Independent Directors: Codified? Part 1
If the Companies Bill 2009 keeps itís date with parliament this budget session, not only will it herald a new legislative framework for enterprise but it may also usher in a new era of corporate governance in Indiaís promoter led business environment. One in which good governance is not just encouraged through voluntary guidelines but mandated by law.
PARLIAMENTARY STANDING COMMITTEE REPORT
ĎMany brush aside the Satyam episode as a one-off-case. However, this episode needs to be seen as a watershed event for the institution of Independent Directors. It is a moot point that such a huge scam could be perpetrated, and that too for several years, under the eyes of some of the most reputed and competent persons serving its Board as Independent Directors. It has raised questions that even highly qualified persons may not provide any insurance for corporate governance, as they tend to trust and provide blind support to the promoters.'
With the Satyam fraud still fresh in memory, the Parliamentary Standing Committee, after scrutinizing the Bill, recommended that it incorporate a code for independent directors Ė a code that will lay down their mode of appointment, role and responsibilities, remuneration and extent of liability.
World over the definition of independence and an independent directorís role & responsibilities are the subject matter of Listing Rules & Company Law. But remuneration, tenure and principles of governance are either left to shareholder vote or comply or explain regimes. But India is different- dominated by promoter owned & managed businesses. And so do we also go the comply or explain way or is the Parliamentary Standing Committee right in suggesting legislative action?
Will this Satyam led approach lead to reactive legislation that will improve governance standards or make the burden of compliance too heavy to bear? To debate that I have with me on the first of this special series Bharat Doshi, Executive Director at Mahindra & Mahindra, Rakesh Khanna, who was former Country Head with Warburg Pincus and now setting up his own fund-Arka Capital Advisors and Cyril Shroff, Managing Partner at Amarchand Mangaldas. You will also hear, through the course of this show, the views of Adam Emmerich, Senior Partner, Wachtell Lipton who I spoke with earlier to this discussion.
Below is a verbatim transcript of the interview. Also watch the video.
Menaka: On this discussion of Independent Directors and whether we need a Code and starting with you (Rajesh) because you represent two constituencies on this panel- that of private equity and hence investor and of Independent Director which is the role you play now on several Boards. Do you believe that this legislation is too reactive to one situation that of Satyam?
Khanna: Yes, I do think it is a bit reactive. In my mind, independence is a state of mind and you cannot legislate beyond a point and true Independent Directors can add a lot of value to the companies but the last thing I want is to have a Code which either shrinks the pool of Independent Directors or prevents people from wanting to be an Independent Director on companies.
Menaka: If I may take that further, why do you think that this may in fact shrink the pool or discourage people from wanting to be Independent Directors? Is it because it attempts to legislate something that should either be left in the realm of guidelines and voluntary compliance?
Khanna: That is one and for example it mandates how you should define Independent Director. I believe that there are broader ways of doing it than what is currently envisaged in the Code- there are limited tenures, there is a concept of a panel of Independent Directors as against leaving companies free to do what they want and in my mind, you should encourage transparency for companies to give rational for what they do and let the public market decide what is right and there are numerous situations where public companies trade at massive discounts to best in class companies based on the performance on various parameters including corporate governance and in my mind thatís the best way to make sure companies do right things.
Menaka: Do markets truly, in India, give companies a premium for good governance?
Khanna: Definitely they do.
Menaka: Genuinely, you actually do believe that?
Khanna: Yes and there are many examples across sectors where they do that.
Menaka: So do you think that this represents, this Parliamentary Standing Committee Report, the Companies Bill and ultimately what will become law, too much government in governance?
Doshi: Thatís right, ultimately a company is all about corporate democracy, the shareholder democracy and here suddenly you start getting into a checklist based approach instead of what I call looking at what is the trait of independence like. When you have people with great reputation, they are there for the professional pride; they are not on the board because they want to be on a board of the company.
Menaka: Are you speaking only from the perspective of M&M because do you believe that description addresses the vast majority of Independent Directors in this country or more likely the Directors of high calibre that you have on the M&M board or maybe some select blue chip companies?
Doshi: First of all, of course I will have respect for my board because I have observed them. On the other hand, I myself am biased person because I am, as an Independent Director and Chairman of the Audit Committee of a very reputed company, so my personal experience is to what an Independent Director can contribute- this is very important. What is lost, where the sense is lost here in terms of regulations of how many years or in terms of how that Independent Directorís relationship is or friendship is or is he really Ė many of you must have read Six degrees of separation. You try to find out any two people will be connected within Six degree.
The point which I am trying to make here that independence is the state of mind and what they can contribute. I must say at the outset that donít just look at the Independent Director as a policeman on the board. He is not just a policeman. When a strategy of a company is being constructed, you need, what I call, a constructive tension. You need that kind of constructive challenge. I am not talking about obstructive nature of the Independent Directorís behaviour. I am talking about constructive.
Menaka: Doesnít he also act as a policeman for representing the minority interest because we are in an environment dominated by family-owned businesses?
Doshi: That is what I am coming to. That is one role which is what he does as an Independent Director in terms of bringing in a fresh view, a fresh set of thinking, the sounding board. The second view is, of course, when he is there, he cannot tolerate anything which does not fall with the known concepts of corporate governance. Here on the known concepts of corporate governance, I want to underline that it is something where I respect principle based legislation rather than thinking about a checklist which I have to tick.
Menaka: Principle-based governance; state of mind is what independence is. It all describes the utopia that maybe India isnít and I am not discounting what Rajesh said about governmentís premiums but we do not have the bottom-up approach in this country. Maybe Rajesh and some private equity firms in the country speak up but they often do so only in the confines of the boardroom and that is the case with several other institutional investors who tend to be mute spectators on board. When that bottom-up is not available, then itís got to be a top down. If itís got to be a top down, then do we live with the fact that we need to move from guidelines to legislated governance or is that going the other extreme. Where do you stand on this?
Shroff: Let me approach from a slightly different angle and let me elaborate on three things which Bharat mentioned. He mentioned independence as a state of mind which is essentially an unconflicted approach, if I can over simplify that a bit. Second, he mentioned expertise that an Independent Director brings the level of expertise and the third thing was a fresh look because the management is perhaps too close to many decisions and situations or projects. So an Independent Director, being a little distant from the day-to-day decision making, can ask questions which sometime, when you are too close to a situation, it either doesnít strike you or you donít have the breadth of experience to ask all of that and these are all three valuable inputs which a director can bring but the concept of an Independent Director that is now sought to be legislated only deals with the first one. It deals with independence as unconflicted state whether itís because of pecuniary interest or lack of personal conflicts or things of that nature.
The latter two, by their very nature, are state of mind and I think we have therefore started off on a wrong foot by itself, which is choosing just one of the criteria for the basis of having a better board which will provide a better governance and thatís where the rest of the discussion probably starts off with a very limited approach. Do we want Independent Directors because they are unconflicted and are therefore more likely to ask all the other questions, which I think is a conceptual fallacy to start with.
Menaka: How do you bring objectivity in decision-making into a definition? For instance, if one of the things as you pointed out an Independent Director is suppose to provide to a board, is some amount of objectivity which the management lacks- it is very difficult to include that in a legal definition so to speak, right?
Shroff: Let me give an example. Banking sector- the Banking Regulation Act that RBI approves the Director. The Act itself provides for you shall have experience in law, finance whatever it is, there is a set of eight or nine criteria. So an expert director is something which is recognised. I know itís very difficult in general corporate India to bring in the concept that expertise is your ticket to the board. The only ticket to the board for the independent category is that you are not ďdependentĒ which I think is a fallacy. The second fallacy in India is that we are dealing with the wrong agency conflict in terms of selection of the definition of independence.
We are borrowing a Western concept of independence which is fundamentally based upon a conflict with the management and those laws are evolved in an environment where there are dispersed shareholders, institutional shareholders and therefore these definitions of independent- whether in US law, the US listing agreement or even in Europe- were based upon essentially trying to protect the minority from the management in control. In India that is not the real conflict. I think the real conflict is the majority minority conflict and there is very little legislation if any or even thinking as yet on trying to deal with that conflict. So we are treating the wrong malady
Emmerich: When Standard Oil Company first added ĎNEí outside directors in 1966, they actually had, before that time, an entirely inside board management. It was noted in the New York Times that this addition of non-management directors, non-employee directors would require a change in the then practice of the group of having a daily board meeting at 11am.
Today virtually all public companies in the US have not only a majority but a overwhelming majority of non-management outside directors and this got its start not with the addition of any outside directors but during the takeover battle that so characterized the 1980s and the increase and the creation, if you will, of shareholder activism during that time and what shareholder activist said is we will no longer satisfy with the so called Wall Street rule, which was to sell a share, to sell your shares your investments in the company if you werenít satisfied with management; rather an engagement by shareholders with management to say, we would like something different to be done here. In 1950s, 90% of shares were held by individuals.
Today 30%; let us say in many companies 70-80-90% of shares are held by institutions. So with the aggregation of power in institutional hands, those shareholders said we want a direct voice, we are able to speak collectively and we want a direct voice in management and in the affairs of a corporation.
Shroff: We are borrowing a western concept of independence, which is fundamentally based upon a conflict that the management and those laws have evolved in an environment where there are dispersed shareholders, institutional shareholders and therefore these definitions of independent- whether in the US law, the US listing agreement or even in Europe- were based upon essentially trying to protect the minority from the management in control. In India that is not the real conflict. I think the real conflict is the majority-minority conflict and there is very little legislation if any or even thinking as yet on trying to deal with that conflict. So we are treating the wrong malady.
Menaka: In fact, doesnít that strengthen the case for maybe a legislated approach to governance and the reason why I am saying that is because the dice is loaded against minority investors in this country because the majority owns the company as well as manages the company as opposed to in the US where you will have dispersed shareholding and the management doesnít necessary own the company.
Shroff: The owner-manager distinction is much clearer.
Menaka: Yes, so in this case the dice is loaded against minority investors and therefore itís for independent directors to ensure that all shareholders or stakeholders are treated equally; then maybe we do need a top-down approach, would you agree with that?
Shroff: A legislated approach is not a problem by itself. I donít have a quarrel with that. I might have a quarrel with do you need to legislate the definition of independence, can it be something which should be put prescribed in an Act of Parliament or should it be there in some other instrument; I think those are separate questions. I agree with the notion of a top-down approach because in India generally that works but it could be a more principle based rather than a more prescriptive rule-based, hard-wired- into-legislation approach.
Doshi: That was the point I was making and I fully agree with him on that portion that of course the independent director here, besides playing the role which I mentioned in the previous question which was the constructive tension and strategy aspect of it. Here the independent director plays the role of the arbiter. He plays the role that here is an issue where there could be a conflict and is there the right decision for the management to take or the majority to take or will it affect the minority. I would definitely ask Mr Khanna that as a private equity holder if he sees that on the board there are independent directors of repute and if he does not get a board seat, you will still consider that this investment is worthwhile and is protected because the way the role will be played by those independent directors.
Khanna: I agree a lot with what Mr Doshi says and little less with some other points that Cyril made which is I believe that beyond a point regulations do not have much of value. There are ways out of every regulation.
Shroff: In fact I agree that they should not be very prescriptive.
Khanna: You cannot be prescriptive on what independence means. Just because you donít pay money to somebody- whether it is commission or it is ESOPs- does not necessarily make the person independent.
Menaka: You cannot play this state of mind Ė how do you define a state of mind?
Khanna: All I am saying is that we are assuming the minority shareholders are fools and they donít know what is happening. The beauty about India is people get to know what is happening and I come back to my point on information does flow out.
Menaka: Sometimes too late. I am not saying they are fools but sometimes they donít get to know what is happening till it is too late.
Khanna: But none of what is in the court will make it come out sooner. So just because you donít give ESOPs to somebody and no commission to somebody and the person is a true independent director doesnít make sure that bad news comes out early.
Menaka: It doesnít make sure but does it reduce the chances of promoter managements appointing Ďbuddiesí on board that they may have relationships with or are related to and therefore those Ďbuddiesí then donít play the role of constructive tension as Mr Doshi is pointing out.
Khanna: I have been on several boards, listed and unlisted. If an entrepreneur wants to bring in buddies, he can bring in buddies and not pay them any money and they are still called independent directors and to Mr Shroffís point, even if you legislate expertise in whatever shape or form, any entrepreneur can get as many people as he wants who are independent. So in my mind the key thing is what is the attitude and state of mind of the management team or the MD or the CEO as to who they bring in and do they genuinely want, what Mr Doshi refers to as constructive tension or a strategic sounding board, by people who think independently or do they want people who agree to what they say without wasting too much time. That is a key determinant and which cannot be legislated.
Menaka: Your experience has been wholly good. My off the record understanding of Corporate India has been mostly bad. Without even putting the stories on air, all the conversations I have with either with Independent directors or sometimes management which speaks with great disregard for their directors on board or their contribution. I don't seem to believe or agree with this fact the leave it up to the managements, the boards and ultimately investors to push it through
Doshi: In that way, one definitely respects the process of the nomination committee.
Menaka: It is not even mandated in this country to have a nomination committee. In many countries, it is mandated to have a nomination committee that is either sort of manned by independent directors or fully manned; we don't even have one in this country.
Doshi: The whole idea of the buddy thing which you underlined let me tell you that people who come on the board, if they have professional pride, if they are people with integrity, they are not going to sacrifice their pride and integrity, they are not going to sacrifice their reputation, for the purpose of being on some board. That is not the attraction for them.
Menaka: So this is M&M and Rajesh Khanna speaking having spent several years with the blue chip private equity firm and will now continue to build another new one. Mr Shroff, you have a wider experience of Corporate India, do you agree with what I am saying, because you have dealt with dozens of promoters?
Doshi: He is independent here on this panel, to bring in the width of experience, and the expertise.
Shroff: I am bit more cynical, probably closer to your perspective and I think a more fundamental question is that the whole discussion pre-supposes that independent directors are the panacea for governance. I think you started off even with quoting that report, quoting that paragraph, which almost blames the independent directors for the Satyam scandal which I think is a complete misnomer. At the end of the day there is only that much that the Independent Directors can do. So independent directors are an instrument of ensuring good governance, I think we should put their importance and their ability to do and the expectations from them in perspective.
You cannot treat them as the primary tool for ensuring good governance. Actually a whole lot more than can and will be far more effective would be including, say for instance, how institutional investors should be sort of dealt with; what are the legal redressal mechanisms, the role of the media. These are actually more powerful instruments than simply independent directors. So this whole discussion is highly overstated. The whole emphasis in the new proposed Bill on Independent Directors and treating it as if we create this category, we legislate it, we prescribe a code for governance for them and everything will be alright with Corporate India, that assumption is completely flawed.
Menaka: I agree with you in many parts though I don't think they are trying to say everything will be alright but they are hoping that things will be better, but we will question that as we discuss what that code should be, how do we define several things.
Shroff: First thing, why should there be a code and why should there be even two categories of directors?
Menaka: First we will give optimistic, Rajesh Khanna a chance to answer this one.
Khanna: I will be optimistic; see think about it, what are we trying to protect? We are trying to protect minority shareholders.
Shroff: The role of a director is not simply to protect a minority; it is to advice the management
Menaka: I would also broaden the minority shareholder; can we say it is to represent all stakeholders, because I think increasingly community, environment- those are things that company boards will have to take into account whilst making decision; so just expand that minority to all stakeholders.
Khanna: I agree with that. So on the stakeholder point, there are many companies which cannot get funding, or cannot attract high quality independent directors, and because of the nature of their governance practices or the management practices or they desire to have buddies who act as rubber stamp boards. So, the expectation would be, that stakeholders would look at companies' boards and based on that determine, whether it is a company which is attractive or not in their perspective.
The second point I am going to make is, which you alluded to and even Bharat, I really think lot of our time is going into stakeholder protection role of an independent director, frankly the most important role is what Bharat very correctly said, which is helping management teams come up with better quality decisions. Broad strategic issues- could be succession, it could be growth, it could be diversification, not because management doesnít know what is the right thing to do but very often having people who understand the business well, but are not involved in the day-to-day affairs can offer a different perspective which is for the management teams to decide whether they would like to agree or not but it is very useful to have.
Menaka: I get what all of you are saying, but I am going to point out one more flow which may be feeds into your argument and that is that, yes we should not be building this edifice of corporate governance in this country on the back of independent directors; but where this may have come from because one- institutional investors, with the exception of few, are relatively almost quiet or mute. Second because the threshold or the ability to go public in India is so easy. So we got to build processes or build rules and regulations not just for the Mahindra and Mahindra's of the world, we got to go beyond that.
Khanna: But the code will not have that.
Menaka: Because the code only talks about the Satyams of the world. I am saying we got to come to a middle path in some fashion.
Khanna: But because we have directors who get no monitory benefits on the companies concerned, does not ensure all the things you are looking to ensure.
Shroff: In fact you might create the reverse incentive. From independent directors, it might equate them to disinterested directors.
Doshi: This is not what you want.