Companies Act 2013 has made it mandatory for listed companies to establish a vigil mechanism for reporting genuine concerns. Further, the draft rules issued by the Ministry of Company Affairs on August 8, 2013, have proposed to extend this requirement to companies that accept deposits from the public and those that have taken more than Rs 50 crore from banks and public financial institutions.

The draft rules also set out the requirement for

Mechanism operated by the audit committee (for companies that do not need an audit committee, a director nominated by the Board);

Reclusion of the audit committee member(s) where there is a conflict;

Access to audit committee chairman for exceptional cases;

Appropriate communication of the mechanism;

Actions against frivolous complaints;

While the Act and the draft rules are a step in the direction of good corporate governance, several issues need clarity.

Genuine concerns: The term ‘genuine concerns’ has not been defined; but going by global best practices, vigil mechanisms normally have a wide scope ranging from conflict of interest to financial reporting. In short, the entire gamut of corporate frauds and misconduct. One may also take a cue from Schedule IV of the Act, which sets out the duties of the independent director including “report concerns about unethical behaviour, actual or suspected fraud or violation of the company’s code of conduct or ethics policy”.

Operation by audit committee: Is it practical? The draft rules do not specify the activities of the audit committee. Surely, one cannot expect the audit committee to receive calls or emails containing concerns. In other countries, the leading practice is to outsource such activity to a service provider for reasons of confidentiality, objectivity and the perceived ‘low-end/ mechanical’ nature of these tasks among others.

The same holds for preliminary evaluation, investigation, corrective action and reporting, which cannot possibly be handled by the audit committee for all the genuine concerns received by it.

Experience shows that the number of such concerns received in a year ranges from 1 to 3 per cent of the employee base — that is, about 100-300 concerns in a year for a company with 10,000 employees.

By no stretch of the imagination can that be practically feasible. Perhaps the intent of the Act and draft rules is to ensure that the audit committee oversees the operation of the mechanism, formulates guidelines and delegates competent personnel/ committee to operate it.

Conflict of interest and reclusion: The proposed provision in the draft rules for reclusion of the audit committee member(s) is in line with good governance practices. However, neither the Act nor the draft rules define ‘conflict of interest’. Thus, the onus of determining that may be on the board. Further, what should be done if, hypothetically, all members of the audit committee are conflicted?

Safeguards against victimisation: Employees will be encouraged to use the mechanism only if there are strong safeguards against victimisation. As a best practice, the whistleblower should be allowed to remain anonymous.

While the Act and draft rules do not require the reporter to reveal his/her identity, they do not encourage anonymity either.

Experience shows that the identity of the reporter is immaterial to the effectiveness of an investigation, so long as the information given is adequate.

The only argument against this could be the likely misuse of the mechanism to discredit someone or repeated instances of frivolous complaints.

Nevertheless, the benefits of anonymity far outweigh the disadvantages. Moreover, for repeated frivolous complaints there could always be provisions to disclose the identity in certain cases.

Access to audit committee chairman for exceptional cases: The purpose of this provision is not clear. Employees, more often than not, may feel uncomfortable or intimidated talking to a person in senior position.

Also, the term ‘appropriate or exceptional cases’ has not been defined. Does it mean that the company or the audit committee is free to lay down the criteria for that?

Appropriate communication: A critical factor for an effective vigil mechanism is the communication with employees. This may include spreading awareness in more than one language, including regional languages.

What it means for independent directors: The code for independent directors is set out in Schedule IV. The duty is to ‘ascertain and ensure’ that the company has an ‘adequate and functional’ vigil mechanism and that the interests of the person using it are not harmed. The independent directors also have to report concerns over unethical behaviour, and actual or suspected fraud or violation of the company’s code of conduct or ethics policy.

To assess the ‘adequate and functional’ factor, independent directors may have to review the concerns received by the audit committee, the investigation initiated, and the corrective action and reporting, if any. This may require auditable documentation of concerns received, minutes of the deliberations, investigation working papers and so on. However, the independent director may not necessarily be equipped to evaluate the evidence presented.

What it means for the auditors: Under Section 143(12) and the draft rules, an auditor should report to the Central Government (with a copy to the audit committee or Board) if he/she has reason to believe that an offence involving fraud is being committed against the company by employees or directors.

The draft rules further define materiality as fraud(s) happening frequently, with the amount involved not less than 5 per cent of the net profit or 2 per cent of the turnover in the preceding year.

For frauds that are not material, the auditor should report to the audit committee, or the Board if there is no audit committee. If not satisfied with the action taken by the audit committee or Board, the auditor may report to the Government even if the fraud is not material.

The moot point is that while the auditor may apply the monetary percentage to determine materiality, he may not have the expertise to quantify the amount involved.

Arpinder Singh is Partner and National Leader – Fraud Investigation and Dispute Services, and Jagdeep Singh is Director – Fraud Investigation and Dispute Services, EY India

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