If only the promoters/management of companies had not unduly enriched themselves at the expense of the minority shareholders and only if they had complied with laws and regulations, the birth of the institution of independent directors (IDs) would not have taken place. It was, therefore, critical that this corporate governance (CG) oversight structure had to be very strong to be able to serve the desired objective. So, if almost the entire foundation of CG rested on the shoulders of the IDs, it is now a moot question as to how fragile this foundation has been, especially in the promoter-controlled Indian context.

If IDs are supposed to be the instruments of CG, we need to clearly agree on their role. This is critical because as a part of defending the extant mechanisms, attempts are being made to redefine their role to include contribution to the development of the corporate strategy, to review the performance of the management in meeting the agreed goals and objectives, and to also add value to the company in various other areas through their knowledge.

Many even suggest that IDs are not just for the minority shareholders; their role is protection of interest of all stakeholders.

None of these, however, is the real role of the IDs. By simple logic, the fundamental role of IDs has to be protection of the minority shareholders, which should be achieved by opposing ideas that are detrimental to their interests, and establishing financial controls to ensure that promoters do not enrich themselves, through unfair means or outlandish remunerations.

It, therefore, follows that anything else that the IDs do should be seen only as a bonus and only to be appreciated but none of these should be at the expense of their primary role. The only real meaning of the word ‘independent’ is that such persons should be independent of the promoters (and the management, which incidentally in India is a combined position in most cases) so that they are able to protect the minority shareholders from the promoters.

It should also be appreciated that IDs, who are required under a government mandate, are not representatives or nominees, of any sort, of the government to enhance a company’s performance. Regulations, in any case, are not supposed to direct companies to hire people to add value to their enterprises. Also, if that indeed was the objective of the regulator, it would have surely specified high eligibility norms/quality, which it has not. 

If we agree to the main and primary role of the IDs, it is absolutely critical to ensure we have the right IDs in place. That is where the basic problem lies. IDs in India are appointed by the promoters. This is the biggest paradox: an ID is appointed by the very promoter whose wrongdoings he is supposed to prevent. As long as IDs are appointed by the promoters, to whom they owe their office (and remuneration), independence shall remain a myth. In the Indian culture, guests will always be polite to their hosts, and in this case, these are guests who are also being paid by the hosts.

Little wonder, we have seen in scores of reported cases that even highly credible and qualified persons working as IDs have been no insurance for CG; they have not even smelt, leave alone detect, malpractices/ frauds. Almost all IDs tend to trust and provide blind support to the promoters because of the inherent paradox of not being able to take a stand against the very promoters who have appointed them. If some high profile IDs do get uncomfortable with an issue that could tarnish their public image, they would hurriedly resign from the boards, giving no reasons for their exit.

And yet, the regulator expects that it is the institution of ID that should ensure CG. Can this shortcoming be overcome? If indeed the role of the ID is to protect the minority shareholders from the promoters, common sense would dictate that the appointment of IDs has to be by someone other than the promoters. The reality is that no company would take on its board a person unless the promoter is extremely comfortable with him; no one will ever take the risk of getting a stranger on its board. And logically too, no sensible person would ever join a strange company’s board.

There is a suggestion in the Companies Bill that IDs henceforth shall be selected from a database of professionals. This too would not help. A company would first request their preferred candidates to enrol in the database and then would seek their profiles from this database. Since no qualifications or experience filters are being prescribed by the law, it would be possible for anyone to enrol in the database.

Realistically speaking, we should do away with the mandatory requirement of IDs, and at best make it voluntary. ID is not a valid concept for India at this point of time. In India, most (nearly 98%) companies are family-run; their stranglehold on their companies is near-complete. Most listed companies actually are run like proprietary firms. Expecting such families to induct true IDs is utopian. IDs will always be appointed by the promoters; corporates would neither accept outsiders nor should outsiders be imposed upon them. So the institution of IDs would always remain a farce, despite any number of loopholes that are plugged. Neither principle-based nor rule-based regulations will work. Let companies hire IDs if they find it necessary and let investors see value in such IDs. This way, only quality IDs will get appointed, and investors will demand and respect high quality IDs and value such companies differently.

However, since mandatory IDs are a reality that one will have to live with, we should attempt to derive at least some value from it. Some radical changes are imperative.

Idea 1: Nomination committee for IDs

Foremost, there is a need to change the appointment process. A nomination committee, comprising only of IDs (like in the US), should be made compulsory.

Appointment of IDs should be on merit and on some objective criteria. Only persons who can clearly demonstrate that they have enough time should be considered. Public disclosures should be made on how an ID was found and why is he being nominated, along with all his past and present relationship of any kind with the company/promoters/major shareholders/management. Profile of the ID along with all present significant commitments as also the proposed remuneration should be put on the websites of the company and the stock exchanges for public comments for 21 days. Existing shareholders alone may not know enough about these people and as such comments from non-shareholders, including potential shareholders, would only help the cause. In addition, each ID should provide a detailed certificate of independence at the time of appointment and annually thereafter.

Idea 2: Eligibility exam for IDs

The second reform is with regard to competence of IDs. It is a reality that most IDs do not even understand the basics of finance, leave aside its huge complexities, and have no noteworthy corporate qualifications or experience. Ask them questions about balance sheets, profit and loss account, sundry debtors, sundry creditors, forex hedging or accounting standards and they would be embarrassed!

Today, literally any person can become an ID. This is because while every job requires a qualification and/or experience, there are no eligibility requirements for an ID. As such, every single Indian, who is above 21 years of age, is qualified to become an ID, which means over 70 crore Indians are eligible to become IDs! And that too for handling such a professional and technical job! No educational qualifications or trainings necessary to understand the corporate world and laws/regulations have been prescribed for IDs in the regulations. It is amusing that a low-level operator in a broking firm has to pass the NCFM exam or to sell mutual fund, a person has to pass the AMFI (Association of Mutual Funds in India) test. But to be at the helm of a corporate, one does not need to have any qualification or pass any exam!

It is well known that scams can be perpetrated by the promoters in almost all areas of a company’s operations – sales, purchase, inventory, personnel and capex. In each of these areas, there are literally hundreds of ways a promoter can siphon off money or present a false picture. Promoters have to be smarter than the IDs; that is why the promoters have been able to set up an enterprise, and even raise money from the public! Most IDs would, as such, have a handicap versus the promoters in terms of knowledge.

Going forward, all new IDs should be required to pass a ‘directors’ knowledge test’ before appointment. There should be a professional institution of directors, membership of which should be obtained by passing the necessary examination after a course of instruction at or by reputed/selected business schools/academic centres. The board appointments should be limited to such certified directors. All existing IDs could be given a six-month timeframe to pass the same. The test should be very extensive and assess the person’s knowledge of finance, Companies Act, SEBI Act/regulations and the like. Many eminent people may scoff at this suggestion and lodge a major protest. The answer to them is that they have accepted tests of various kinds at various stages of their lives and this is one test which should be no different. Provision must be made for continuing professional education requirements.

On tenure, the Companies Bill has put a cap of five years, extendable by another five years. The limited tenure argument is based on the premise that familiarity breeds complacence. However, this argument is faulty and assumes that IDs do not connive, by design or negligence, with the promoters in the first five or 10 years. The real problem is that familiarity has existed even before their appointment. Fixed tenure could have been valid only in case an ‘outsider’, not known to the promoter, came on to the board as with the passage of time, there is a possibility that he could become friendly with the promoter.

On pecuniary relationship, the law prescribes that an ID should not have one at the time of appointment. But what about the pecuniary relationship that gets established post-appointment? When someone earns huge monies from a company as an ID, it may be debatable if he would remain independent anymore. The truth is that he would never dissent for the fear of being shown the door.  This becomes more acute as nearly half of the IDs are retired people, who naturally would be significantly dependent on the ID remuneration, more so if the remuneration is high. Such IDs would be guided more by their personal economic rationale and their independence would surely be under threat.

Idea 3: ID as whistleblower

The Companies Bill also stipulates that a director should give detailed reasons for his resignation from a board. This is a good idea. But in reality, these reasons would continue to be vague. What is required is an exit interview by an independent body; this would be a good way to convert these IDs into whistleblowers of sorts.

Idea 4: Pre-approval for related party transactions (RPTs)

On another front, it is generally accepted that huge sums of monies are siphoned away from the companies by the parties. Presently, the audit committee is expected to review related party transactions (RPTs) on a periodic basis after such transactions have taken place. Such reviews are of limited use as the transaction could not be undone even if the audit committee expresses negative opinion on the transactions. This handicap can be removed if the requirement of pre-approval by audit committee of major RPTs and major restructuring proposals could be mandated.

Idea 5: The one-third formula

There is also a need to bring a new paradigm on board composition. As a suggestion, 1/3rd of the board should be of promoter-directors, another one-third should be of professional directors appointed by the management who would not be deemed as IDs, and the balance one-third should be the IDs.

Idea 6: Auditors paid by investors, working for investors

Alongside, there is a crying need to make the auditors more accountable. Auditors are a very critical constituent of the corporate world. After all, investors and many others depend on audited accounts and thousands of crores of rupees can be lost by investors on the basis of fraudulent accounts.

No disclaimers should be allowed to the auditors. They are the only ones who have complete and unbridled access to every single company document and it should be their responsibility to ensure that they have reviewed all the papers themselves and have not depended upon management’s confirmations. It is ironical that auditors who have complete access to the company and all documents through the year are able to walk away with impunity, and IDs, who attend four or five, and that too short, meetings are held accountable.

Moreover, auditors should not be appointed by the promoters (who also are in the voting majority at the AGMs). The auditors’ job is to prepare financial statements not for the promoters but for the public shareholders. Auditors for listed companies should be selected, based upon objective criteria, from a panel created by ministry of corporate affairs/SEBI; these auditors can then be subjected to greater regulations and oversight. The audit fee should be paid from the investor education / protection fund (IEPF/IPF) or from a new transaction fee/listing fee.

Errant auditors should be punished severely, and their certificate of practice should be revoked for lifetime. Also, all audit firms who resign from their clients should be required to submit a detailed report to the regulators explaining in detail the reasons for their resignation.

In addition to the auditors, institutional investors can play a significant role in ensuring CG. Each institutional investor should have a clear policy on voting and detailed disclosures of voting activity.

A change in mindset

But more than anything else, it is important to realise that CG is being addressed from the wrong end: independent directors are not the solution to achieve better CG. Corporate governance is the job of the regulators. It is their job to detect and punish non-compliance. It cannot be the responsibility of IDs to ensure compliance.

To achieve better CG, first all regulations should be reviewed, to make these meaningful, simpler and free of loopholes. It is better not to have laws than to have ones which are opaque or which cannot be enforced. Moreover, there is a need to mandate better corporate disclosures. There is already a huge amount of information that corporates have to disclose. The focus should be on quality and not quantity, and making these investor-friendly. But, most importantly, the need is to enforce compliance of regulations.  Malpractices abound. This is because one may never be caught. And if one is caught, it may take years for the indictment, which also may not happen if one can bribe his way out. And if the indictment happens, it may be too late and too minor. So breaking the law comes easily.

The regulatory agencies should strengthen their surveillance and enforcement functions (including an early warning system) to ensure compliance of all laws and regulations. Alongside, there is a need to develop a system for swift investigation and also swift and adequate punishment to the offenders, which will also act as a deterrent. What is required is compliance and punishment for non-compliance and not name it as CG.

If we only tinker around with the existing regulations, as is presently being proposed without addressing the core issues, CG would continue to be a casualty. Like compliance of Clause 49 was achieved literally overnight in 2006, corporates shall again achieve literal compliance with whatever new laws/regulations are put in place. This would also be achieved easily by finding several loopholes in the guidelines that are exploited so easily by our ingenuous India Inc.

Ultimately, it’s also important to recognise that at its core CG is not a matter of regulation. There is something more important than regulation and compliance: ethics. If the promoters have the right DNA, they do not need IDs. And that if they do not have the right DNA, IDs cannot do any good. For most managements now ethics is an afterthought; ethics cannot be an afterthought. Governance has to be driven by the management and there is no substitute for that. Good behaviour will be valued and respected by the market. Expecting regulations to infuse morality into managements people is a far-fetched idea. Emphasis should more be on meaningful and timely disclosures, and on severe punishment in case of non-compliance of laws and regulations. Let IDs not become a tool to provide a false sense of security to the investors and the regulators.