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! 
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Helpful comments provided by Senthil Kumar Bommayan are gratefully acknowledged