12 October 2017

The Kotak panel on corporate governance should separate best practices from mandatory provisions

I have an op-ed piece in today's The Economic Times where I argue that implementing the Kotak Committee report on Corporate Governance should be proceeded with extreme caution and most recommendations should be implemented as best practices rather than new legal provisions. The piece is linked here.  The full article is also reproduced below:

You would be forgiven for thinking this is a parallel universe. A core private sector committee instituted by the Securities and Exchange Board of India (Sebi) is advocating stringent new corporate governance norms. And, bureaucrats are opposing it on grounds of ease of doing business.

For that reason, in a blind test, the Kotak Committee report on corporate governance could easily pass as drafted entirely by career regulators. The committee seeks to order a firm control over corporate India, which has often careened off its ideal highway. A fiat — or positivist law, in jurisprudence jargon — relies on the command followed by sanction in the event of disobedience. By contrast, best practices set non-mandatory targets, which have the benefit of flexibility.

This distinction is very different from the ‘rule-based vs principle-based’ debate many have engaged in over the last decade. The clearest example of the former is the listing regulations of Sebi. The best example of the latter is the ‘comply-or-explain’ provisions relating to Corporate Social Responsibility (CSR).

Before discussing the report, it is useful to remember that the influence of the board in driving a company is limited, even in the fragmented ownership model of the US and Britain. And this is not based on some ‘left-leaning’ opinion, but on a detailed study by that flag-bearer of capitalist thought, McKinsey. Only 10 per cent of directors surveyed felt that they fully understood the industry dynamics in which their company operated. Similarly, what is seen as a slam dunk in the report — that a split role between chairman and managing director (MD) is the best board structure — is based on the premise that there ought to be an alternate power centre.

However, the reality is more complex. There are companies where a chairman ought to also be the MD, as it requires an army-like commandand-control structure. Additionally, both leading corporate battles and corporate governance battles in the last year revolved around two power centres. This caused problems in functioning of the companies involved. So, there is significant downside to a split role.

Similarly, it isn’t clear whether mandating a woman director on the board alone is good enough. The woman director should, according to the norms, be an independent director (ID), under 70, and be paid, broadly, a minimum of Rs 50,000 for each meeting. Such level of detail is too intrusive.

In the Bored Room
Combined with incorporating these into a sanction-based law, this would mean a company and its directors not following any of the ‘ands’ would, in theory, be in violation of the law with collective and individual liability. The contrast couldn’t be more stark with the fact recently reported in ET that 40 per cent of the listed companies are not even in compliance with the womanon-board provision.
Ideally, some of the provisions should indeed have the force and mandate of law followed by penal consequences for their violation. These include having an independent director for the quorum of board meetings, limiting the directorship and committee memberships, introduction of declaration of true independence, introduction of the concept of lead ID with specific enabling roles, enhanced scrutiny of material subsidiary’s fund utilisation, enhanced monitoring of group companies, enhanced scrutiny and disclosure of related-party transactions, introducing transparency in ownership of global depositary receipts in Indian companies, full disclosure of credit rating assigned to securities, various enhanced disclosures and bringing chartered accountants under the purview of Sebi.

Some of the provisions, which require to be segregated into a ‘complyor-explain’ code of conduct include increasing the minimum size of the board to six from three, introducing a matrix of competence for directors, having a minimum number of five board and audit committee meetings from the earlier four, introducing an annual update programme for directors, a formal meeting between non-executive directors and senior management, splitting the chairman’s role from the managing director’s, formal training of IDs every five years, enhancing the role of the Nomination and Remuneration committee and the Stakeholder Relationship Committee, and introduction of a stewardship code.

Essentially, the segregation is based on whether violating the provisions should be met with a penalty of Rs 1 crore and a jail sentence of up to 10 years. Additionally, not every listed company is necessarily complex, requiring the same standards. For less complex companies, a single rigid rule would harm their ease of doing business.

However, even for those companies, setting best practices would set a good standard for corporate hygiene, so long as it is not immediately to be met with serious penalty. Many of the recommendations would also cause private companies to remain private, because the next Mark Zuckerberg of India is not likely to hand over control to a group of admittedly non-expert outsiders.

Inconvenient Directors
Some of the items discussed should be not be implemented as presented. These include putting a minimum compensation for IDs, or maximum compensation for executive directors, amendments to insider trading norms (which require a complete relook, rather than amending a part) and promoter reclassification (which also requires a complete relook).

Finally, the items missing from the report are the significant learnings from the Tata and Infosys governance fiascos and could have been specifically introduced. For instance, enhanced protection from removal of ‘inconvenient’ IDs.

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