India: Ombudsman, Superman Or Godman?

Last Updated: 26 October 2016
Article by Nitin Potdar

Today, buzzwords like 'good governance', 'independent directors' and 'minority interest' are an integral part of any corporate discussion or debate. It's considered highly trendy these days to stress upon the need for independent directors in every forum.

On the brighter side, this is indeed a positive environmental change in favour of impartial and objective governance; one that merits thundering applause. The fundamental purpose behind the appointment of independent directors is clearly indisputable, so would be their independence, impartiality and wide experience in "steering" companies in the right directions especially in this era of rampant scams and frequent scandals.

On the flip side, the notion of Independent directors, as is being constructed in the public domain and through the imminent legislation, is prone to few serious challenges. The proposed Companies Bill 2011 (Bill) is likely to pass sweeping legislations in the backdrop of recommendations made by the Kumar Mangalam Birla committee, Naresh Chandra committee and the Narayana Murthy committee, this is an opportune time to put the issue in perspective.

In India, the concept of corporate governance was first raised by Kumar Mangalam Birla Committee in 1999. To its credit, it made a very pertinent observation:

"In an age where capital flows worldwide, just as quickly as information, a company that does not promote a culture of strong, independent oversight, risks its very stability and future health."

It went into great detail describing the desired number strength and personality attributes of the independent directors andalso their remuneration. On the ideal attributes of independent directors, the committee called for individuals with certain personal characteristics and core competencies such as recognition of importance of the board's tasks, integrity, a sense of accountability, track record of achievements, and the ability to ask tough questions. Besides, having financial literacy, experience, leadership qualities and the ability to think strategically, it wished the directors to show significant degree of commitment to the company and devote adequate time for meeting, preparation and attendance.

While the report was quite elaborate and impressive, it housed one apparent contradiction. On the one hand, it seconded the Blue Ribbond Committee report stating the need for non-executive directors, independent or otherwise, to help bring an independent judgement on the boards decision especially on issues of, inter alia, strategy and performance. On the other, it attributed (under Para 6.2) the obligation of, inter alia, 'evaluating the performance of the management' as an all-encompassing requirement of the board and not of any single set of directors, whether independent or not.

A more watered down and pragmatic observation on the duties of independent directors was made under the Naresh Chandra Committee Report, wherein in the elaboration of duties, it limited itself only to debating of strategy, close monitoring of progress and ensuring of putting forth adequate systems for ensuring growth. Now, unless this is interpreted from an implementation perspective (not policy perspective), it would defeat the very purpose as independent directors cannot (and should not) dictate policy. Their job is to ensure the execution of policy decisions in a fair and transparent manner. How then are they supposed to give "considerably more time in debating strategy, closely monitoring progress and ensuring that systems are put in place for profitable growth" as the committee recommended?

The Narayana Murthy Committee Report was equally rational in its recommendations. It advised exclusion of nominee directors from the definition of independent directors and suggested the same compensation structure as utilized for the non-executive director compensation. It further called for such compensation to be fixed by the Board of Directors and be approved by shareholders in general meeting with limits set for the maximum number of stock options that can be granted to non-executive directors in any financial year and in aggregate.

It's pertinent to note that the listing agreement that was amended in pursuance of the Narayana Murthy committee report only incorporated (under Clause 49) the operative sections including the definition of independent directors but did not list out the duties which the committee had identified as a requisite for an independent director to perform.

For the first time, the concept of independent directors is introduced in Company Law under the proposed Bill (Companies Bill, 2011) with slight departure from Clause 49 of the listing agreement. The Bill prescribes a very strict definition of 'independent director', to include amongst others, "a person of integrity and possess the relevant expertise and experience" in the opinion of the board. Also the Central Government is vested with the power to prescribe manner and procedure for selection of independent directors. Additionally, an independent director is also required to declare that he meets the criteria of independence as stipulated in the Bill.

In addition, Schedule IV of the Bill provides a comprehensive code on professional conduct, role, functions, duties, manner of appointment, reappointment, provision for holding of separate meeting and evaluation mechanism for independent directors. Some of the intricate roles and functions include the following:

  1. Bringing an independent judgment to bear on the board's deliberations especially on issues of strategy, performance, risk management, resources, key appointments and standards of conduct;
  2. Bringing an objective view in the evaluation of the performance of the board and management,
  3. Scrutinizing the performance of management in meeting agreed goals and objective and monitor the reporting of performance,
  4. Satisfying themselves on the integrity of financial information and whether financial controls and the systems of risk management are robust and defensible,
  5. Safeguarding the interests of all stakeholders, particularly the minority shareholders,
  6. Balancing the conflicting interest of the stakeholders,
  7. Determining appropriate levels of remuneration of executive directors, key managerial personnel and senior management and playing a prime role in appointing, and where necessary, recommending removal of the executive directors, key managerial personnel and senior management, and
  8. To moderate and arbitrate in the interest of the company as whole, if there is conflict between the management and shareholder's interest.

The role of independent directors as prescribed in the Bill is no doubt very onerous, and may dissuade potential independent directors to take up such position. Everyone appreciates the stress on the need for independent directors to undertake appropriate induction, regularly update and refresh their skills, knowledge and familiarity with the company, as also acting within his authority to assist in protecting the legitimate interests of the company, shareholders and its employees. But how is the poor independent guy to define "sufficient attention" and "appropriate clarification" with respect to the company's matters especially when so much is expected of him.

Yes, we need to make independent directors accountable for their performance but are we now moving from one extreme to the other? The role that was not even defined earlier has now been stretched too far, making an independent director almost the promoter of the company. This is like asking the third umpire to rush on the field and lead the team.

The evolving realities in China also merit attention. India's business arch rival is already busy debating the role and efficacy of independent directors. Noted expert Chien-Chung Lin sees two models emerging in the near future. One: where the state controls as the regulator and the independent director functions as an intermediary; and two: where the state controls as a major shareholder and independent director is a representative of other stakeholders.

Here, it would be appropriate to take note of the corporate governance experiments in western countries. The Italian example is the most pertinent. In Italy, independence standards for directors are chiefly provided by the Italian corporate governance code (the Preda Code) that was updated in 2002 and 2006 following the infamous Cirio and Parmalat financial scandals. The Preda Code's provisions are generally not mandatory, but they require all Italian listed companies to present a yearly corporate governance report declaring whether and to what extent they conform to the Code. This reporting system follows the "comply-or-explain" principle, which allows companies to apply corporate governance principles with an eye to their own specificities. Article 3 of the Preda Code prescribes independence of judgment for all directors. However, only non-executive directors are recommended to provide an "independent and unbiased judgment on proposed resolutions. It's in this context that the Preda Code refers to a non-executive director as an 'independent director'. The Preda Code even goes further in identifying and addressing the most common symptoms of lack of independence. This approach to corporate governance seems more grounded although it remains to be seen whether its enforcement achieves the desired goal.

The moot point is clear and evident -- the Indian corporate world needs to welcome independent directors not merely by legislative default, but by self-regulatory design. If they are viewed as a compliance burden, no amount of legislation can help our cause. In this context, Wharton management professors Jitendra Singh and Michael Useem make such an apt remark:

"It's important to get really first-rate directors, but there is an important responsibility that comes to the chairman of the board. And that is, you have to model behaviour in a manner where dissenting opinions are welcomed" Bull's eye!

Former SEBI Chairman, M. Damodaran once rightly remarked "that corporate governance is a continuum that's way beyond the scope of mere legislation. But, unless this continuum is backed by prudent curriculum – both in content and practice - independent directors across companies will struggle to fulfil the very purpose that effects their appointment. More than just expanding the work horizon of an independent director, the need of the hour is a regulatory and operational framework that defines the attributes, qualifications and monitoring of independent directors."

Till such time, the corporate world will have little idea as to who's home in the guise of an independent director – Ombudsman, Superman or Godman?

Originally published by The Firm – CNBC TV18, July 17, 2012.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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