Independent Directors: Codified? Part 2
This is a special series on the Parliamentary Standing Committee's recommendation of a Code for Independent Directors in the Companies Bill 2009.
Should the law create two classes of Directors and can a Code protect against real conflicts of interest i.e. related party transactions.
India's Companies Act, 1956 recognises Executive and Non-Executive Directors. The concept of Independent Directors was introduced, defined and regulated by SEBI in its listing agreement.
The Companies Bill, 2009 is the first attempt to legislate the definition, role and responsibility, tenure, remuneration and liability of an Independent Director.
Joining us in the second part of this Independent Director 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.
Shroff: Except for certain purposes for public markets, why should you create a concept in the Companies Act of Independent Directors and not- Independent Directors because you are implicitly thereby setting a different set of rights, obligations, and expectations from these two polls. So you are creating a sort of Brahmin class and a Kshatriya class in the company which necessarily means that their roles and responsibilities, in relation to the enterprise, are different. Then you will have to get into the question of if the roles and responsibilities are different, are their powers any different and are their liabilities any different. So, you have created effectively a two tier system which is not consistently thought through and which might actually carry consequences that for certain purposes they are the same and for certain other purposes they are not.
So what are you going to make a Code for? Is it really a Code for regulating best practice, is it a Code for how the appointment, remuneration that mechanism is going to work which was otherwise there in the listing agreement in the definition of independence or talking of a nominations committee.
So I donít think Code should equate to the mechanics of how Independence is defined and how people are brought on board. That is mechanical appointment related process. If the Code is about how they are going to behave, you will then necessarily have to get into the question of how should the Kshatriyas behave and how should the Brahmins behave and what is expected. One is only going to do puja and the other is going to go and fight in the field. And what the rules of the game are. You have to deal with that.
Doshi: First of all there is one major distinction between a set of Executive Directors or Managing Directors who spend their entire time on the company versus an Independent Director who brings his knowledge, his expertise but he cannot spend more than seven-eight days in a year or ten days in a year on the companyís operation. So the knowledge base and the responsibility base is therefore different. So, while there is, what I call, two circles- they are overlapping circles- there is a certain aspect where their liability or their responsibility would be same but there are various other aspects where the liability of the Executive management would be much greater. So that is one distinction.
Menaka: So you are arguing in favour of a distinction whereas Shroff is saying there should be no distinction?
Shroff: Bharat is coming from that an Independent Director doesn't only bring absence of conflict but he brings expertise and strategy and the Brahmin class will have to bring expertise and strategy which means you will have to get into what are the qualifications, what is the background, what is the skill set.
Menaka: Yes, but not from the law point of view. Maybe the law just needs to ensure that you are independent, that you are the Brahmin and not a Kshatriya or a friend of the Kshatriya.
Shroff: Or just say unconflicted.
Menaka: And then you leave the expertise up to the company in that sense.
Doshi: And you also need a balance. For e.g. he talked about whether the company should go into diversification or not or whether company should be progressing or growing in a particular way. Now, at that particular point, if your 'X' company is involved only in automobiles and not in tractors and if you have knowledge of people around who can say that the whole rural market is different from what one talks about urban market and brings different input on that.
Menaka: You can hire advisers to do that. You don't need Independent Directors on board with a code and responsibilities and liabilities?
Doshi: There is a difference. The advisor will never be responsible for the other stakeholders which you referred to. He will never be responsible. He is then giving advice just to the management. He is not giving advice to a company who has multiple stakeholders including private equity shareholders, including minority shareholders. So here is an Independent Director who is keeping these thoughts in mind while he is doing his duty but he cannot be doing a duty which will make completely the circle co-centric.
Shroff: You are mixing up the two things again. So is it a role to advice a management and give a different perspective or is it really to protect the interest of all other stakeholders?
Doshi: Simultaneously, it happens simultaneously.
Menaka: Both in parts.
Doshi: Both in parts and now I must tell you one thing. You need the Independent Director and the definition which you are talking about and in my mind the definition is a trait. It is not something which is a definition to be written down. But what I am trying to point out is that when there are issues of conflict, you also not only want to show that the company is behaving fairly but you also want to convince people around that there are people who take care of it because there is no conflict of interest as far as they are concerned.
Menaka: So that means you have to have no conflict of interest and it cannot be just a trait but itís got to be a defined no-conflict of interest, right?
Menaka: In which case we are proceeding on the right path through this Companies Bill.
Doshi: No but the point is that the definition- whether it is eight years-nine months or nine years-one month- will that definition change?
Menaka: We will come to the tenure in a bit but at least you have conceded that if you got to create the right perception and the right carry through of a company working for all its stakeholders and certain individuals on board protecting the rights of all stakeholders, then you also got to create the perception that that individual is independent from the management of that company or any one set of those stakeholders and therefore Independent needs to be defined in law and therefore we cannot have this rarefied argument saying itís a stake of mind and hence letís not try and legislate on it because thatís not going to give us anything.
Doshi: So you can define that but that still does not take away the aspects of that character, that integrity and trait.
Menaka: Of course it doesn't; it's a minimum, not a maximum. You have to be minimum of this to be Independent; the rest we leave up to people who are picking you.
Shroff: It is also drawing certain presumption that if you are independent because you are not dependent, as defined over here, therefore you are presumed to be wise, you are presumed to be unconflicted and that you will protect the interest of stakeholders. That is an underlying presumption.
Menaka: Where does it say that?
Shroff: That is an assumption.
Menaka: I am completely against government in governance and I really donít believe that this top-down thing works fully but I donít believe that they have said anywhere that as long as you are independent, we donít care about the rest. I think in several places they have said, we would like you to pick expert people. Thatís why the whole suggestion of a panel. Thankfully the Minister has assured us that the panel is not going to become mandatory saying you have to pick Independent Directors from a government appointed panel. But the whole suggestion of the panel came about saying why donít you try and identify right kind of experts in this country, people of high integrity, high social standing.
Shroff: You might need to perhaps create a best practices Code, not the kind of Code that it been currently talked about. So how the decision making will go, what would be the level of the discussion and debate that would take place. Would an independent Director in the minutes or would in any minutes of decision, which can impact the minority, have a recording of how the interests of the minority were protected. So, if there is a decision, say on a merger or maybe it could be a merger with a group company, how are the interests of the minority shareholders protected? Are you not going to legislate, if you are going to, on decisions - the decision making process? That would be far more effective.
Menaka: You are expanding this scope of this Code, the government will hug you.
Shroff: As a matter of best practice.
Menaka: But even best practice means voluntary or mandatory?
Doshi: Thatís why best practice, voluntary comply and explain approach.
Menaka: Comply or explain does not fully work in this country unfortunately.
The NYSE says no Director qualifies as Independent unless the Board of Directors affirmatively determine that the Director has no material relationship with the listed company either directly or indirectly; of course there is a long list of other qualifiers to pass the independent test.
Emmerich: The definition of Independence is something thatís included in the stock exchange regulations- not having an employment relationship with the company, not being dependent upon the company for variable compensation and so forth- but all those things taken together arenít what really has defined the change in the nature of public companies. The single most important thing that has defined the change in the nature of Boards in the US and the change in the conceptualisation- both within the boardroom and outside the boardroom- of the role of directors in the US over the last 50 years has the rise of institutional shareholders and change in the political climate in the corporate sphere that says managements will not be left alone and entirely trusted by shareholders but rather shareholders would demand an active engagement by the company.
That lack of activism makes India more dependent on the robustness of technical definition. SEBI regulation say an Independent Director should not have any material pecuniary relationships or transactions with the company, its promoters, its directors, senior management or its holding company, subsidiaries and associates.
Companies Bill, 2009 proposed that any pecuniary relationship should not amount to 10% or more of the companyís gross turnover in the current year or the preceding too.
What the Parliamentary Standing Committee has suggested that Independent Directors should not have had any kind of pecuniary relationship material or otherwise with the company at all.
Shroff: What is the whole purpose of this dependent and independent? You are trying to ensure that your interests are not aligned with those against whom you are preventing the conflict which could be Ė in the Western concept against the management, in the Indian context it is really the majority.
Menaka: You are creating the objectivity.
Shroff: You are creative objectivity and therefore the interest of and the mentality of an independent director should not be aligned because of an interest that they have with the majority but should be aligned with the other stakeholders including the minority, right?
Shroff: This is not achieving that by any shot. Therefore, perhaps the whole concept should change from directors whose interests are aligned with the management/majority/ promoter in management and others. That would probably fix it.
Menaka: I think we have had this conversation before. I donít know if you recall, over the last several years, about whether minority shareholders should get together and pick somebody who represents their interests on board and that person then becomes the minority shareholder director or you have nominee directors where institutions come and pick people their representatives on board. I donít know what the big problem with this definition is because the definition of independence is. In the US, the SEC puts it down and also prevents previous pecuniary relationships. In India, maybe the Parliamentary Committee is going one step forward and saying no kind of pecuniary relationship at all with the company. What is the harm in that?
Shroff: There is no harm. Itís too narrow.
Menaka: So no material pecuniary relationship is better than no pecuniary relationship. Is that such a big deal?
Shroff: No, it's not such a big Ė but the real issue is that its addressing the wrong conflict.
Menaka: How do you enhance this definition then to represent the conflict that you are talking about?
Khanna: Have more disclosure perhaps; more disclosure on the background of directors, more disclosures that when they were decisions- which had conflicts- who voted in what matter.
Shroff: And you need to get a little more prescriptive on related party conflict because that is one of the core areas where majority-minority conflicts emerge.
Menaka: The definition is quite prescriptive on that.
Shroff: That's definition of director but thatís not a definition of decision which are taken. Today the Companies Act concept, even under existing law and to some extent even in the new law that is emerging itís a very narrow concept of Interested Directors and what typically happens is the promoter-director will just recuse himself but pretty much knowing that the rest of the decision is going to get taken by those who are present. Itís just under Section 299 there is a disclosure requirement and a very narrow threshold. But that doesnít capture the real conflicts of interest that are there in related party contract.
In Canadaís famous Hollinger International case, Independent Directors objected to controlling shareholder Conrad Blackís attempt to sell the company through the sale of the holding company. The Independent Directors invoked the shareholders rights plan to block the deal and that move was upheld in court. The court in fact noted that though handpicked by Conrad Black the relationship had not stopped Independent Directors from challenging his decision.
But thatís rarely a case in India as best illustrated by the Satyam-Mayas deal attempt. In 2008, IT major Satyam decided to use most of its cash to diversify into real estate via an acquisition of Mayas, a company owned by the son of Satyam promoter Maralinga Raja. The diversification via $1.6 billion related party transaction was approved by the board, including six very well reputed Independent Directors, in the course of single less than two hour board meeting.
Sheriff: Technically the Rajas recued themselves from the Mayas decision but the decision still got taken by Independent Directors and whatever maybe the other circumstances surrounding that, thatís the gap in the Company Law, where first you define the two different levels of independence- one is of the Independent Director as a threshold to entry on the board- thatís point one and the second is how decisions which have agency conflicts of this nature, how they get taken and thatís much narrower.
Menace: But thatís what this Code hopes to address.
Sheriff: It actually adds colour on the first part of independence namely what is your passport to independence to get on the board.
Menace: But they have asked the Ministry to device a Code which deals with responsibilities, roles and responsibilities, tenure, remuneration, liabilities, they have also mentioned that.
Shroff: It will only increase the threshold for Independent Directors to get in on the board but having got in on the board, the decisions with those kind of related party conflicts will still get taken.
Emmerich: One of the things that struck me in this debate in India about the role of Independent Directors and I have been able to understand that is the absence of any great concern, any seemingly great concern with transactions that companies or companies with a promoter, which is virtually the entire market place, are entering into that are not desired by shareholders and in a way it seems to me again that the focus on various requirements or standards that Independent Directors should have to meet-whether itís with respect to remuneration, tenure, rotation- seems to again leave out the question of what it is it they are suppose to do if they meet these requirements, whether they will be more aggressive in confronting management about business plan.
Had Satyam proceeded with its acquisition of Maytas, it could have done so without shareholder approval because Indiaís Company Law does not require shareholder approval of such related party transactions.
The Companies Bill, 2009 attempted to put some types and sizes of related party transactions to shareholder vote but after corporate lobbying, the Ministry has now proposed to do so only in the case of bigger companies.
More recently SEBI suggested that the new law goes step further and disallow Ďinterestedí shareholders from voting on the special resolution of the prescribed related party transaction. It is this crucial conflict of interest that is least addressed by the Companies Bill, 2009.
Shroff: India may have to find some solution because you are essentially adopting western concepts which are based on a different conflict i.e. management conflict. We are trying to create distance from the management and trying to apply that to an environment where the main conflict Ė all of this was a conflict of interest discussion-the main conflicts are majority- minority conflicts and you are not even touching that subject.
Menaka: I am going to ask Rajesh what he thinks before I come back to you on what that concept India needs to adopt is.
Shroff: I think something needs to be invented for that.
Khanna: Somehow, in my personal mind, lot of focus is on conflict which is a very small part of what an Independent Director does. But if thatís such a big deal for many people, you can do many things. You can have public databases of which Independent Director is on what Boards, what decisions were taken by those Boards and let there be transparency of information so people can have points of view on companies and people. Maybe there are accounting firms, before related party transactions get done, who need to opine on something but if you are just into solving the conflict Ėthatís a very narrow part of what a good quality Independent Director can bring to a company.
Shroff: But the very word Independent Director is founded on the concept of absence of conflict, this whole discussion is about absence of conflict.
Khanna: I understand but conflict doesnít necessarily mean that the role is just to take care of related party transaction.
Shroff: Conflicts can be much broader.
Khanna: It may not be conflicts but better decision-making.
Menaka: And whether we like it or not we are tasking a human being with the job of maintaining all stakeholder interest as oppose to only specific stakeholder interest which are represented by promoter management on board. So, in a sense for us, the Independent Director is the guardian or the policeman for all stakeholders to ensure that there is fair play. Now, if beyond that, you want your Independent Director to play an expert scientific advisory role, then you pick him accordingly or you want him to play an expert HR role, you pick him accordingly.
Shroff: But like you said you can hire services for that. Why do you need to bring it on the board?
Menaka: Because maybe when you hire, there are other issues of conflicts or whatever. Independent Directors, if this becomes law, will be cheaper than advisors to get on board.