The spirit of independence remains unaddressed

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In law and theory company directors are stewards of the interests of all shareholders. To help inculcate and protect the spirit of independence of independent directors in practice was rightly positioned at the top of the Securities and Exchange Board of India’s (Sebi’s) mandate to the Uday Kotak Committee on Corporate Governance. It is on this fundamental matter that the committee’s recommendations would have had profound positive impact with consequences for making more robust the future growth of corporate India and arguably the broader economy. While the committee has made several praiseworthy and purposeful recommendations in areas of audit, related-party transactions, skills and strategy and responsibilities for independent directors, it has side-stepped this golden opportunity to materially strengthen the institution of independent directors.

As is well known, Indian public securities markets are dominated by companies where controlling shareholders wield control through dominant representation on the board and/or key executive functions. Skin in the game and alignment of interests are valued by any investor. Yet, such control is also subject to risks of private rent-seeking and enrichment at the cost of other shareholders.

A major supervisory role of independent directors was to help contain this risk. Successive reforms have placed great responsibilities on the institution of independent directors, for instance by requiring their representation on boards, key committees, oversight of related-party transactions and so forth. The Kotak Committee’s recommendations have added to them. In practice, however, the stated intent of these reforms are undermined by controlling shareholders’ ability to dominate or determine outright matters related to identification, nomination, election, re-election, and dismissal of these directors (and sometimes their prospects elsewhere). In effect, the dependence of the monitors on those who are to be monitored intrinsically inhibits the freedom to do so. The committee has left this materially untouched.

Few, if any, comparable markets—that are dominated by controlled companies and of this size—have truly managed this effectively. Yet lessons from recent crises, current circumstances and the promising multi-decadal prospects for the Indian economy present urgent and the strongest arguments to yet make more meaningful governance reform.

The Indian market is in the midst of an unprecedented and deliberate shift in the level of its citizens’ savings being entrusted to equity-linked mutual fund, insurance, and pension products. Mobilization of these savings is the first and easier part; its sustenance will hinge on trust and quality of governance that safeguards their capital. Domestic institutional investors will be asked to exercise greater stewardship as recommended by codes and other means—but the inability to genuinely hold boards accountable through the instruments available can render those efforts somewhat toothless. The non-performing asset and twin balance sheet problems that hobble the economy have origins in normal misjudgments of risk that boards and managements may make but these are compounded when accompanied by deficient governance and oversight.

A continuation of such broad-based governance failure will hurt India’s growth story. Technology disruptions underway will reshape several industries globally and in India. Companies whose boards are stacked with directors where loyalty is their principal and over-riding credential have arguably lower chances of emerging winners through this transition. As they grow over the next decade, companies belonging to many Indian corporate houses may also see the inevitable dilution of the controlling shareholding. This will result in efforts by some to cling on to management and control, when however their own interests and those of other shareholders would be better served by resorting to responsible and vigilant ownership through their shareholding, leaving the boards and management in the hands of competent professionals. For these reasons and more, corporate governance and the institution of independent directors must be unfettered to serve to their intended potential.

Requiring that independent director elections and dismissals be approved by a majority of non-controlling shareholders (not just those voting at meetings) would go a long way toward releasing independent directors from any moral obligation towards controlling shareholders as their benefactors and also secure them against unreasonable dismissals. There is regulatory precedent for this in related-party transaction resolutions. To preclude incipient rifts and formation of factions on the board, controlling shareholders may retain their role in director identification and nomination. While no model is foolproof, this would create circumstances for accountability to both controlling and non-controlling shareholders. Ultimately, any rejection of an independent director candidate by a diverse group of non-controlling investors will only be exercised where there is reasonably clear evidence and conviction of a candidate’s dubious credentials, incompetence or compromised independence.

This change will usher in genuine and overdue engagement between investors and the boards that are stewards of their capital. It would also hold investors, particularly the institutional variety, accountable for the manner in which their shareholder rights are exercised. Responsibilities for negative governance-related outcomes would then also be a reflection of their own stewardship failure rather than helplessness.

Controlled companies that are confident in their governance standards and the independence of their directors should welcome this model or, at the least not shy away from such a change. To be fair, corporate India has many world-class independent directors who demonstrate genuine independence even without such protection; this change would only increase their number by bringing in more to their fold assured by such protection.

This change may be introduced progressively starting with the largest companies, allowing more preparation for smaller firms.

It is not a time for half measures. This is an opportunity for Indian leadership and original thinking; not just for the sake of it, but because it is needed.

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