Thursday, October 12, 2017

The Spirit of Independence Remains Unaddressed

Following publication of SEBI's Kotak Committee Report on Corporate Governance  on the 5th October 2017, it was quite clear that independence of directors, which was among the key focus SEBI wanted the Committee to have, will get no leg-up right now. Sure, there were several recommendations that address the symptoms of the disease (of corporate greed and misdemeanour in large sections of the sector) but no attempt to confront the primal cause of the ailment, namely, how to restore a measure of freedom and independence to the vast majority of the so-called independent directors on company boards. The strangle hold of the controlling shareholders on the selection, remuneration, continuation or separation , of independent directors had to be curtailed if the IDs were to feel free to act on their judgement on critical issues that affect the company and its stakeholders including the non-controlling shareholders. This was a bullet the Kotak Committee was not willing or able to bite. Sad. Don't know how long the IDs and the non-controlling shareholders have to wait still!

My co-authored article on the subject that was published by Mint on the 11th October deals with this topic and is available here

Friday, July 14, 2017

A Briefing on Board and Director Independence in Controlled Companies

At the request of National Stock Exchange of India, Centre for Excellence in Corporate Governance, I wrote a short Briefing Note for circulation to company directors, secretaries, and other interested persons. This was released earlier this week.The topic of the Briefing was Board and Director Independence in Controlled Companies. Full text of this Briefing, No. 18, June 2017, is available here.

The Briefing describes what are "controlled companies" (in effect where some shareholders control the composition of their board of directors with or without a majority of equity holding in their companies, and also exercise directly or indirectly management control of the business operations); how in such a situation independence of the board and its directors can be compromised and their monitoring of the executive can suffer; some not-so-apparent-nuances of director independence; what can the controlling shareholders, the regulators, and the independent directors do to safeguard and exercise independent judgement on matters to protect and promote the interests of the absentee (or non-controlling) shareholders.
Among the suggested measures are appointments and removals of independent directors by a majority of non-controlling shareholders, with some safeguards to preempt any abuse of this power to the detriment of the company, and similar measures in respect of independent auditors on whom independent directors and investors largely depend for the fair representation of companies' financial affairs. The suggestions may sound radical but there are signs of similar directional movement in some other countries as well, given the increasing trends towards concentration of voting power in the hands of controlling shareholders and the potential abuse of such power for their entrenchment and enrichment at the expense of other shareholders. 

Bolstering Director Independence in Controlled Companies in India

A vast majority of listed companies in India is “Controlled” by dominant shareholders acting also as the executive, directly or indirectly. Most of the legislative and regulatory requirements, however, are based on “best practices” evolved in countries like the United States where corporate ownership is “dispersed” with no identifiable controlling shareholder in management. In this paper, based on my submissions to a Committee appointed in June 2017 by the capital market regulator, Securities and Exchange Board of India (SEBI), I have proposed for consideration some structural changes in the manner of appointment, functioning, and removal of independent directors on listed company boards aimed at further enabling such directors to exercise their independence without undue inhibition in the interest of non-controlling shareholders. Principally, the recommendations seek restraints on controlling shareholders’ voting power in approving appointment and removal of independent directors (and independent auditors), with the rest of the shareholders being exclusively empowered to approve them. Following is an executive summary of the recommendations. The full document is available here 

Executive Summary

1.     With the implementation of the recommendations of numerous advisory committees and deliberations of parliamentary committees since the turn of the century, corporate governance regulations in the country have been brought up substantially on par with international standards in most areas.  The Committee for Corporate Governance under the chairmanship of Shri Uday Kotak, constituted by SEBI is a timely and welcome initiative and is well positioned to review and recommend measures appropriate to our circumstances and objectives.
2.     Most of the best practices especially in respect of board and director independence have evolved in countries like the US, where corporate ownership is largely dispersed with no identifiable promoter; most corporations are stand-alone entities. On the other hand, corporate ownership in India is concentrated, with “controlling shareholders” most often also managing their businesses. Regulations need to take account of such structural differences if the efficacy of some of international best practices were to be obtained in full measure. The performance of an important component such as the institution of independent directors to protect shareholder interests, for example, is perceived to be sub-optimal in the country, in comparison.
3.     Countries with predominantly dispersed ownership have in recent times made special provisions for “controlled companies” in their jurisdictions which are the exception. Time may be opportune for India to revisit the subject and provide for governance practices which can address issues normally associated with such companies. This submission attempts to provide a set of measures to address this situation.
4.     The recommendations made in this submission are aimed to garner the advantages of international best practices such as independent directors, within a framework that seeks to neutralise the disadvantages posed by the concentrated ownership scenario in the country.
5.     The recommendations seek to achieve this objective primarily by circumscribing controlling shareholders’ power to select, appoint, and influence independent directors on their boards. Instead, non-controlling shareholders are vested with powers to have a more effective say in the appointment and functioning of independent directors. Provisions have also been made to guard against any abuse of this authority to the detriment of the interests of the company and its stakeholders including shareholders.  
6.     Unlike in some countries where the required proportion of independent directors on the board declines in controlled companies, our recommendations propose an increase in the proportion of independent shareholders to 75% of the board, with controlling shareholders nominees being capped at 25% of the board seats. This is expected to strengthen the independence quotient of the board in controlled companies. Scarcity of suitable candidates to take up these positions, if at all a real problem, needs to be addressed aggressively rather than being allowed to dilute desired objectives.. (Experience in Continental Europe and the UK in respect of women on boards offers an instructive precedent).
7.     Having truly independent directors on board will make little difference to effective governance if the voice of independence is not made to count; some of these “enabling” measures include presence of majority of independent directors to determine quorum of meetings, and independent directors’ majority support to approve key corporate issues.
8.     There has also to be a will on the part of independent directors to function objectively in the interests of the company and its shareholders. Recommendations on this important element of effective performance deal with some personally rigorous criteria of independence and involuntary exit mid-term, thus making it difficult for independent directors to desert mid-term without some explanation to the non-controlling shareholders who appointed them.
9.     Other recommendations deal with the troublesome issues of over-boarding, conscientious commitment to the positions held, wider involvement of Key Managerial Personnel, transparency and disclosure in directors’ association with controlling shareholders beyond the subject company.
10.  In respect of Related Party Transactions, measures to strengthen informed decision making by independent directors have been recommended including credible information inputs audited by the company’s statutory auditors and secretarial auditors where applicable.
11.  In a significant departure from decades old convention of controlling shareholders choosing their nominees as auditors of the company and going through the formalities of their choice being endorsed by the board and approved by the shareholders with the help of their own votes, the recommendations propose vesting the power to approve in the hands exclusively of non-controlling shareholders, on the ground that it is inequitable and less than fair for the audited to choose the auditor
12.  Given the sizable holdings of Institutional Investors in a large number of listed companies in India, the recommendations include introduction of a Stewardship Code for their active and transparent participation in the governance processes of their investee companies.

Wednesday, March 1, 2017

Controlled Company Governance: What Role for Independent Directors?




Although it is widely believed that most independent directors on company boards held their position “at the pleasure” of the controlling shareholders, the events that happened in recent months at the Tata Group, the unquestioned role model for good and ethical corporate governance, have catapulted the topic to the debating fora and for judicial resolution. That a senior industrialist like Nusli Wadia, a long-time friend and Tata well-wisher, could be voted out as an independent director from the board of a Tata company is possibly proof enough (if such was required) of the tenuous sustainability of the institution of independent directors on company boards. This paper explores the relevance, reality, and possible resuscitation of this institution that for several decades now has enjoyed the exalted position of indispensability in the good governance discourse around the world.
Section I describes the connotation of “controlled companies” and their widespread prevalence especially in the Indian context. Section II briefly outlines the concept of board and director independence particularly in listed companies and the practical challenges it is exposed to. The concluding Section III seeks to assess the continuing role and relevance of independent directors on (mainly, controlled) company boards and a few measures (some of them probably out-of-the-box and unorthodox) that might merit consideration and adoption.

I
Controlled Companies

Controlled corporations have been variously defined in different jurisdictions; one that possibly captures best the wide-ranging connotative intricacies of such entities is offered by the Canadian Coalition for Good Governance (here):

“Controlled Corporation” means a corporation controlled by a Controlling Shareholder or group of shareholders who together (directly or indirectly) control a sufficient number of common shares of the corporation to be able to elect the board of directors or to direct the management or policies of the corporation.

“Controlling Shareholder” means a person or company that directly or indirectly controls a sufficient number of common shares of a corporation to be able to elect the board of directors or to direct the management or policies of the corporation.

What these definitions seek to encompass is both the de jure and de facto control of the corporation, whether it is achieved by a majority of voting equity or by other means such as authority, howsoever derived, to appoint a majority of directors on the company’s board. Indian law spells out some of these sources of control, such as:

“… the right to appoint majority of directors or to control the management or policy decisions exercisable by a person or persons individually or in concert, directly or indirectly, including by virtue of their shareholding or management rights or shareholders agreements or voting agreements or in any other manner.” (Companies Act, section 2 (27))

Sponsors of the company (labelled “promoters” in India) are a major example of such controllers. They are specifically covered in an inclusive definition in the Companies Act -section 2 (69) as a person:

“(b) who has control over the affairs of the company, directly or indirectly whether as a shareholder, director or otherwise;
  (c) in accordance with whose advice, directions or instructions the Board of directors of the company is accustomed to act.”

A vast majority of listed companies in India is sponsored by promoters, whether they are business families, domestic or multinational groups, or the State. Hence what would pass for a relatively minor exception in the US and the UK, this category of controlled companies is the general rule in India and indeed in the rest of the world. It is in this context that governance of controlled companies in India in line with the regime applicable to the majority of companies in the US and UK needs to be considered and debated upon.

Closely Held Corporations Distinguished

There is one other important caveat that bears noting in this discussion: “controlled” corporations need to be distinguished from “closely held” corporations, the latter denoting corporations that have a small number of shareholders, most of whom either participate in or directly monitor corporate management. It has been argued that as contracting parties are the best judges of their respective interests, they could opt out of statutory mandates concerning their mutual rights and obligations so long as no public interest was involved. Such closely held corporations are not the focus of this paper; its concern rather, are those companies that are publicly traded with several thousand or even millions of absentee shareholders who cannot and do not participate in the management of the corporation’s business. This fundamental distinction effectively rules out, as Melvin Eisenberg pointed out more than a quarter of a century ago, any mutually agreed opt-out possibilities with regard to any rights and obligations otherwise mandated (here). Boards and directors of public companies including those that are “controlled” (but not “closely held”) have their responsibilities more than clearly laid out in legislation; they can have no excuse to lower their guard against potential tunnelling, nor any recourse to age old clichés like “they (the promoters) know best” and “what’s good for the promoters must be good for the rest” and so on. In this context, it would be interesting to explore if the shareholders of Tata Sons (mainly the Tata Trusts, Shapoorji Pallonji group, and a handful of others), were not legitimately entitled to exercise some opt-out provisions (such as those they wrote in to the amended Articles of the company) by mutual consent, so long such measures did not fall foul of any public interest requirements.  

Non-Controlling “Promoters”

While “promoters” as an expression generally connotes persons or entities who sponsor a company and are associated with it as executive management in control, the inclusive definition in the Companies Act would, theoretically include wittingly or otherwise, some founding shareholders even after long past their relinquishing management control just because they had been “named as such in a prospectus or is [were] identified by the company in the annual return,” section 2 (69) (a). In practice this could lead to some back-seat driving situations if such shareholders chose to behave (as was indeed the case recently at a major IT company reputed for its gold standards in governance) as if they were actually in day to day control! Of course, like any other absentee shareholder, they would be entitled to their rights which could be exercised at meetings of members of the company, but not by inflicting themselves upon the functioning of the board or the executive within their respective realms of primacy.

Governing the Controlling Entities

Several controlling entities are structured as private limited companies, thus falling outside the ambit of relatively more rigorous regulatory governance discipline even though the companies they controlled could themselves be very large and publicly traded entities. To overcome this anomalous situation, corporate legislation had introduced the legal fiction of “deemed public companies” where such private limited companies would attract all provisions applicable to public limited companies. Over time this provision had been diluted by successive amendments, and finally the Companies Act of 2013 has completely dropped the concept. With this, entities (whether individuals, families, private limited companies, charitable trusts, or whatever else) controlling other corporations now have no disclosure or other obligations.

In many instances, this kind of information blackout leaves a company’s non-controlling shareholders with little knowledge of the identity of the ultimate owner/controller, indeed an unenviable situation.  
  

Monitoring Boards and Controlled Companies

With the proliferation of absentee shareholder population in publicly traded corporations and coping with the paradigm shift towards escalating complexities of husbanding large entities, the old adage of “owners managed and managers owned” gave way to a separation of ownership from operational control of corporations in the US and the UK in late nineteenth and early twentieth centuries, as Adolph Berle, Jr and Gardiner Means established in 1932-33. Overseeing the Executive and protecting and promoting the interests of the company and its shareholders became the principal responsibility of the directors, besides of course approving and guiding the business course of the company and its values in line with the overall dictates of the shareholders at large. The inherent dissonance between the interests of the largely distanced shareholders on the one hand, and on the other, those of the executive in day to day operations of the entity with both the opportunity and the desire to further their own personal interests, gave rise to the “monitoring” board with the predominant emphasis on oversight and control.

Professor Stephen Bainbridge of the UCLA (quoting Cheffins 2009) traces, in his 2009 book, Corporate Governance after the Financial Crisis (P. 51), the trigger towards the ascendency of the monitoring function in modern times to the collapse in the US of Penn Central in 1970, “amidst personality clashes, mismanagement, and lax board oversight.” Penn was not alone in this turbulence of corporate misbehaviour as soon thereafter several prominent corporations were implicated in illegal corrupt payments scandals unleashed by the infamous Watergate probes around that time.  Almost overnight, the monitoring role of the board moved up centre-stage; and who else but Independent Directors could, if at all, effectively perform this surveillance function? Criteria of independence were tightened and made more rigorous and extensive, requirements as to the proportion of independence directors on boards were enhanced, over-boarding was frowned upon, and the virtual indispensability and assumed infallibility of the institution of independent directors were cast in stone by successive legislation and regulation. And the world followed suit, whether or not such measures were appropriate to their circumstances, in the name of “best practices” and harmonisation of governance requirements of the globalised regime of international investments and securities markets. The jury, however, is out as to whether these measures had indeed enhanced board independent oversight and led to any improved levels of absentee shareholder protection, irrespective of whether the share ownership is dispersed or concentrated.

II
Independence and its Inhibitors

It is now well established in corporate governance literature and practice that “independence” as an attribute expected of directors refers to an ability to objectively decide on issues that impact the interests of  the corporation and its shareholders (and, in India, other prescribed stakeholders too) without any impairment due to any extraneous influence, pressure, threat, or  such other factors. This is seen to be particularly important in the publicly traded companies with a vast number of absentee shareholders who have no role in the management of the business of their corporation, whether such management is exercised by professional hired managers (as in the case of dispersed ownership corporations such as largely the case in the US and the UK) or by a group of sponsoring shareholders or promoters (as in the case of concentrated ownership corporations as predominantly is the case in the rest of the world including India). The fiduciary obligations of the board and directors to the company and its shareholders postulate that their interests must be protected and promoted; in the corporate format, the people closest to the operations who can, if they wish to (and as a general rule, they have every natural reason to do so) look after their personal interests in preference over the interests of the company and its absentee shareholders. In such circumstances, the board in addition to guiding and directing executive management to pursue the business objectives of the corporation and to create and preserve wealth, will also have to assume and discharge a surveillance role to ensure that such created wealth is duly transmitted to or held for the rightful claimants, the shareholders of the company. It is in this role of oversight and supervision that the attribute of independence assumes its paramount importance.

 Challenges to Board and Director Independence

“Board capture” is arguably the biggest challenge to the exercise of independent judgement by company directors. Individual independence can be compromised in numerous ways: high levels of compensation, recognition in corporate and social circles, loss of office if not compliant, and so on. While this challenge is applicable universally, it is all the more relevant and prevalent in case of controlled companies.

Warren Buffett, the Omaha based Berkshire Hathaway chairman and the practising guru of all that is considered excellent in corporate investment and governance, postulated in one of his famous annual letters to his shareholders (1993): [independent] director power is weakest where there is a controlling shareholder who is also the manager; when disagreements arise between the directors and the management, there is little that a director could do other than to object or in extreme cases, resign. Director power is strongest at the other extreme, where the controlling shareholder does not also act as the manager; in case of serious disagreements, the director can take the case to the controlling shareholder for redress. Problems surface, though, when the controlling shareholder while technically not involved in executive management, de facto seeks, or is seen to exercise that function (as has been alleged in the recent Tata Sons case).

Given that the vast majority of listed companies in India, as noted earlier, qualifies as “controlled” and as such most of the boards (barring a limited few honourable exceptions) would likely be “weak” in governance in terms of independent oversight (as has been observed in several instances ex post, around the world), revisiting the concept may well be an option. That well qualified independent outside directors add value to board deliberations especially in their contributing and counselling roles is an undisputed fact; in fact, most corporate controllers welcome this aspect of the value delivered by such directors, and “what they bring to the table” is an oft-repeated question when a new director nominee is under consideration for appointment. This is where and how, as I have argued elsewhere, invited independence as opposed to imposed independence has worked well. It is the third controlling or surveillance role of independent directors that the controllers find anathema since by definition it exposes and constrains any ulterior plans of self-enrichment they may have at the expense of other absentee shareholders.


III
Coping with Controlled Companies

Controlled companies are here to stay with all their good and not-so-good traits. How could countries reap the undoubted economic benefits that such companies offer and yet attempt to mitigate the ill effects that are apparently inherent in that model? Clearly, the present prescription of inducting independent directors on their boards seems to have yielded less than optimal desired results.

The Best Business Monitors in the Block

Who can best perform the business monitoring function but the people who have a long term vested interest in its success and prosperity? Not without reason had seers and scholars identified self-interest as the strongest driver of success and excellence in performance, although far too often their greed and covetousness are not easy to completely eschew. Research suggests that family owned and controlled enterprises create superior wealth for shareholders principally because of their close managerial control and supervision, improving productivity and reducing avoidable costs; precisely avoiding what Adam Smith, father of modern day capitalism, had perceptively predicted, “negligence and profusion … must always prevail, more or less, in the management of such a company,” if run by agents and not principals. This is underlying source of one of the perennial dilemmas in corporate governance: should the choice be the (family) controlled model with inherent tunnelling potential and weak board governance or the (‘professional’) management controlled model with problematic shorter term business focus and likely high costs and operating inefficiencies and leakages but possibly a strong measure of board governance. Clearly, there will be exceptions within the two stylised categories, but that is what they will be, mere exceptions.

Indispensability of Independent Oversight

Does this mean we do away with independent oversight in controlled companies? Of course not, that will be like throwing the baby with the bathwater. Because of the inherent tunnelling potential in controlled corporations, there is perhaps an even greater need for such objective and unbiased surveillance in such companies.

On the contrary, regulatory requirements on board and director independence and oversight in many European jurisdictions appear to be quite minimal compared to the requirements in a country like India. For example, many of these countries do not even require related party transactions (a key tunnelling instrument) to be reviewed or approved by independent directors (here); it is probably a recognition that outside independent directors in controlled companies cannot possibly do justice to such tasks, given the equations and relationships involved. Many independent directors on audit committees (a mandatory requirement) in Indian listed companies have expressed the near-infeasibility of approving related party transactions since the required information to do justice to the job is nearly always not available to them, dependent as they are on the executive management and controlling shareholders themselves for such information.

One has probably to look beyond the present regulatory framework of independence to find somewhat better solutions. This is what is attempted in the following section.  

Revisiting the Concept of Director Independence

Over time, criteria of independence have been tightened in virtually every jurisdiction around the world, India included. Is there a need to strengthen these further in order to enable directors to exercise their independence of judgement more frequently and appropriately? Perhaps, the scope for such regulatory initiatives is not large barring an odd improvement here and there, as the present requirements are extensive enough. Yes, there are some process-related improvements that could perhaps help the independent voices to be better heard and heeded (here and here, for example). What follows are a few more perspectives that may merit some regulatory attention.

Personal Materiality of Compensation

Let me begin with unequivocally endorsing the view that independent directors ought to be paid an equitable compensation commensurate with the experience and expertise they bring to the company, and having regard to the complexities of the company and the personal risk they undertake in assuming the onerous job on the board. The thrust of discussion here is the potential risk of erosion in independence in case of what might be termed “excessive” compensation, that expression clearly being relative and subjective.

Independent directors, as rational and normal human beings, will be as self-interested as others, but awareness of their fiduciary obligations to the company and its shareholders by virtue of being directors would likely temper and contain their natural inclinations. Thresholds of resistance to temptations of self-interest are however not uniformly cast in stone and it is quite conceivable that they may be breached when confronted by overwhelming circumstances in different cases. A major contributory could be the pecuniary benefits accruing from the directorship and the likely impact of its loss in case of a serious disagreement with the controlling shareholders of the company.  The size of the compensation package (formally approved and otherwise extended) in relation to the individual’s financial status would under such circumstances assume relevance. While absolute figures are important in themselves, the key factor is their relative weightage in the individual’s overall income/wealth scenario. If the offending company’s compensation is only say 1% of the total income of the individual, the chances are foregoing that may not be a big deal and consequently, the director’s threshold level of independence would be higher than if the compensation package was worth say 25% of the individual’s personal income.

Again, following the age-old concepts of consumer’s surplus and laws of diminishing returns, the threshold levels can be higher or lower for different persons and for the same person at different stages of his or her career.   A just-become director may dislike losing the job more than an old hand who had been there and done that. One may also have to weigh possible contagion effects of word-of-mouth reputational loss that might follow earning the unenviable label of being a “difficult” director, a breed not likely to be in great demand from other companies looking for directors.

Among the qualifying criteria of independence, would it be useful to add a condition that a director’s independence status would be breached if the compensation proposed by an appointing company were to be more than say 5% of the invitee’s average annual income over three preceding years? These levels are of course exploratory and open to further fine tuning.

Not too many countries or companies have thought it appropriate to link director compensation with independence apart from general guidelines postulating it should be high enough to attract talent but not so high as to impair their independence of judgement. One company that has walked the talk is Warren Buffett’s Berkshire Hathaway that specifies in their 2016 Corporate Governance Guidelines (here, Art. 8):

“… Director fees are nominal and are limited to immediate compensation. Changes in the form and amount of director compensation are determined by the full Board, taking into consideration the Company’s policy that the fees should be of no consequence to any director serving the Company. …” [Emphasis supplied]

Non-Controlling Shareholders to Elect Independent Directors

Overseeing the actions and inactions of the controlling shareholders with reference to their impact on the interests of (absentee) shareholders and other prescribed stakeholders positions the independent directors often in a confrontational role opposite the controlling shareholders. In such a situation, ends of natural justice may require that the controlling shareholders do not influence the selection and appointment of such directors (somewhat analogous to the accused in a case not being allowed to choose the judge). Would it therefore be advisable to mandate that the independent directors be chosen by a majority of non-controlling shareholders of the company in general meeting? This need not take away the role of the nomination committee and the controlling shareholders still recommending the names of suitable persons for positions of independent directors but the actual voting at the members’ meeting will be limited to the non-controlling shareholders present in person or by valid proxies. The same principle could apply to approvals of such directors’ compensation, their resignation or removal mid-term, and their reappointment.

The principle of some shareholders’ voting rights being restricted under certain circumstances  has already been accepted in many countries, and  in India with interested shareholders in case of related party transactions being excluded from voting on resolutions relating to the relevant contracts. This suggestion of excluding controlling shareholders from voting on resolution electing independent directors may be seen as an extension of the principle.

There will of course be the usual red-alert that this rule may be abused by a recalcitrant minority intent on trouble making, and the oft-cited tyranny-of- the-minority arguments; suitable safeguards may need to be put in place to address these concerns.

Replacing Independent Directors with Board Auditors

A third perspective (not entirely new since some variant or other has been used in Japan and some European countries) is to altogether move away from the concept of independent directors on boards and replace them with a panel of Board Auditors or Governance Auditors who would be entrusted with the task of reviewing board performance from the point of view of regulatory compliance, protection and promotion of interests of absentee shareholder and other prescribed stakeholders, reporting to the absentee shareholders of the company. The position would be akin to the financial auditors of the company in effect assuring absentee shareholders on the veracity and fairness of the financials presented to them (“absentee shareholders” is advisedly used here since the controlling shareholders would already be aware of the financials since they are the ones who prepare them for board review and auditor certification).

In proposing this option, it is not intended to dilute the fiduciary responsibilities of directors nor their duties and obligations. They will continue to exercise their contributing, counselling, and controlling roles in a strictly stewardship sense. It is just that their actions will be reviewed by a peer panel acting as auditors (maybe even concurrently) so that their independent evaluation may offer a satisfactory assurance to the absentee shareholders that their board of directors are duly protecting and promoting their interests.

There would be issues to be addressed with regard to the qualifications, appointment processes, remuneration, and so on. Principally, conflicts of interest of any kind will need to be avoided, and many of the criteria which currently apply to independent directors would also apply to these auditors. One could also think of a term of say three years for these auditors after which there should be a cool-off period of three years before reappointment. Suitable non-disclosure and non-compete covenants would need to be arranged; such auditors’ concurrent or sequential appointment as directors or auditors, or consultants, say for a cool-off period of three years should be prohibited in other organisations competing in material lines of the company’s businesses. These are preliminary thoughts and would need to be deliberated upon more fully before getting finalised.

The panel of board auditors would also be required to be appointed by the non-controlling shareholders of the company in general meeting and report to them. And equally, the board and the controlling shareholders may recommend names but the final appointment would be by a majority of non-controlling shareholders. Panel members will not of course incur any fiduciary obligations since they will not be “directors” in a legal sense.

Since this suggestion would result in a paradigm shift in the scheme of governance generally accepted now, some caution in its introduction may be advisable. For example, this may initially be made applicable only to the largest companies based on their size of revenues, assets, or market capitalisation. Also, during a transition period of say two or three years (at the option of the companies) independent directors on the board and members of the board audit panel may operate in parallel, to ensure smooth changeover.

Would these alternatives be any more effective than the present system in case of controlled companies? I believe they will. Time alone will tell! 
__________________

Helpful comments provided by Senthil Kumar Bommayan are gratefully acknowledged

Sunday, January 29, 2017

Shareholder Primacy in India: So Near and Yet So Far!



Shareholder Primacy in India: So Near and yet So Far![1]

The scholarly debate on primacy among the shareholders, boards and the executive in corporate governance is intellectually as challenging as it is yet inconclusive, although more recent trends around the world would seem to suggest at least a glacial tilt towards shareholders’ supremacy. This note attempts to explore the issue with specific reference to India and its listed corporate universe.

A.    Some Measures Supporting Shareholder Primacy
Indian company law incorporates several measures that aim to establish shareholder primacy over the corporate board and the executive. Some of these (with illustrative comparisons with some developed market jurisdiction) are enumerated below.

Right to Elect and Remunerate Directors
As is quite well known, the fundamental format of the corporation makes it impossible and indeed even undesirable for all shareholders to actively participate in management; instead, shareholders elect a small group of people trusted for their “integrity” and “competence”  as directors  to protect and promote their interests,  guiding and overseeing the executive management and periodically report back on the company’s state of affairs. The directors thus elected incur, consequently, a fiduciary or trusteeship obligation to act in the interests of the company and all its shareholders. The components of this right include choosing fit and proper candidates to act as directors, expecting their independence from operating management so as to promote fair and objective supervision, approving appropriate executive and directorial compensation, and so on. Some of the distinguishing features of Indian company legislation and regulation are undernoted:
·        Directors are to be elected individually and not collectively as a “slate” proposed by incumbent board and management in the United States until recently
·        Director candidates’ profiles are to be circulated to shareholders for assessing suitability
·        Objectivity and independence of at least a third of the board are required by statute (unlike say in the US where the requirement of majority of the board to be independent is prescribed by listing regulations, and “controlled companies” are exempt from the requirement of majority of the board to be independent; additionally, such “controlled companies” are also exempt from independence requirements with regard to their compensation, nomination, and governance committees)
·        Executive compensation is to be approved by the shareholders individually for each whole time director including the managing director (unlike in the US where the Compensation Committee of the board is authorised to finalise and approve such compensation). This US position is undergoing a change in recent times, thanks to the ‘Say in Pay’ movement that sought greater empowerment of shareholders in this matter; as yet, the ‘say in pay’ vote by shareholders is only advisory and not binding on the company unless its management and board choose to act on the advisory votes.
·        Statutory ceilings on non-executive directors’ compensation individually and in the aggregate (not to exceed 1% of net profits of the company if there is a managing director, whole time director or ‘manager” and 3% in any other case)  help to contain such expense within reasonable limits (unlike in the US where no such limitations apply as long as the company’s remuneration policy for directors and certain other details are disclosed to shareholders in the annual report)
·        Prohibition of stock option grants to independent directors is aimed at promoting independence levels (unlike in the US)
·        Statutorily providing for board diversity by mandating at least one woman director on the board (although several  countries in continental Europe and even the UK have, or are fast moving towards, such provisions (with the European Parliament having approved a draft directive to have 40% representation for the under-represented sex on listed company boards in member countries), the US (barring the State of California effective 2016) does not as yet  have any such mandate; companies however are required to report to shareholders whether they consider diversity in board composition and if yes, how they implement it)
·        Statutorily enabling election of a ‘Small Shareholders Director’ to protect their interests (although the idea may be conceptually flawed, since once appointed a director from whichever constituency, the person’s fiduciary obligations extend to the whole company and body of shareholders, not limited to the constituency that elected him or her). There are no  comparable provisions in the US or other developed markets

Right to Protect Holdings Equitably
Shareholders’ rights to peaceably hold, dispose or otherwise deal with their holdings can be vitiated under certain circumstances such as when preferential issues of capital are made to some but not all the shareholders, or when mergers or acquisitions take place, or when there are changes in the ‘control’ of the company, and so on.  Some of the legislative or regulatory provisions in India seeking to protect shareholder interest are undernoted.
·        Fair price discovery methodology mandated based on market prices over a period, in case of offers to buy out shares from holders so inclined to sell (given the relatively small and shallow trading operations may render these mechanisms may be vulnerable to manipulation by vested interests but if they succeed even to a limited extent, they would be welcome) 
·        Mandatory offer to buy up to some prescribed percentage shares  from willing shareholders in case of acquisitions and/or change of ‘control’ of the company
·        In the event of ninety percent of the capital having been acquired by the majority shareholders, the remaining ten percent shareholders can be squeezed out whether or not they wish to sell their holdings. Law provides for fair and reasonable price to be paid to the concerned shareholders

Right to Credible and Comprehensive Feedback
·        Entitlement to receive annually detailed financials and reports of directors. Disclosure requirements in India are probably the most comprehensive among comparable and developed markets
·        Right to appoint independent statutory auditors vested in shareholders at their annual general meetings, unlike many other jurisdictions where the audit committee of the board decides on the appointment and remuneration of such auditors. Auditor independence criteria and rotation are other topics statutorily covered in India
·        All subsidiary company accounts and financials need to be audited individually and summary results made available to the shareholders of the holding company, with full audited accounts being made available on holding company web sites  (unlike in jurisdictions such as the US where unlisted subsidiaries’ accounts need not be audited separately or made available to holding company shareholders)

Right to Protect and Determine Business Purpose, Continuity, and Solvency
·        Restriction on the powers of the board in respect of selling, leasing, or otherwise disposing of the whole or substantially the whole of the undertakings of the company
·        Restriction on borrowings aimed at preventing undue financing risk of the company without specific shareholder concurrence by a super majority for borrowings beyond the aggregate of the company’s paid up share capital and free reserves y
·        Restrictions and disclosure of contributions to political parties
·        Contributions in excess of prescribed limits, to charitable and other funds to be approved by shareholders
·       Modifications in the objects clause in the charter documents may not be made except with the approval of shareholders by a special (super majority) resolution through postal ballot (to provide for widest possible access to all shareholders). Companies with unspent money from an IPO are also required to offer an exit option to dissenting shareholders

Right to Agitate against Oppression and Mismanagement
·        Eligible shareholders (at least 100 in number, or at least 10% of the total number of shareholders, or holders of at least 10% of the issued share capital including preference capital if any) may seek legal redress in case of alleged oppression of shareholders or mismanagement of the company, prejudicially impacting the interests of the company or its shareholders
·        Central government has been vested with powers to carry out inspections and investigations on the basis of a special resolution of the shareholders or a report from the Registrar of Companies, or in public interest. Similarly, government’s Serious Fraud Investigation Office is also empowered to undertake investigations in appropriate cases.

Right to Reasonable Protection from Tunnelling
·        A common method of unfair expropriation of shareholder wealth by controlling shareholders is through related party transactions favouring the controlling shareholders at the expense of other absentee shareholders. By prohibiting such shareholders from exercising their votes supporting resolutions on such transactions at shareholders’ meetings, interests of shareholders not in operational control are safeguarded since only they can by a majority approve or reject such transactions
·        Audit committees are required to review and approve or reject all related party transactions; although this requirement imposes a very onerous responsibility on audit committee members, it provides a valuable oversight mechanism to filter out abusive related party transactions, protecting other absentee shareholders’ interests

B.    Shareholder Primacy in India: Fact and Fiction
While these and other such measures clearly indicate legislative intent of protecting and promoting shareholder primacy in key areas of company governance, whether these translate in to reality is a moot question. There are several reasons why these measures are rarely utilised optimally to their full potential, some of which are undernoted.

Attendance and Voting at Members’ Meetings
·        In general, votes are exercised at members’ meetings in person, or by proxies present at the meeting. Attendance at such meetings thus assumes great significance. Traditionally, only a fraction of the shareholder population takes the trouble of attending meetings, either because their miniscule holdings do not merit or justify the time and effort involved  or simply they do not have the expertise to meaningfully participate in such meetings.
·        To incentivise attendance (as well as to minimise and manage any potential shareholder hostility), companies have often offered some freebies but even in such cases, it is not unusual for many shareholders to collect the freebies and depart without participating in the proceedings, or just be mute spectators.
·        To obviate this deficiency at least in respect of key resolutions coming up for approval, a system of postal/electronic ballot has been introduced for some years but even this appears to have had limited success due to continuing retail shareholder indifference; but a regulatory mandate covering mutual funds (but not other institutional investors as yet) regarding disclosure of voting details with reference to their investee companies has led to a significant increase in their voting participation. 

Investors Apathy and Impact of Crony Capitalism
·        Many institutional investors, especially in the foreign institutions category, believe their relatively small holdings (in their overall portfolio) in the companies do not justify the cost of monitoring and evaluation of governance practices, and participation in voting. To some extent, emergence of proxy advisory firms appears to have persuaded at least some of them to more actively participate in members’ meetings in recent years. Blatant breach of basic governance norms of course do attract their intervention (as in the case of Satyam Computers and Steel Authority of India, to mention a few) but even then, the time consuming and costly processes of navigating such interventions through the Indian judicial system often act as major deterrents to 
·        Large domestic institutional investors largely are owned or controlled by the State and hence their voting decisions are as often as not likely to be influenced by political compulsions of the incumbent government. Traditionally, business and government nexus or crony capitalism has worked to their mutual advantage both in the field of policy making and in operational facilitation (here). As a general rule, governments of the day in India have tended not to upset incumbent managements of companies (as for example, in the case of (now Lord) Swraj Paul’s unsuccessful attempts to take over DCM and Escorts, two of India’s vintage companies in the nineteen eighties). Manifestation of this basic policy of calculated non-interference usually takes the form of such institutions abstaining from participating in meetings or voting on key resolutions, paving the way for incumbent management or the “establishment” to cope with any serious challenge

                                                                                                                                
C.    Strengthening Shareholder Primacy
Maintaining a tenuous equilibrium of constructive tension among shareholders, boards of directors, the executive and the controllers is an important mechanism for establishing good governance in companies. Any effort to further strengthen the level of good governance will need to address both the inhibitors and the intent-practice gaps in the governance structures. Following are some areas where further scope for improvement likely exists.

Enhancing Institutional Investor Participation in Company Governance
Institutional investors do have their accountability and trusteeship obligations to their own stakeholders and in that context likely owe it to them to actively participate in their investee companies’ governance processes to contain governance risk premiums such companies’ securities suffer. The Stewardship Code dealing with such institutional investors may be revisited to explore further strengthening of its provisions to promote greater investor participation in such matters.

 Enabling Independent Directors towards Enhanced Contribution
Having introduced the undoubtedly valuable institution of independent directors in board governance, it is probably opportune now to take some further legislative initiatives to strengthen the voice of independence at the board level (here) Following are some of the measures that may help in that direction.
·        Certain key proposals and decisions to require affirmative approval of a majority of all independent directors (whether or not present or participating)
·        Quorum requirements for board and committee meetings to require the presence of a majority of the independent membership of the board or the committees. The newly introduced requirement of presence of at least one independent director at board meetings is a good beginning but its utility is likely limited since it applies only to board meetings called at short notice.

Countervailing Controlling Shareholders’ Inappropriate Governance
Board and director “capture” is a well-established phenomenon that impairs good governance; to shield the institution of independent directors from the debilitating effects of such practices, some structural reforms may be necessary in countries like India where concentrated corporate ownership and dominant control are the rule rather than the exception. Following are some of the measures may help in this direction.
·        Recommendations of the nomination committee for induction of new independent directors to be approved by a majority of only the independent directors on the board (whether or not present and participating) for tabling at shareholders’ meetings
·        Resolutions electing new independent directors at shareholders’ meetings to be approved by a majority only of shareholders not in operational control, with controlling shareholders not participating in the voting (such a restriction on voting rights has already been accepted in principle in case of related party transactions). This measure is justified on the basis that one of the major role of independent directors is to monitor executive performance to ensure wealth is created and created wealth is passed on to (or held for) all the shareholders of the company; in electing such directors with a surveillance role over the executive, it is not unreasonable to disempower  shareholders in management whose activities are to be so supervised, from voting and influencing the  election of such independent directors
·        Independent directors “resigning” mid-term during their tenure to be required to explain the reasons for their decision to the shareholders at an immediately following members’ meeting for approval by a majority only of non-controlling shareholders. Barring extenuating personal circumstances, such “resigning” directors may also be required to be present at the members’ meeting and respond to any questions from the non-controlling shareholders.

Pretty much the same reasoning also applies to the appointment of independent statutory auditors whose role by definition is to objectively examine the affairs of the company and report to shareholders on the true and fair status of the financials. Accordingly, it would not be unfair to require that their appointment at the general meeting of members is approved by a majority of non-controlling shareholders, with the controlling shareholders’ votes not being reckoned. Auditors’ resignations or proposals for their replacement may also similarly be required to be subject to approval of the majority of non-controlling shareholders, with such auditors being required to explain their viewpoint to them.

D.   Towards Better Governance in a World of Concentrated Corporate Ownership
It is apparent from this discussion Indian corporate law leans towards protecting and promoting shareholder primacy even while recognising other stakeholder interests and  offering substantial freedom to the boards and the executive to carry out their responsibilities. The sting in the tail however is that many of these wholesome provisions are frustrated partly out of non-controlling shareholders’ own indifference and partly by gaps in measures aimed at containing self-serving controlling shareholders in pursuit of their illicit objectives. Of course, there will be, and indeed are, examples of excellence even now of controlling shareholders with exemplary concern and behaviour towards absentee shareholders and their interests but regrettably they are relatively a small proportion of the total corporate population. This paper has enumerated some of the measures that may help to bridge these gaps and take the country closer to better standards of governance in the corporate sector.   

As a general rule excessive and invasive legislation is not a preferred option in a free market economy and it would be ever more desirable if corporations were to adopt such measures on their own and distinguish themselves from the rest. Sadly, experience in most countries has shown that corporations tend to respond to mandates than exhortations. Affirmative action in respect of having due share of women on corporate boards is a telling instance of legislation over persuasion being the more effective method of achieving objectives as observed in continental Europe and the UK in recent decades. Nevertheless,  the recommended measures may, perhaps, first be introduced on a “comply or explain” basis and depending upon the level of observed compliance in practice over a two or three year period, and be made mandatory if found necessary.



[1] Assistance provided by Jitendra Nath Gupta and Stakeholder Empowerment Services is gratefully acknowledged