are often adopted by developing countries, from more developed nations. This allows developing countries to import legal wisdom from developed jurisdictions, which may have a rich historic background for a particular legal framework. However, it has been suggested that emerging markets should not copy codes implemented in mature markets. Moreover, there is a lack of universal consensus regarding the effectiveness of legal transplants. Nonetheless, in the context of corporate governance in India, legal transplants have not been very effective, as is evidenced by the fact that government companies were discovered to be major violators of Clause 49 of the Listing Agreement, which details the guidelines regarding corporate governance that listed companies in India must comply with.

Additionally, the theory of path dependence states that an outcome is structured in specific ways based on the historical context and the prevalent socio-economic conditions. Consequently, differences in models of corporate governance, as well as historical and social background, play a role in the effectiveness of a legal transplant. Markets have always operated in relation with communities and social organizations, such as families and religion and governments and never in a vacuum. Thus, legal rules which have been shaped by particular political, historical and cultural elements cannot be transplanted in another jurisdiction, unless similar conditions prevail in the other State as well. Recently, there has been a marked shift from the transplant model to an entirely autochthonous model in the field of corporate governance in India. From the perspective of legal reform, it has been suggested that rules which can be enforced with the existing enforcement structure must be preferred over the creation of ideal rules which require the development of new structures for their implementation.

The inefficiency of India’s Transplanted Model

Further, the Satyam scam of 2009, worked to showcase the gaps that were present in the effective implementation of the legal transplants. The Satyam scam was one of India’s biggest corporate governance and financial accounting scandals. In this matter, the ambiguity regarding the duties of the independent directors and the promoters especially highlighted the failure of the corporate governance model.

Moreover, it has been claimed that multiple measures borrowed from other jurisdictions, primarily the U.S. and U.K., have failed to improve corporate governance in India. For instance, S. 166 of The Companies Act, 2013, gives directors overarching discretionary powers, which may be utilized to further their own interest with little accountability. In addition to this, it was found that “more than 3,000 people who were on the boards of various companies on January 1, 2006, were re-designated as independent directors” in order to comply with the requirements under Clause 49 of the Listing Agreement. This defeats the very reasoning behind these reforms and demonstrates the ineffectiveness of legal transplants.

Additionally, the transplanted corporate governance model is not perfect in its functioning even in its countries of origin, such as the U.S. and U.K. Some problems associated with the transplanted model include the dispersed nature of shareholding, combined with a lack of oversight, excessive interference by managers in determining their own remuneration, and the lack of a division between the roles of the CEO and Chairperson. Contrastingly, Indian laws have a comprehensive system with respect to these concerns. Controlling shareholders in India do play a role in the management of the company, and the management’s remuneration is limited by legal provisions and is subject to the shareholders’ approval. Additionally, despite the lack of a mandatory provision requiring a separation of the roles of the CEO and the Chairperson, Indian companies tend to follow the separation.

However, in the context of Anglo-Saxon corporate governance models, it has been stated that strong managers and relatively unprotected minority shareholders have been at the centre of corporate governance failures. This was evidenced in the case of Parmalat, where the controlling shareholders had illegally used corporate resources at the expense of minority shareholders. Moreover, the CEO and chairperson positions were held by the same person despite the codes of practice recommending a separation. Further, on analyzing some corporate governance failures such as Enron, WorldCom, Satyam and Xerox, it was found that they had certain common features, including incompetence of management, the inefficiency of internal audit, and non-compliance with internal regulations.

Conclusion

While it has been acknowledged that there is no one successful model of corporate governance, several prescriptive ruleshave been laid down on the basis of research. A study conducted in Sri Lanka sought to determine the impact of certain corporate governance characteristics, such as CEO duality, and the presence of independent directors, on the probability of corporate failure. It was found that the companies which failed in corporate governance had fewer independent directors on their board and practiced CEO duality. The independent nature of directors allows them to oversee corporate management effectively, while looking after the interests of the shareholders. This aspect becomes especially important when seen in the context of Enron’s collapse, which was largely attributed to fraudulent activity by the board of directors. In addition to this, a number of other factors also need to be considered. For instance, it has been claimed that for successful corporate governance, it is important that the remuneration of directors be determined on the basis of the company’s performance. Hence, the transplanted ‘outsider model’ as well as the Indian ‘insider’ model will benefit greatly by applying these rules and incorporating them in their systems.

Another important aspect which must be considered is that unethical activity by individuals in top management positions cannot be completely stopped, however, certain mechanisms can be established which help in the detection of such activity at the earliest. It is imperative for transparency and accountability to be built into the structure of the corporation. Reforms must be introduced to counter undue pressure on employees from the corporation’s leadership. Further, workplaces must not enable a culture of silence where workers do not raise relevant concerns due to fear of retaliation. The corporation’s culture must be receptive for internal systems of scrutiny, such as internal audits, to function properly.

In conclusion, both the models have their own set of failings and need to be modified in order to competently establish successful models of corporate governance. Further, legal transplantation is an inevitable process, but it should be conducted only after a thorough analysis of the historic, and socio-economic background of both the jurisdictions concerned. An alien system of corporate governance may fail to meet its potential in an unsuitable setting, which does not offer support for its implementation. Therefore, a seemingly ‘perfect’ model of corporate governance may also prove to be incapable of being applied in practice, thereby defeating its very purpose. The focus should, thus, be on the development of systems which can function within the existing social, economic and political conditions.

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