The Hindu Business Line : The new `independence' movement

SO MUCH has been said recently on the role of independent directors on corporate boards. Most of it has been in the context of the largely official and some private initiatives in the last decade toward improving corporate governance practices. These include the appointment of (a larger number of) independent directors. The underlying premise is that such directors help promote greater professionalism, transparency, and accountability in board functioning. The larger the proportion of independent directors to the total board strength, better able the board is expected to be to fulfil the fiduciary tasks entrusted to it by the shareholders.

Regulatory, other eligibility criteria

The mandatory corporate governance guidelines of the Securities and Exchange Board of India (SEBI) for listed companies, enforced through their Listing Agreements with stock exchanges, require that at least half or a third of the board should consist of independent directors, depending on whether the chairman is executive or non-executive. SEBI treats board nominees of shareholding or creditor institutions as independent directors. The focus here is on other independent directors.

As the deadline (end-2005) for compliance with the SEBI requirement is just a few weeks away, many listed companies may be scrambling to find suitable persons to be appointed as (additional) independent directors.

A person to be appointed as a director, whether as independent or not, must be free of specified disqualifications under Section 284 of the Companies Act, 1956. These relate to lack of mental soundness and of financial solvency, and directorship of a company that has defaulted in meeting specified statutory-disclosure and contractual-financial obligations.

In addition, certain SEBI-prescribed criteria apply to independent directors. These require, in essence, that such a director should not be related to the promoters, other directors, or top managers of the company, should not have been an executive of the company during the preceding three financial years, and should have no significant or material financial/business dealings with the company.

The requirements are aimed at avoiding potential conflicts of interest, or relationships that could impinge on the director's independence. Also, to preclude significant shareholders enlarging their sphere of influence over the company by entering the board in the guise of independent directors, the SEBI guidelines bar a shareholder holding two per cent or more of the company's voting shares from qualifying as an independent director.

From a positive perspective, independent directors should be chosen for their probity, competence, and objectivity. Some practising professionals or executives of other companies may bring to the board useful expertise and experience. Cross directorships could be useful from this viewpoint. However, most of such candidates may not be able or willing to spare the time and effort needed to perform the onerous functions of an independent director. If they are already associated with the company or with a competitor in a significant way, potential conflicts of interest may preclude their appointment to the board.

Candidates for public sector companies

There have been complaints from the corporate sector that it is difficult to meet the SEBI deadline as it is not easy to find suitable persons to fill the growing number of independent directorships. With a number of listed companies having significant or majority state ownership, there may be a move to compile a panel from whom independent directors can be chosen by these companies.

Given the predilections of the public sector, one should not be surprised if such a panel consists largely of retired civil servants and former senior officers of public sector banks and other financial institutions. A directorship may be viewed as a reward for past services rendered by the selectee, or a good turn by an old-boy network. The panel may be flaunted to disprove any alleged shortage of appropriate candidates to fill the emerging independent board seats. In course of time, even private companies may be asked to scan the panel to pick suitable candidates for their boards.

Persons on such a panel may indeed have the requisite credentials, and be capable of providing valuable advice and guidance to the companies inducting them.

However, to prevent potential conflicts of interest of officials while still in public service, they should not, as a general rule, be allowed to be appointed as independent directors of companies, whether in the public or private sector, during a "cooling-off period" of, say, three to five years, after they retire from or quit their public sector jobs. Moreover, this rule should be strictly enforced in respect of appointments to private companies with which the officials may have had significant dealings in their official capacity. Similarly, during the cooling-off period, a retired public sector official should not be allowed to function as an independent director of a company where a member of his immediate family is, or was during the past five years, employed as an officer of that company.

Private companies

In the private sector, the natural tendency of the principal or dominant shareholder, or the executive management, is to induct persons who can be relied on to lend support for them and endorse their major decisions. They are unlikely to choose persons about whom they know little, or in whom they cannot readily repose confidence, however suitable the persons may otherwise be for the directorships.

One cannot, however, generalise that, in reality, those controlling or managing private companies would only seek `independent' directors who would toe their line faithfully. Some enlightened managements may show genuine interest in seeking unbiased views and advice of independent directors in directing and managing the company's affairs.

In practice, the degree of freedom enjoyed or exercised by an independent director to act in the best interests of the company without undue influence or interference by the controlling shareholder or executive management varies with the degree of their openness and receptivity toward the director's views. A dominant shareholder or strong chief executive used to steamrollering decisions through a pliant board may find really independent directors a nuisance. Resourceful shareholders and chief executives can, however, employ suasive and other means to secure the directors' support.

Controlling shareholders with a substantial stake in a company may treat lightly, if not disregard, the views and advice of an independent director who has no or only an insignificant financial stake in the company.

If an independent director frequently dissents from the management's proposals, or adopts a seemingly adversarial attitude toward the management, he may be shown the door when his current term comes to a close, albeit his approach is justified by the company's interests. The risk of premature termination of the directorship may well mould the behaviour of a not-so-strong independent director, especially where the directorship carries a substantial compensation besides the sitting fee. If, however, the director has the courage of his convictions, he or she may even voluntarily step down before the relationship with the management turns too sour.

Where several independent directors act in concert, their dissent may pose a challenge to the management. But if, as is most likely, they are a minority of the board, they could be overridden by a majority aligned with the management.

For his part, an independent director should be concerned more about exercising his judgment in the best interests of the company and less about the consequences of annoying or displeasing the controlling shareholders and top managers. A director with a reputation and track record would no doubt add weight and dignity to the board. But, ultimately, his value to the company should be measured by his contribution to the governance and progress of the company.

To guard against his developing vested interests in the company, or becoming rather stale in his views, it is desirable that an independent director is not retained for more than four to five years. His remuneration should preferably be limited to just the sitting fee.

Mutual trust essential

The independence of `independent directors' may turn out to be just a shibboleth if controlling shareholders and top managements of companies choose such directors from a restricted circle of reliable friends and associates. At the same time, it would not be realistic to expect the shareholders and managements to draft unknown but truly independent directors and run the risk of their boats being rocked by the directors. Corporate governance can be enhanced only if independent directors are chosen on merit. Also, the relationship between the independent director, on the one hand, and the controlling shareholder and top management, on the other, should be founded and built on mutual trust. The director should have the ability and the courage to exercise his judgment in the best interests of the company without fear or favour. The independence of his judgment should be valued by the other side, with room for honest debate and dissent. Else, the regulatory requirement may only be fulfilled in form, not in reality.

(The author, a company director and freelance writer on finance and law, can be reached on mspartha@vsnl.com.)

Article E-Mail :: Comment :: Syndication :: Printer Friendly Page

Stories in this Section
The new `independence' movement

Stitch in time

Food for thought from the oil-for-food scam

Oil, inflation and interest rates

Deconstructing reconstructed accounts

`Institutional innovation' of doubtful merit

Woes of hi-tech banking

Doha Round: Consensus not `developing'

Trading experiences

The Volcker report

IT trade unions

CEOs in public sector units