Appointment of independent directors necessary for improved corporate governance – The Economic Times


Are we better off in terms of corporate governance than we were a decade or two ago? If yes, how come we have so many corporate disasters from time to time? How do corporate bosses walk away with obscene packages even when their companies have not done well? Why are ordinary shareholders not able to make themselves heard? These are questions that demand responses. That is why the consultative paper on corporate governance issued by Sebi recently is welcome. We must hope that if corporate governance keeps evolving, we will eventually get somewhere.

The Sebi paper has many proposals, some of which align the requirements under Clause 49 of the listing agreement with those of the Companies Bill, now awaiting enactment. These include: mandating an upper limit for the tenure of independent directors, limiting the number of directorships an individual can hold, making whistle-blower mechanisms compulsory, norms for succession planning and so on. These are all useful at the margin. And yet, in the aggregate, they seem inadequate because they fail to address the central issue, namely, the appointment of independent directors. Corporate governance is about ensuring accountability of management to shareholders and to society at large. There are two instruments for doing so, the board of directors and the market for corporate control (takeovers).

The latter is politically fraught everywhere, so we have to perforce fall back on the former. The big change in recent decades has been the mandatory appointment of independent directors. If corporate governance is still unsatisfactory, it is because the mechanism of independent directors is not effective enough. Lack of boardroom diversity, the absence of succession planning, overgenerous packages for top management, poor risk management — such problems have to do with how independent directors are appointed.

Fix this and you make a big difference. Independent directors are expected to act independently of management. They are expected to ask tough questions. They are expected to take tough decisions, including the removal of the CEO where necessary. In practice, very little of this happens. Why? Because the so-called independent directors are beholden to management for their appointment. They are taken care of through handsome fees and commissions. In some cases, they are brazen enough to earn lucrative consulting fees from the very companies they are supposed to watch over. They are content, therefore, to nod their heads to whatever management wants done. There is another aspect of the mechanism of independent directors that is troubling. Many independent directors are retired bureaucrats, regulators or bankers who have had dealings with companies.

The directorship is a reward for services done when these people were in office. Knowing that they can expect future rewards can influence the decisions of public officials. Not only is the independent directorship an ineffective check on management, it has had the perverse effect of subverting the public interest. How independent directors are appointed is, therefore, the central issue in corporate governance today. We need to get right our understanding of who an independent director is. An independent director is whoever is independent of management, including promoters. If this is accepted, it should be obvious that one reform is vital: not more than 50% of independent directors should be appointed by management. The rest should be appointed by other interest groups, such as minority shareholders, employees and institutional shareholders.

The Sebi paper proposes that, in companies that exceed a certain market capitalisation, minority shareholders should have at least one representative on the board. This is fine. But the paper also says that nominees of institutions would not be regarded as independent directors. This is hard to comprehend. The interests of institutional investors in equity do not, in general, differ from those of ordinary ones: institutional interests invest on behalf of ordinary investors. Getting their nominees on board is crucial to securing board independence. Private equity investors insist on placing their nominees on boards and this is seen to deliver results.

How to compensate independent directors is a vexed issue. Pay too little, and you may not get the right people. Pay too much, and you compromise independence. But this issue gets mitigated when we resolve the selection of independent directors. If 50% of them will come in as appointees of non-management interests (employees, institutions and minority shareholders), then management does not call the tune, no matter how well independent directors are paid. The problem of boardroom diversity is also addressed because you no longer have all independent directors from a cosy club of corporate executives and retired bureaucrats. So, the nexus between the corporate world and serving bureaucrats is loosened when management is restricted in selecting independent directors.

Once independent directors start asserting themselves, management will be less able to perpetuate itself or pay itself whatever it likes. Whichever way you look at it, management selecting all independent directors is the nub of the issue. Why it has still not been addressed is in itself a comment on how serious the efforts to overhaul corporate governance are.

via Appointment of independent directors necessary for improved corporate governance – The Economic Times.

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