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.