Corporate Governance: A DNA Necessity

January 2021

1. Introduction

A year or so after the pandemic broke, the world may have adapted to the changed environment but it is not easy for companies to manage in these volatile and uncertain times. As the corporate sector grapples with various issues like high non-performing assets, boardroom disputes, senior management officials and directors are coming under increased scrutiny. A director is personally responsible for managing the affairs of a company and always had a fiduciary duty towards the company and its various stakeholders. But, now, there is a statutory duty[1] under the Companies Act, 2013 (“Act”) which obligates a director to act in good faith to promote the objects of the company for the benefit of its shareholders, act in the best interest of the employees, community, shareholders, and even protect the environment. Therefore, a director, independent or otherwise, has a duty to act in the best interests of the company and ensure that such duties are overarching over his own. The unprecedented legal changes caused by the pandemic has placed the Board collectively in a tough spot.

This newsletter examines the issues around governance due to the pandemic and how it has to be deep-rooted in every company, now more than ever.

2. The Challenges

It would be correct to state that the directors have faced unprecedented challenges in recent months, in virtually every area and the gamut includes compliance with legal and contractual obligations; business continuity while people moved to operate from home; monitoring employee health and safety, amongst others. Under the Act, the Board has to oversee the business and affairs of the corporation, which is possible through a reasonable system of monitoring and reporting to them. Courts have, time and again, found that directors would have failed in their oversight efforts where they failed to implement reporting or prescribe adequate checks and balances via systems and controls and if they existed, consciously failed to monitor or oversee the operations. In the course of the pandemic, the Indian government – both central and state – introduced numerous binding and non-binding advisories on different aspects, be it workforce or contract related and organizations grappled with varied issues. And, in this context directors were compelled to make tough decisions that could have been considered a compromise of fiduciary responsibilities. Some areas of concern are discussed below.

In contractual matters, regardless of whether a company issued, has to issue or receive notices of claims arising out of COVID-19 the Board and senior management was (and continues to be) duty bound to evaluate impact for compliance with contract requirements. And, evaluation would not be easy, given the inability to estimate the duration of the disruption, determining whether it is caused by the pandemic or a measure taken in reaction to it and assess the costs suffered rapidly. Further, contract documents may be ambiguous as to whether an event can be both a force majeure event and give rise to a compensable variation or extension of time. Often, large contracts allow parties to suspend work in certain circumstances. If the suspension is not the result of a breach by the suspended contractor, it may be entitled to an extension of time and costs. Suspension is easier to contemplate than to carry out; however, there are often disputes over suspension-related costs and impacts. Proper management and documentation of suspensions and their impacts warrant careful attention when responding to disruptions. These situations again raise the question as to what position should directors take to be on the right side of their duties.

The health and safety requirements too have come under increased scrutiny and may be amended or interpreted to include compliance with government directives, including additional sanitation, testing and physical distancing requirements. Most concerns in these areas are on who should bear additional costs at site and/or in labor accommodation facilities. Then, the disruptions to the supply chain and consequential impact cannot be undermined. And, of course, one cannot disregard the role of insurance. The costs and losses arising from COVID-19 impacts will depend on the scope and wording of the policies and facts concerning the impacts. The Board will have to continue to ensure that coverage is available and assess the requirements for a claim. With everyone working remotely, a top concern would be to avoid or minimize cybersecurity threats and in managing the security of technology systems which were not built to withstand these real-time complexities. They also need to ensure that their own critical data and those of their customers remained protected at all times. Again, when the world is experiencing a double whammy in terms of a pandemic and recession, financing matters assume significance. Now, while the Reserve Bank of India sought to provide relief to borrowers via moratorium on loan payments, but challenges continued as lenders took action against the defaulting companies and directors, thereby exposing them to personal liability.

It goes without saying that the situations and challenges contemplated above reveal that finding parity amongst the interests of the different stakeholders has not been and, in the medium term, will not be easy. Needless to say, it will be hard to take a firm view as every situation will be fact specific and aspects like proof of knowledge, consent, failure to exercise diligence shall matter. But the question will arise if the Board directors did justice to their fiduciary responsibilities? Now, more than ever, they must make independent judgments, take informed decisions based on reliable data and their specialized knowledge. They need to think ahead and should not make decisions that will affect the company in the long run. Even the role of an independent director as watchdog of listed and public companies has changed and they will have to ensure that public stakes are protected. In a post-COVID world they will need to protect the company from economic distress. The gatekeepers of the Board shall have to ensure a system of even greater guidelines, policies and systems to safeguard all stakeholders.

3. The Law and Possible Risk Mitigation by Board

As stated, section 166 of the Act provides for the fiduciary duties of a director and covers the business judgement rule which allows for a test of reasonableness and diligence. This means that if directors demonstrate they acted keeping in mind all the factors at hand and then took a careful business decision, it should protect them from personal liability. In recent months and even before the virus consumed the globe, the courts took steps against directors who failed in discharging their governance duties, be it prohibiting directors from alienating their personal properties or assets, or even arrest. It, therefore, becomes all the more important for directors to be aware of conflict situations and should proactively avoid them. Further, with family members in the management or as promoters, careful attention has to be given to related party transactions where there is a singular obligation on the Board members to ensure that directors or their relatives should not be the beneficiaries. Amongst other primary considerations should be the health and safety of its workforce, customers and suppliers.

Most companies were never keen on developing a contingency plan and are now realizing the ensuing repercussions. A lot of businesses shut because of their inability to foresee and prepare ahead. A detailed financial assessment is crucial to create a crisis plan which will determine revenues and expenses to understand the actual financial condition and the duration for which it can be sustained. This clearly requires a deep analysis of cash flow, financing solutions (if needed) and a clear line of communication to other stakeholders who should be made aware of the financial condition. If not done already, the Board should strategize, plan, chalk and clearly outline the company’s disaster plan which should address every aspect, mentioned in the challenges above. As part of its ongoing monitoring and oversight responsibilities, the Board should also prepare for and discuss implementation with management. At such a time, directors should be able to make quick decisions to tackle a situation that requires prompt actions. It is also necessary to continuously evaluate potential future disruptions to operations.

Other possible risk mitigation factors include contractual indemnity protection and director and officer liability insurance. While these are usually included nowadays, but they often have carve-outs and do not protect against criminal and regulatory liabilities. In other words, and simply put, boards have had to and continue to explore restructuring of operations (manufacturing or otherwise), finance (debt and capital), workforce, supply chain etc.

The significance of communication cannot be overstated. Shareholders should be cognizant of the company’s current situation and the Board should periodically revisit its communication strategy to keep them informed of its plans to address the challenges while keeping its eyes on the long-term goals. Where required, they should communicate the issues to the counterparty too in advance, which ought to help in resolving problems. Given the havoc that the uncertainty of the virus placed on everyone, directors and top management ought to communicate decisions effectively internally, which will enhance both corporate governance and promote transparency and trust.

It is also necessary to touch upon the role of governance scorecards and their implementation in India. Globally, the development of governance scorecards led to creation of BSE-IFC Corporate Governance Scorecard[2] that established a mechanism for benchmarking companies on various governance issues. It was developed on the basis of four OECD principles for corporate governance, namely (a) enforcing rights and equitable treatment of shareholders; (b) role of stakeholders; (c) disclosures and transparency; and (d) responsibilities of the Board. These raised the bar for companies to demonstrate compliance, not merely with the letter of the law but in the spirit of the law too. Extracting from BSE’s website, “the CG Scorecard will help companies to benchmark themselves on their corporate governance status as well as provide investors a standardized measure of the corporate governance status of any company.

4. Conclusion  

From the foregoing, it is clear that issues to be dealt by the Board and its committees including disclosure standards, stakeholder knowledge, risk management and overall strategy for long term health of the company shall be key in determining its effectiveness.  There is no question that everything that a company does has the potential to be categorized under the general umbrella of corporate governance, be it environmental, social or business related. 13 months after the virus emerged in Wuhan, organizations have gone past their survival mode and those with institutionalized governance practices have fared better. Right leadership is essential to develop the culture of commitment to integrity, fairness, honesty, transparency and ethical conduct, which has to be disseminated to all the stakeholders, employees or otherwise, through constant communication, backed by cogent evidence and training. Without a doubt, corporate governance has to be embedded in the DNA of any organization and shall only create and enhance stakeholder value.

Author

Priti Suri

[1] Section 166 of the Act introduced these obligations and the previous 1956 law did not contain any such obligations; rather, was governed by the general provisions of the board and precedents

[2] See https://www.bseindia.com/static/about/CorporateGovernanceScorecard.aspx (last accessed on Jan 25)