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Can the Audit Committee comprise of executive directors as its members - A study

Ramaswami Kalidas 
on 17 November 2020

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Introduction

Section 177(1) of the Companies Act, 2013 (hereinafter referred to as “The Act”) which corresponds to Section 292A of the predecessor Act of 1956 provides that every listed public company and every other company satisfying the benchmarks laid down under Rule 6 of the Companies (Meetings of Board and its Powers)Rules, 2014 shall constitute an Audit Committee. The said rule has to be read in conjunction with Rule 4 of the Companies (Appointment and Qualification of Directors)Rules 2014 which sets out the thresholds which are to be applied in respect of unlisted public limited companies. As per Rule 4 of the above Rules, apart from having a minimum of two independent directors, unlisted public limited companies which satisfy any one of the following criteria shall constitute the Committee:

a) companies which have a paid-up share capital of rupees ten crores or more or
b) companies which have a turnover of rupees one hundred crores or more or
c) companies which have in aggregate outstanding loans, debentures, and deposits exceeding rupees fifty crores of more.

Can the Audit Committee comprise of executive directors as its members - A study

The above conditions are mutually exclusiveness and satisfying any one of the same will bring an unlisted public company within the ambit of the requirement.

It is pertinent to note that through an amendment to the above rule introduced by the Companies (Appointment and Qualification of Directors) Amendment Rules, 2017, made effective from 5.7.2017, the following classes of unlisted public companies have been exempt from the requirement of setting up the above Committee:

a) a joint venture which expression has been defined by circular no.9/2017 dated 5.7.2017 as also under the Explanation contained under the amended Section 2(6)of the Act which defines an “Associate company”.
b) a wholly-owned subsidiary and
c) a dormant company as defined under Section 455 of the Act.

Committee to be a qualified and independent Committee

Regulation 18 of the Listing Regulations, provides, inter alia, that a listed company shall constitute a qualified and independent audit committee (Emphasis supplied). The expression “qualified and independent” is conspicuous by its absence in the Act so far as the makeup of the committee is concerned. This should not, however, lead to the erroneous conclusion that the Act permits a company to compromise on the quality of the committee. Notwithstanding the absence of the above expression in the Act, the terms of reference of the committee as carved out in the Act lay emphasis on the need for the independence of the committee for it to function in an efficacious manner.

Composition of the Committee

There are subtle differences between the Act and the Listing Regulations in so far as the composition of the Committee is concerned.

It would be appropriate to cull out the differences as under:

 

Composition under the Act

Section 177(2) provides that the committee shall consist of a minimum of three directors with the independent directors forming the majority.

Proviso under the sub-section stipulates that the majority of the members in the committee including its chairperson shall be persons who have the ability to read and understand the financial statement.

The term “ Financial statement” has been defined under Section 2(40) inclusively to cover, in relation to a company, the Balance Sheet drawn up as on the date of close of the financial year, the profit and loss statement or in the case of a non-profit company, the statement of Income and Expenditure for the year, the cash flow statement, statement of changes in the equity, if any and explanatory notes annexed to or forming a part of the above Statements.

Therefore it follows that the ability to read and understand the above documents will give rise to the possession of the ability on the part of a person to read and understand the Statements as contemplated under the sub-section.

Composition under the Listing Regulations

 

Regulation 18(1)(a)stipulates that the committee shall consist of a minimum of three members with two-thirds thereof being made up of independent directors. The Regulation is therefore more stringent as it provides for a higher composition of independent directors in comparison to the need for a simple majority of independent directors as provided in the Act.

Through an amendment put through by the SEBI (LODR) (Amendment) Regulations, 2019 made effective from 1.4.2019, every listed company which has issued equity shares with Special Rights(SR)which are outstanding shall ensure that the committee is comprised entirely of independent directors.

Having said this, notwithstanding the prescribed composition there exist a few companies in which the entire committee is made up of independent directors irrespective of whether the company has issued equity with SR.

All members of Committee to be financially literate

The listing regulations further provide that all the members of the committee shall be financially literate and at least one member shall have expertise in financial management or accounting. By contrast, the Act provides that only the majority of the members need to have the ability to read and understand the financial statements.

The expression “financial literacy” as used in the Regulations carries the same connotation as contemplated in the Act.

Regulations provide for at least one member being in possession of accounting or related financial management expertise

The requirement that at least one member of the committee shall have qualifications in the area of accounting or financial management is a requirement which is not provided in the Act.

Under Explanation (2)of the above Regulation, a person is considered as having accounting or related financial management expertise if he possesses experience in finance or accounting or requisite professional certification in accounting or any other comparable experience or background which results in the individual’s financial sophistication, including being or having been a chief executive officer, chief financial officer or another senior officer with financial oversight responsibilities.

Audit committee to invite financial director or head of finance, head of internal audit and representative of the statutory auditor and others to be present at the meetings of the committee

Regulation 18(1)(f) of the Listing regulations provides that the committee at its discretion shall invite the finance director or head of the finance function, head of the internal audit and a representative of the statutory auditor and any other executives to be present at the meetings of the committee.

This requirement is triggered off by the fact that the audit committee both under the Act as also under the regulations, inter alia, has the following specific responsibilities as per its terms of reference:

a) the recommendation for the appointment, remuneration, and terms of reference of appointment of auditors in the company.
b) review and monitor the auditor’s independence and performance and the effectiveness of the audit process.
c) examination of the financial statement and the auditors’ report thereon.
d) approval or any subsequent modifications of transactions with related parties.
e) scrutiny of inter-corporate loans and investments
f) valuation of undertakings or assets of the company whenever such exercise is called for.
g) evaluation of internal financial controls and risk management systems
h) monitoring the end-use of funds raised through public offers and matters related thereto.

The Audit Committee has to necessarily depend upon the support and information provided by the persons referred to above if it has to articulate effectively on the above matters. In fact without the active involvement of the persons involved in the operational functions, discussion of the committee on the above matters would be rendered ineffective and incomplete. It is therefore for this reason that it is customary in most companies to direct that the CEO and the CFO shall be present at every meeting of the committee as” permanent invitees” so that they can make meaningful contributions to the discourse of the committee. In case the discussions of the Committee veer around operational issues/plant efficiency and the like, it is not unusual for the committee to seek the presence of senior persons engaged in the above areas also to participate at its meetings as invitees.

Having said this, it is only for making the discussion of the committee enriching and effective that the presence of the persons engaged in the above matters is called for by the committee. By no means can an inference be drawn on account of the above that the committee can comprise of the Director(finance) or the Managing director/CEO as one of its members.

No mandate either in the Act or in the Regulations for the appointment of Managing Director/Director in charge of operations to be a member of the Committee

The objective of constituting an audit committee is to ensure that there exists as a sub-set of the Board, a committee which is independent of the board to articulate on financial matters including internal control, internal audit et al.The board is not permitted in any way to exercise its influence or authority on the committee in respect of the above matters. This is evident from the fact that the committee is allowed, in particular, to approve related party transactions. The Committee is also allowed to approve the appointment of the CFO and the terms of his appointment. Besides, the head of the Internal Audit function reports independently to the Committee.

In addition, the committee is authorized to investigate any activity within its terms of reference, to seek information from any employee, obtain legal or professional advice from outside.

In view of the above, despite the fact that the committee is an off-shoot of the board, it can exercise powers independently on the above issues and it shall not brook any interference from the board on the same. The Committee shall indeed keep the board informed and in the loop and but it is not expected to take directions from the board for discharging its duties on the above matters.

The inclusion of executive directors in the committee as members is most undesirable and would be counterproductive in that their presence can vitiate the independent functioning of the committee. By all means, they shall be invited to join in the discussions of the committee but shall not have the right of membership to the committee nor be clothed with any voting rights in the committee.

Section 177(7) does not contemplate the appointment of KMPs to the Committee

It is pertinent to note that subsection (7) under Section 177 provides expressly that the company’s auditors and KMPs shall have only a right to be heard at the meetings of the committee but shall not have the right to vote. By definition under Section 2(51), a KMP includes inter alia, the CEO, or the managing director, the whole time director. From the above subsection, it can be clearly inferred that the Act only postulates that the KMPs can only help the cause of the committee by participating in its discussions on relevant matters without being armed with any right to vote thereat. Hence they cannot be appointed as members of the Committee.

Listing Regulations do not specifically bar the appointment of executive directors on the committee

As has been stated above, the listing regulations only provide that the committee may at its discretion invite, inter alia, the finance director to be present at the meetings of the committee.

Nowhere does it specifically prohibit the appointment of executive directors as members of the committee. This has ostensibly led to an erroneous belief that in the absence of any express prohibition in the regulations it is in order for the committee to have executive directors as its members.

It has been observed with consternation that some of the renowned listed companies have appointed their executive directors on the committee due to the apparent chink in the regulations.

The responsibilities of the Audit Committee, inter alia, is to ensure the integrity of financial controls and integrated reporting as also in identifying and managing financial risks.

That being so, it would not be appropriate to allow executive directors to be part of the Committee since they would interfere with its independent functioning.

It is humbly submitted that since one of the objectives of setting up the above committee is to uphold the principles of corporate governance, it would be a travesty of justice if executive directors are allowed to be part of the committee. the quality of corporate Governance is non-negotiable and it should never be compromised at the altar of law. It is imperative that the committee be allowed to function without any fear or favor which possibility may be jeopardized if executive directors are allowed to be part of the committee.

It is submitted that SEBI should review the matter and if need be, amend the regulations to debar expressly appointment of executive directors as part of the Committee.

The committee should consist of only Independent directors and other non-executive directors

It follows from the above that whilst the majority and two-thirds, of the committee, should, respectively, be comprised of independent directors, the balance seats in the committee should be occupied by non-independent non-executive directors.

It is pertinent to note that in most geographical jurisdictions of the World, the audit committee has an optimum composition of non-executive and independent directors, with the latter holding swayin terms of numerical strength.

Composition of Committee as per the UK Companies Act 2008

It is pertinent to note that Section 94 of the Companies Act 2008 in the UK also echoes the above sentiments and determines that the audit committee must consist of at least three members who must be directors of the company and not:

• be involved in the day to day management of the company for the past financial year;

• be a full-time employee for the company for the past 3 financial years;

• be a material supplier or customer of the company such that a reasonable and informed third party would conclude in the circumstances that the integrity,

Impartiality or objectivity of that director is compromised by that relationship; and

• be related to anybody who falls within the above criteria.

As the above requirements are prescriptive, it follows that where the company has an audit committee whose composition is different from what has been prescribed above, it would not be a committee that answers to the prescription of the Act. Any decision taken by such an improperly constituted committee would not be deemed to be duly authorized under the law and it could result in liability being fastened on to the members of the committee.

Conclusion

In the above exposition, the message that has been driven home loud and clear is that the Audit Committee shall function independently, and with this end in mind, it should be ensured that it should comprise only of the majority of independent directors with the balance being made up by non-executive and non-independent directors. Companies that have appointed executive directors on the committee have obviously compromised on the independence and quality of the Committee and it is about time that the Regulars take appropriate action in the matter to uphold the principles of corporate governance. The Audit Committee, all said and done, stands on the bedrock of corporate governance and any compromise on its constitution should not be permitted under any circumstances.


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