Corporate Governance in Private Limited Companies

Transparency is often just as effective as a rigidly applied rule book and is usually more flexible and less expensive to administer. – By Gary Hamel

 Corporate governance in private limited companies is an often-ignored topic as it is not mandatory by law. The Companies Act and SEBI Listing Agreement focus on corporate governance aspects of public listed companies. The reason for excluding private limited companies is that they do not have numerous shareholders hence the risk is minimal. I beg to differ. Corporate governance encompasses much more than shareholder rights. Corporate governance includes rights of investors, financial institutions, customers, suppliers, employees and society.  

Let us first cover the backdrop of the problem briefly. In India, 90% of the companies are either unlisted public companies or private limited companies Private limited companies fall under three groups – 1) private companies belonging to business families; 2) private companies as subsidiaries of listed Indian public companies; and 3) private companies as subsidiaries of foreign companies.  

The corporate governance is limited in 1st and 3rd categories as in the 2nd category the provisions of listed companies apply to quite an extent. In the second category, it is dependent on the owners to take the initiative. The biggest challenge is for 3rd category as holding companies provisions may not be applicable in India. However, they are applicable in the country of the holding company. If the holding company is listed then corporate governance aspects apply of the relevant country. Though, quite frequently the focus in the subsidiary company is not the same as holding company. These companies sometimes have turnover and employees more than the listed organizations. Still these are not covered in the regulatory ambit.

The Institute of Companies Secretary of India has issued recommendatory guidelines for it. The Companies Bill, presently awaiting parliamentary approval does cover the same. This definitely is a step in the right direction. Organizations must take first mover advantage to incorporate the provisions in their governance, risk management and compliance programs.  I am giving below five areas that they can focus on:

1.     Corporate Social Responsibility

In 2009, Ministry of Corporate Affairs (MCA) issued voluntary guidelines for Corporate Social Responsibility (CSR). The guidelines discuss key aspects of governance practices that business organizations need to focus on. The policy covers six aspects- 1) Care of all stakeholders; 2) Ethical functioning; 3) Respect for workers’ rights and welfare; 4) Respect for human rights; 5) Respect for environment; and 6) Activities of social and inclusive development. The policy requires that business entities should provide an implementation strategy covering projects, timelines, resource allocation etc.

Organizations to communicate their commitment to CSR can put the policy on their website with each locations implementation strategy. This will help communicate organizations ethical stance to all third parties wishing to do business with it.

2.    Appointment of Board of Directors

In public listed companies, independent board of directors is appointed to ensure better governance. Family owned listed companies and private limited companies are remarkably cagey about appointment of external independent directors as they consider it as interference and sharing of power.

The private companies owned by foreign companies generally appoint directors from within the subsidiary organization. Friends and colleagues are appointed and they form a coterie. Although, this is legal it does influence governance as Chairman/ CEO lose the benefit of independent viewpoints and unbiased opinions. Boards have two purposes – 1) Act as trustees for the organization 2) Provide strategic insight to CEO. However, CEOs of private limited companies are disadvantageous position in comparison to listed companies CEOs

In such cases, it is a good practice to appoint directors from other group organizations. Secondly, if the holding company management permits, appoint exceptionally qualified independent directors. Here, management gurus, ethics leaders, financial experts and other professionals can be appointed. A right balance must be maintained to have an effective board.

3.    Rules and Performance of Board of Directors

 Unfortunately, the board meetings in private limited companies are sometimes held for namesake. It is more to complete the paperwork to meet the regulatory requirements can have an engaged discussion and chart out business strategies.

To ensure the board members are engaged the first step is to formulate and implement rules for the directors and define their area of responsibility.  Roles and responsibilities should be given according the qualifications and skill sets of the member. If the board skills are not sufficiently diversified, additional members must be appointed. Board members should commit sufficient time to the company. On a periodic basis, their performance against the targets should be evaluated by other board members. The mandate must be to add business value to the organization. It is a good practice to early audit the participation of board members in meetings and their respective performance.

4.    Risk Management & Internal Controls

 Indian Company Law mandates all companies private and public limited, over specified turnovers and capital to have proper internal control systems. The external auditors are required to report on the status of internal controls.

However, it does not mandate audit committees or risk committees for private limited companies at board level. It is a good practice to formulate one and ensure it provides relevant information to the audit. Financial and risk management experts can be appointed from within the organization or outside to give an independent view.

 5.    Appointment of Auditors

 Auditors in family owned companies are sometimes appointed based on old business relationships. This practice in India, significantly affects the independence of the auditors.

In respect to subsidiary companies, Indian and foreign companies, auditors are chosen by the holding company’s management. In most cases, the holding company’s auditors are appointed for confidence in consolidation of financial statements. Although this is a good practice, in Indian context there is a small snag. Local relationships with the auditors might circumvent the independence. Hence, if local management is involved in frauds, the auditors may compromise in ethical reporting. It is a good practice to frequently call on the holding companies audit partner and advise him/her on the issues. Direct relationships with international partners put a check on local auditors.

 Closing thoughts

In India, corporate governance practices are just a little over a decade old and mostly focused on listed public companies. In private limited companies, it is still in nascent stage. Organizations however can voluntarily take the initiative to adopt best practices. This improves confidence of third parties and brand reputation. It also benefits if the organization in a few years is planning to turn public limited or plans to sell the company.

 

References:

Ministry of Corporate Affairs (MCA) – Corporate Social Responsibility (CSR)  Voluntary Guidelines.


 

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