Corporate India may not be too thrilled, but Sebi’s proposals on independent directors are good for India’s governance credentials
The Securities and Exchange Board of India (Sebi) recently came out with a consultation paper, tightening rules for appointments and resignations of independent directors. The proposed rules bring in some much-needed changes as to how independent directors are selected, voted on and possibly even remunerated. There is a clear attempt to correct the balance of power between minority shareholders and promoters, or the operating management, in deciding who is to become an independent director and join the board.
Today, the whole framework of corporate governance is based on the concept of independent directors and their ability to represent the interests of minority shareholders and act as a check and balance on promoters and the operating management. However, the current reality is that in most cases it is the promoter group and operating management that decides and effectively elects the independent directors. While there is a board nomination committee that is supposed to select and vet candidates, in reality, the promoter group decides who they wish to nominate and can ensure their election.
Minority shareholders, whose interests are supposed to be represented by these independent directors, have very little say. Either these directors are appointed as additional directors and become a fait accompli or their election is ensured with the promoters typically being able to push through an ordinary resolution on the strength of their votes alone (especially as many foreign portfolio investors do not vote). Most institutional investors do not feel empowered to suggest a candidate or oppose the directors proposed by the promoter group. It is rare that institutional investors are even consulted. Directors with a poor track record of ensuring governance face limited consequences and still seem to be able to join new boards. Director appointments are rarely contested. It is also a fact that there are only a few cases of successful board-managed and -run companies in India. Most boards in India do not appear to be truly and fully independent from the promoters or management. How many boards in India would actually vote to sack a CEO/ promoter?
The proposed Sebi rules make the election or reappointment of each director subject to a dual vote. A majority of all shareholders have to vote for the proposed director, as well as a simple majority of the minority shareholders (non-promoter shareholders). If either track votes against, then either a new director will have to be proposed or after a 90-day cool-off period and adequate justification, the same director can be proposed again. However, in this second vote, all shareholders will vote once (no dual vote) and the disputed director will have to win 75 per cent of shareholder votes. This new methodology will give significant veto powers to the minority shareholder base and ensure that unwanted directors cannot be forced on to the board. It also ensures that a small minority of investors cannot block a director and hold the company hostage. Besides, it gives the promoter group/management the time and opportunity to convince the sceptics and try to address any concerns on the proposed candidate. Personally, I think this is an excellent and balanced approach to independent director selection. It seems to follow the model in operation in the UK currently.
Similar rules are proposed for any director who is to be removed. By giving minority investors effective veto rights over the removal of independent directors, we will hopefully protect them from undue promoter group influence. They can at least contemplate voting against the promoter group and/or operating management and try to protect minority shareholder interests. Today, it is not realistic to expect independent directors to vote against the promoter group if their presence on the board is totally dependent on the promoter or management. Many independent directors, no doubt understand their responsibility to minority shareholders and ensure fairness, but the current incentive structure makes it difficult to go against the wishes of the promoter group. The new rules will balance the incentives more fairly and encourage genuine protection of minority shareholder rights.
Sebi has also proposed giving more disclosures around reasons why directors step down. Their entire resignation letter has to be disclosed and if they give the standard reasons of pre-occupation or a lack of time, then they will be precluded from joining another board for 12 months after stepping down. This step will hopefully encourage greater transparency on the reasons for leaving the board. Investors take any independent director leaving the board as a serious matter and they would like to know the real reasons for a director stepping down. I don’t think directors should simply walk away, with no reason, and wish away their responsibilities to the minority investors they were elected to protect.
After the new rules, the promoter group cannot appoint an independent director as an additional director and not subject the appointment to shareholder approval for almost 12 months (until the next AGM). No board appointment should be made without prior shareholder approval and in the case of a casual vacancy due to death/resignation etc., shareholder approval must be obtained within three months, according to the new proposal. Again a sensible suggestion. Sebi has also turned its sights on tightening the definitions of eligibility to be an independent director and the composition of the audit and nomination committees.
The final point is around director compensation. Given the responsibilities put on the independent directors, they must be fairly compensated. It is not easy to put in the time and energy needed to do full justice to the directorship. There are legal liabilities. The directors should be offered employee stock ownership plans, giving them significant upside if the company does well. The ESOP plan can vest over the full five-year term of the directorship. There can also be a mechanism for claw backs. This will ensure directors care about market capitalisation and the economic success and reputation of the firm. I see no reason why this is a conflict. As investors, we want the directors fully aligned. Given the premium the market is paying for good governance, directors will push for best practice rather than take short cuts if properly incentivised.
While corporate India will not be thrilled by all these proposed changes, the institutional investors think these are well-thought-out and sensible steps. Environmental, social, and corporate governance and stewardship are concepts whose time has come. These are long-term structural trends. All investors increasingly care about these issues. If India were to take leadership in these areas, we will not only burnish our governance credentials but attract large flows of long-term capital. The largest and most sophisticated investors of the world are leading the charge on both ESG and stewardship. It makes sense for us to join this movement and aspire for emerging market leadership as it is the right thing to do.
Sebi must be complimented for coming out with these proposed steps and guidelines. We must go ahead and implement them—the sooner the better.The writer is with Amansa Capital