01 February 2013

Corporate governance – too much of a good thing?

I have a piece in the current edition of Outlook Business on the proposed corporate governance norms sought to be introduced by SEBI. Below is the full piece (linked here - nice graphic):

SEBI has decided to come out with a major consultative paper reviewing the corporate governance norms in India as it applies to listed companies. It merges its own developmental philosophy with the thinking of the Companies Bill which is pending passage in Parliament. Of course the Companies Bill has governance provisions for all public limited companies (private limited companies are broadly exempt) and surprisingly, several enhanced standards for listed companies. Some of the proposals in the Bill are tougher than those contained in today's corporate governance norms set in the SEBI mandated listing agreement.

This author broadly supports most of the reforms sought to be introduced by SEBI with this paper. However, on going through the vast number of recommendations and proposals, two broad problems also arise. One, that the huge incremental changes will be costly and will require substantial changes in the way companies are run today. Second, while each proposal is sound, on a collective basis, these proposals might be crossing the limit of corporate governance and getting into the territory of over-regulation. The proposals all but state everything a company needs to do except the time it should wake up in the morning. This may look good at first blush, but over-regulation will also keep more companies from being listed. Exhibit A to this point is America's Sarbanes Oxley Act which has stunted the growth of the public listed company in that country.

This article looks at most if not all of the two dozen recommendations critically. For the sake of analysis, let us divide them into the good, the bad and the ugly.

The good
Black and  white terms. SEBI proposes a formal letter of appointment be issued to directors, which should explicitly state the rights and obligations of the directors and this letter be disclosed to all.  This is a good thing. Rights and fiduciary duties should be stated in black and white and directors should know both their duties and their rights so that a shareholder can protest in a shareholder meeting or otherwise if he or she crosses the contractually stated lakshman rekha of what is agreed. Psychological studies have shown that these kinds of firm written commitments have an impact on behaviour. Similarly, it is good to recommend continuing director training. As all of us learn through our lives and creating a classroom where directors can learn from each other and in an institutional framework would clearly be progressive and keeping it disclosure based rather than a mandatory provision is a good move.

Term. The term of independent directors has been proposed to be limited to two terms of 5 years with a 3 year cooling off. This is a much needed move as dirctors who hang around for a period longer than 10 years are highly unlikely to be independent of entrenched interests. For the truly qualified and independent, there are many other opportunities. Working at one company as independent director for thirty or more years compromises independence. Though, only a few people have abused their stay beyond reasonable welcome, this was a necessary prophylactic for better governance. Similarly, a proposal to limit independent directorships to 7 listed companies may be a bit extreme, but should not impact most high quality independent directors. To be  sure, 7 listed company directorships for one person is a lot of work.

Role of IDs. There have been several new proposed roles for independent directors including leadership roles in the company where they meet in the absence of the non-independent directors and review the performance of the others. On the same lines, introduction of performance evaluation of directors is a good move and  would put pressure on boards to work on tangible outputs and well established processes to achieve those targets instead of propounding abstract theories and dilbertisms.

Noisy withdrawal. Another great development is the direction to directors, particularly the independent ones, from resigning for ‘personal reasons’. SEBI has played this with nuance. It has not proposed forcing directors to make a 'noisy withdrawal', but seeks to create an environment where appropriate disclosure has to be made to shareholders explaining the resignation. A subtle pressure is put on directors resigning on personal grounds to explain why those same personal grounds are not reason enough to withdraw from all companies where they sit as directors. This is a great move without tipping over into micro-management.

Whistleblowing. Mandatory provisions for whistleblowing rights would be a step in the right direction. The current status of optionally protecting those who uncover fraud is unacceptable. Protection to those who uncover fraud must be a law given right and those who victimise such people must be the ones facing the wrath of law.

Related party deals. The non-regulation of pay is a step in the right direction, though runaway pay has been tackled through proper disclosures. The ratio of top management pay to the median worker is to be provided. In addition, shareholder approval of non-interested shareholders voting for the pay of promoter-directors is a good move. There is an extensive portion rightly dedicated to related party transactions which have been the bane of corporate India's image of rapacious promoters. Several hurdles have been put in the way of self dealing - through approval of non-interested shareholders, disclosures, restriction of superior rights, approval of audit committee and a new fiduciary duty of majority shareholder towards minority shareholders. These are bold moves and are likely to be opposed by many a powerful promoter. But they are a move in the right direction given our history of problems in this area.

Proxy advisors. The paper also seeks to grant some sort of recognition to proxy advisory firms which advice investors on how to vote in the interest of the company. These are firms whose time has come and they will clearly impose substantial burden, both real and through the press, on those companies who take excessive liberties with their shareholders.
Institutions’ duties. Finally, without deciding, the paper disccusses the role of institutional shareholders and their role and duty in playing a somewhat more active role in acting as a check and a balance to the untrammeled power of the promoters.

The Bad
Nominee director independence. Nominee directors are proposed to be branded as congenitally non-independent. This is a departure from the current position where nominees from certain financial institutions are not considered non-independent. While, there are problems with the current regime, the proposed regime would bring its own problem – i.e. branding nominees of creditors as interested in more than the repayment of their loans on time. Something which they clearly don’t represent. Their role begins and ends with ensuring repayment of interest and capital. Clearly, the current regime is more nuanced and appropriate, though some black sheep do wander in the guise of independent nominee directors. On the whole, the status quo is probably better as the exemption providing the clothes of independence is only given to certain financial institutions and banks.

ESOPs to IDs. If the company will prosper its key stakeholders should do well. Many employees will get greater pay and employee stock options. Similarly, top management can also be rewarded with higher pay and stock options. It is not clear why independent directors are not deemed suitable enough to be awarded stock options. Shouldn’t they do well if the company does well and also lose some investment when the company doesn’t do well. The bar on awarding stock options to independent directors needs to be lifted and they should have an interest with skin in the game as well. This will be good for the performance of the company as the directors collectively drive the strategic vision of the company.

Micro-regulation. There are other areas of micro-management of what ought to be a good practices code, like having a proper succession planning, a risk management framework, appointing nomination and remuneration committees, supervision of the internal auditors to name a few. These are best left to the wisdom of the company's directors rather than be introduced as legal obligations.

Class no-action. On a separate note, there is a provision for class action suits, which is a non event because these are permitted even today under the civil procedure code for any corporate case - though unused for reason of delay in justice rather than because the right doesn't exist.

The Ugly
Minority representation. SEBI discusses at some length the appointment of directors representing minority shareholders. And it seems it comes to no firm conclusion. It finds that appointment by ‘majority of minority’ may create an abusive system in which a rival can acquire shares and sabotage the company. However, the alternate system it comes up with also does not pass the same test. SEBI has proposed one director appointment from those shareholders who own say shares worth not more than Rs. 20,000. This gives power to those who hardly have any skin in the game and thus may not be the best counter-balancing force against a problematic majority. In addition this would give power to those shareholders who are the least affected and are therefore most likely to be fronts for other interest groups. It may instead be better to push for cumulative voting which gives a better voice to minority shareholders.

70 is the new 50. There is discussion about the age of directors and approvals and minimum and maximum ages. These are quite pointless micro-management. There are many young savants and many people in their prime even after they cross 70. Anyways if you can be a prime minister of the country of over a billion at 70, why should good people be disallowed from director roles at that age. Let good people be on the boards of companies rather than decide it on such factors as age. If age restrictions were implemented in California's corporate laws, I'm sure Silicon Valley would be the poorer. In fact the story of India's youngest CEO starts tragi-comically (he was featured in Time magazine as the world's youngest CEO at 14) with Indian law prohibiting him from being a director in the company he founded and he was forced to incorporate in the US. Clearly it is time to make that concept history.

Conclusion. Overall, I would give the paper high marks, particularly, if it avoids in its finality areas of over-regulation and dumps them in favour of innovation, disclosures, checks and balances and the right level of regulation.

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