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
