Role Of Independent Directors In The Changing Business

Published Date: 02 Nov 2017

Abstract:

The literature on corporate governance and various codes emphasis that the Board of directors should provide direction to the company, evaluate and approve strategies, appoint and remove the chief executive officer and decide the compensation for him and other members of the top management. While an Independent Director should focus on the adequacy and effectiveness of the internal control and risk management systems. They are expected to protect the interest of non-controlling shareholders, should be watchful to identify weaknesses and should act tough only when required. Despite Enron, World com and Satyam’s Boards having many Independent Directors could not avert the major corporate disasters. The challenges of Independent Directors are many folds and growing day by day. The government expects Independent Directors to bring an independent judgment to bear on the Board’s deliberations especially on the issue of strategy, performance; risk management, resources, key appointments and standards of conduct and bring an objective view in the evaluation of performance of Board and management. The public outrage in many corporate failures suggests that there is a huge expectation gap between what Independent Directors can do and what stakeholders expect to do. This gap is created because all the stakeholders have hyped the role of Independent Directors under the code of corporate governance. In order to be effective, they need to understand they can effectively protect the interest of non-controlling shareholders even when the Board is devoid of certain critical responsibilities. This paper attempts to find out "the ultimate measure of Independent Directors not where they stand in moments of comfort, but where they actually stand and should stand at the time of challenges and controversy."

Key Words: Independent Director, Corporate Governance, CEO, Board of Directors, Stakeholders.

Introduction:

It is widely accepted that the presence of Independent Directors in the Board room improves the quality of corporate governance. Accordingly, corporate governance mechanisms all over the globe, including in India, focus on Independent Directors. The Independent Directors are expected to protect the interest of non-controlling shareholders. They should be watchful to identify weaknesses before they surface in the product market. But, they should not be over reactive. It is expected that the Rajyasabha will pass the Companies Bill, 2012 in the budget session, in February, 2013 and India will get a modern Companies Act. The history of corporate India suggests that in spite of having vested power under clause 49 of the Listing Agreement with stock exchanges enforced by market watchdog SEBI, Independent Directors were forced to act like lame ducks. The code for Independent Directors included in the Bill (schedule IV) requires a number of provisions which are expected to be fulfilled by the Independent Directors (IDs). The objective of the paper is to highlight the journey of the Independent Directors from its gestation period up to the Companies Bill, 2012 become an efficient Act.

Concept of Independent Director:

An Independent Director is a director (member) of a Board of directors who does not have a material or pecuniary relationship with company or related persons, except sitting fees. However, the clause 49 of the listing Agreement defines Independent Directors as follows: "for the purpose of this clause the expression ‘independent directors’ means directors who apart from receiving director’s remuneration, do not have any other material pecuniary relationship or transactions with the company, its promoters, its management, or its subsidiaries, which in judgment of the Board may affect independence of judgment of the directors."

Role, Responsibilities and Duties:

An Independent Director is a person having many years of experience and acts as a guide for the company. The role they play in a company broadly includes improving corporate credibility and governance standards, function as watchdog, play a vital role in risk management. Independent Director plays an active role in various committees to be set up by a company to ensure good governance. Listed companies are required to set up audit committees of minimum three directors, on which, two-thirds should be Independent Director.

The role and responsibility of an Independent Director arising out clause 49 requirements of role of audit committee would include:

1. Oversight of company financial reporting process and disclosure of its financial information.

2. Recommending to Board on the appointment, re-appointment and if required replacement or removal of statutory auditor and fixation of audit fees.

3. Review with management, the annual financial statements before approval by the Board with particular reference to Directors Responsibility Statement, changes in accounting policy, major accounting estimates, audit findings adjustments, compliance with listing and other legal requirements, disclosure of related party transactions and qualification in the draft audit report.

4. Review of quarterly financial statements.

5. Review with management, performance of statutory and internal auditors, adequacy of internal control systems, adequacy of internal audit function including their structure, frequency, reporting.

6. Discussing significant finding of internal auditors, including internal investigations made by them into areas of fraud, irregularities or major failures of internal control systems.

7. Discussing with auditors on the scope of the audit.

8. Reviewing reasons for defaults into payments.

9. Reviewing the whistle blower mechanism.

10. Mandatory review must be made of related party transactions and internal control weaknesses.

11. Review financial statements of subsidiary companies with special attention to investments made by them.

12. Review uses/application of funds from public issues, rights issues, preferential issues etc.

13. Disclose shareholdings in the listed company.

Duties & Responsibilities of an Independent Director. The duties and responsibilities of Independent Directors are normally as they are of director of the Company:

1. He should furnish information in the prescribed form to the company about disclosure of General Notice of directorship, membership of body corporate and other entities.

2. He should also inform the company about any change in the details submitted subsequently.

3. He should provide a list of his relatives as defined in the Companies Act and their directorship and interest in other concerns.

4. The Director shall have fiduciary duty to act in good faith and in the interest of the company.

5. It is the duty of the independent director to acquire proper understanding of the business of the company.

6. He should act only within the powers laid down by the Memorandum of Association and Articles of Association and by applicable law and regulations.

7. He should not be a Director of more than fifteen companies.

Such an independent director could be working as member of Audit Committee prescribed under Section 292A of the Companies Act. In such situation he has to look into the obligations of Audit Committee and perform the duty.

Corporate Governance- the seed of independent director:

Nobel Laureate Milton Friedman defined corporate governance (CG) as "the conduct of business in accordance with shareholders’ desire, which generally is to make as much money as possible, while conforming to the basic rules of the society embodied in law and local customs." So, corporate governance is the process of managing the corporate by establishing better relation with the top management and other interested parties to the affairs of the company with a view to maximize the shareholders’ value in the long run through better business practices, better quality of work life and culture.

The Board of directors of a listed company is primarily an oversight Board. It oversees the management of the company to ensure that the interest of the non-controlling shareholders is protected. The Board is collectively responsible for the governance of the company. It also functions as advisory Board. Since corporate governance, evolved over the past century promotes the allocation of the nation’s savings to its nation’s savings to its most productive uses. The creation, maintenance and distribution of wealth are handled by one group (Board of directors) while the provision of capital is done by another (shareholders).

The corporate governance mechanism envisaged is evolved to achieve the following corporate governance outcomes as stated in the OECD principle:

Ensuring that effective corporate governance frame work consistent with the rule of law,

Protecting the rights of shareholders and facilitate the exercise of their rights,

Ensuring the equitable treatment of all shareholders including minority and foreign shareholders,

Recognizing the rights stakeholders and encourage their active co-operation in creating wealth, jobs and the sustainability of financially sound enterprises,

Ensuring timely and accurate disclosure on all material matters, and

Ensuring the strategic guidance of the company, the effective monitoring of the Board and the Board’s accountability to the stakeholders.

Again the corporate governance needs to facilitate a few essential and some of which include:

Raising sources across the market in a cost-effective manner

Corporate reputation and higher brand equity

Public confidence in a corporation: In fact, McKinsey study indicates that 60 per cent of investors cite good governance as a key factor for their choice of investments

Roping best talent and motivating managers for maximum returns through a more conducive environment

Enhancing operational efficiency

Cushioning the effects of globalization and enhanced cross-border investments.

As the economies grew, business units became even larger and more complex, the shareholder control and ownership became more, scattered and dispersed. There was a gradual shift in control from direct owners in to the hands of Board. The creation, maintenance and distribution of wealth are handled by one group while the provision of capital is done by another group. In this complex network with divergent interest of all stakeholders the necessity of non-executive directors got in to the focus and their role in the Board meeting hyped with committed expectations.

Relevance of Independent Directors:

The most important function of a monitoring Board is to provide direction to the company. In a professionally managed company in which no individual or group holds significant voting rights, the strategies are formulated by the CEO. A business has many stakeholder groups, whose interests are impacted by strategies, policies and operations of the business stakeholder groups which have low interest level and high power should be kept satisfied to avoid them gaining interest and becoming a member of a group, which has high level of interest and high power. Managers ensure participation by stakeholder groups, which have high interest level and high power, because they are major drivers of the change and major opponents of strategies. Indian corporates do follow the same practice. As the economies diminished and ownership became more scattered and dispersed. There was a gradual shift in control from direct owners into the hands of Board. The capital providers, idea generators and executives formed distinct groups. The creation, maintenance and distribution of wealth are handled by one group while the provision of capital is done by another group. The companies need to generate surplus for sustainability and growth and to ensure adequate return on capital to retain the existing shareholders and to attract the potential investors of other stakeholder groups. This approach leads to ignoring the interest of those groups, which have low power, even if their interests are impacted significantly by strategies, policies and operation of the company Managers are rewarded for manipulating the stakeholders and not for aligning and protecting interests of various stakeholder groups or for resolving concerns of various stakeholder groups in just, fair and equitable manner. Accordingly, the primary role of Independent Directors is to protect the interest of non-controlling shareholders. In the changing business environment the new paradigm of corporate governance is evolving. A large number of companies adopting sustainable reporting guidelines issued by the organization called Global Reporting Initiative (GRI). The government has issued National Voluntary Guideline (NVG) on Social, Economic and Environmental responsibilities of companies. The Companies Bill, 2012 requires Independent Directors of safeguard the interest of all stakeholders and to balance the conflicting interest of the stakeholders.

In the extent of corporate governance model, the primary role of Independent Directors is to protect the interest of the non-controlling shareholders. In the new paradigm, Independent Directors are expected to take two additional responsibilities. They have to ensure that the executive management is making serious endeavor to meet the social expectations and to act as an arbitrator in a dispute between stakeholder groups. In the present formulation Independent Directors might not be able to discharge their existing and additional responsibilities effectively.

Presence of Independent Directors in the Boards and effect on firm performance – A Tangle:

Different studies across the world have so far been conducted to find whether Independent Directors actually contribute to firm performance or not and the result is heterogeneous – positive, negative and tangential (mix) relationships.

Hutchinson (2002) have suggests that the interaction of investment opportunities and the proportion of non-executive directors on the board shows that firms perform better with increased number of non-executive directors on the board. This suggests that the negative relationships between firm performance and investment opportunities are weakened when the proportion of non-executive directors on the board is higher. Thus, it does appear that the monitoring role of non-executive directors overcomes the agency problem of high investment opportunities such that these firms become more profitable.

The results obtained by Choi et al. (2007) suggest that board independence is critical to an emerging market that is subject to external shocks and may lack sufficient liquidity as well as indigenous industrial infrastructure. They note further that in such market environments firms with insider-dominant boards and entrenched inside ownerships can actively involving them in major activities of the firm, with additional assistance from outside institutional shareholders, foreign investors in particular.

Again, Kumar and Sivaramkrishnan (2007) showed that shareholders value can increases as board dependence (not independence) increases. In other words, when a board is more independent it performs worse. The reason for this, the authors note, may be because when directors get equity awards, tension is created between the boards monitoring and contracting (supervision) roles. They argue that the reason that explains this finding is that a more dependent director benefits less from superior information about the firm’s economic prospects generated by monitoring than a less dependent director. Thus, as more dependent directors sit on the board; there is a substitution effect that lowers its optimal monitoring effort. On the other hand, from the view point of shareholder value maximization, such a board is also more inclined to award less efficient contracts to the manager. This tendency however imposes a negative wealth effect on the board if it has an equity stake. In equilibrium, this negative wealth affects ex-ante so that it is able to award a more informed (or efficient) managerial compensation contract ex-post. Thus, the net effect of increased (or decreased) board dependence and shareholder value is ambiguous.

In their study, Duchin al. (2008) examined the effects on board independence or performance that are largely free from endogeneity problems. Their main findings is that the effectiveness of outside directors depends on the cost of acquiring information about the firm because when the cost is low, performance increases when outside directors are added to the board but if the cost of information is high performance worsen when outside directors are added to the board. Thy further state that for firms that constitute their boards to maximize value, an increase in the number of independent directors on such boards would be harmful. On the other hand, if firm managers constitute their boards with too low independent directors for the reason of minimizing oversight, an increase in the number of Independent Directors would have a uniform impact on performance across firms. So, when organizations are forced by legislation to put more Independent Directors on their board, mixed performance should be expected across firms. In other words, there is no consistency in the performance of Independent Directors that can be guaranteed across firms.

The study report of Gillete et al. (2008) shows that the presence of outside directors on corporate boards leads to better decision making. They also find that the most efficient board structure is the single-tired board with a majority of outside directors, and that the presence of outside directors improves the quality corporate decision making even when they are not in the majority.

Failure of Independent Directors:

The whole idea behind mandating Independent Directors was to ensure companies follow good corporate governance practices and protect interests of minority shareholders. They are required to exercise oversight to prevent willful compromise of the interest of the stakeholders. But it is unfortunate that in many instances companies have made a mockery of the statutory provision requiring of Independent Directors. Many appoint their friends and high profile names who lack the qualification to become Independent Directors. And event those are fit for the pasts in number of occasions failed to perform.

Since in a professionally managed company the CEO formulates the strategies, the Board finds it difficult to propose alternative strategies or to audit the strategy proposed by the CEO due to knowledge gap between the CEO and Independent Directors. Another very important function of a monitoring Board is to set the ‘tone at the top’. In practice the ‘tone at the top’ is set by the CEO and Independent Directors do not get the opportunity to change the organization culture. It cannot be discarded the fact that the Board as an institution, has failed in its monitoring role. Strong arguments can be added in this regard. Although, as law, directors are appointed by shareholders in practice, the incumbent management appoints Independent Directors. Usually, an enlightened CEO desires a strong advisory Board rather than a strong monitoring Board. Monitoring might require Independent Directors to break the ‘Board room decorum’. Presence of individuals, who are respected for their work in other fields, does not necessarily improve the corporate governance. This has been established time and again by corporate governance failure in companies like Satyam, Enron, World Com and so on.

Some of the examples where Independent Directors were failed to protect the minority shareholders’ interest are:

Enron Saga:

Housten based Enron Corporation quickly became synonymous with the term massive accounting fraud in the fall of 2001 with its sudden collapse and bankruptcy. Many people have described the utility company’s ruse as a cleverly designed fraud involving the use of thousands of off balance sheet partnerships to hide massive losses and unimaginable debts from investors. Enron’s staggering increase in revenue was unprecedented – rising from $ 9.2 billion in 1995 to $ 100.8 billion in 2000, and the company achieved this growth without any large acquisitions along the way which was quite impossible. The Independent Directors, the auditing firm Arthur Andersen, investors none have raised questions about these incredible revenue growths and cooking up of account was carried out smoothly.

Collapse of World Com:

Almost from the beginning, World Com used aggressive accounting practices to inflate its earnings and operating cash flows. One of the principal shenanigans involved making acquisitions, writing off much of the costs immediately, creating reserves and then releasing those reserves into income as needed. The company treated $ 14.7 billion in 2001 line costs as current expenses. By transferring part of a current expense to a capital A/c, World Com increased both its net income (due to understated expenses) and its assets (since capitalized costs are treated as an investment). Not only that, it reduced its reserve accounts in order to provide credits against line expenses. The Independent Directors as well as the Auditor Arthur Andersen LLP were taken into confidence and none of the members carried the role of whistle- blower. On the contrary, instead of asking tough questions of company’s top executives or continuing to demand access to company records, the audit firm shrugged its shoulders and acquiesced to a client that paid the firm more than $ 40 million in auditing and consulting fees in a three year span.

Xerox scandal:

In 2002 Xerox revealed that over the past five years it had improperly classified over $ 6 billion in revenue, leading to an overstatement of earnings by nearly $ 2 billion. The effect of the manipulation was that the company counts as earnings what essentially future revenue was. The audit fraud allowed Xerox to manipulate its earning by over a billion on dollars during the relevant period. What was shocking that the four outside auditors of Xerox for different period of time like KPMG, Ronald Safran, Michael Con Way and Thomas Yoho have failed along with the Independent Directors to detect such malpractice!

Tyco: Most shameless Heist by Senior management:

Like World Com Tyco were in rapid takeover mode and from 1999-2002 it acquire more than 700 companies for a combined total of approximately $ 29 billion. The acquisitions allow the company to reload its dwindling reserves, providing a consistent source of artificial earning boosts. Moreover, the frequent acquisitions allowed company to show strong operating cash flow, even though it merely resulted from an accounting loophole. The company used the benefits of acquisition for manipulating the accounts even there were no take overs earned out. It has used a number of financial shenanigans like understatement of expenses and overstatement of revenue resulting inflated profit to attract investors and dupe them in practice. The external audit firms, Independent Directors were taken into confidence and such earnings management executed.

Millions of investors in Enron, World Com, Tyco, Satyam paid heavy prices for failing to spot early signs of operating problems that had been camouflaged by financial shenanigans. The Independent Directors too are liable for failing to discharge their duties. It seems that the role of Independent Director may be the best part-time job in the world. Sitting as an outside director on a corporate board brings prestige, perks and huge commissions with cash and non-cash compensation often exceeding million rupees per year. It is very hard to see how an Independent Director like Prof. Krishna Palepu of Havard University is really ‘independent’ when it was disclosed that he had taken $ 200.000 from Satyam in 2007 for providing professional services.

From the above it is evident that legally, directors are responsible for the company even if they delegate almost completely to management. However, the scope of this responsibility is hard to reconcile with the limits of time and knowledge that the Independent Directors must live with. Boards that clearly understand their roles will have to use their limited uses better because their efforts will then become more focused. Thus, there is a growing gap between society’s expectations and what a Board can truly achieve. As the economy matures, many companies now feeling this pressure.

In 2012 the Govt. of India used its power under the constitution to issue a presidential directive to compel Coal India Ltd. (CIL) to sign fuel supply agreement (FSA) with power producers to supply as much as 80 percent of the fuel requirements of power plants or pay penalties if it does not meet the commitment - even the Independent Directors rejected the request from Prime Minister’s Office to sign the FSA. This leads the questions whether Independent Directors of State Owned Enterprises (SOEs) are really independent or not.

After the AMRI fire incident the role of Independent Directors came under scanner in December, 2011. AMRI has earned a reputation of a well-run hospital with high quality of service but the Board has failed to appreciate the reputation risk. It did not pay attention to risk management and to the responsibility of ‘setting the tone at the top’.

Independent Directors are expected to act independently of management. They are expected to take tough decisions including the removal of the CEO where necessary. In practice, very little of this happens. Because the so-called Independent Directors are beholder to management for their appointments. They are taken care of through handsome fees and commissions. In some cases, they are brazen enough to earn lucrative consulting fees from the heads to whatever management wants done.

The scale of `7,000 crore financial fraud of Satyam Computer Service had pointed out the role of Independent Directors across corporate India. For long, companies across the world have appointed luminaries to the Board secure in the knowledge that their presence would lend a symbol of ethical behaviour to the Board room. Satyam was no exception – its Board included noted academics such as a Havard Professor, Dean of IBS and some retired professionals and bureaucrats but all of them failed to protect the interest of stakeholders and alleged for their gross negligence in performing their role as Independent Directors.

Expected role in the changing business environment:

Several initiatives worldwide have been taken to drive Board performance. Regulatory changes have affected the composition, role and responsibilities of the Boards worldwide and stronger framework for director’s fiduciary responsibilities have resulted. Consequently, Boards are trying to find a balance between increased security and regulatory reforms imposed from outside and efforts made by the Boards themselves.

Embodied in the recent regulatory requirements in several countries is the notion and confirmed catechism that Independent Directors provide a particular type of objective, shareholder – minded monitoring and it has been argued by the governance advocates and regulators that Independent Directors improve corporate decision making and business performance.

The quest for corporate governance is also present in the provisions dealing with appointment of Independent Directors. The Companies Act, 1956 only provided for Independent Directors for the remuneration committee. The Companies Bill, 2012 are a reproduction of clause 49 of the Listing Agreement, but not restricted to that alone. Independent Directors may receive fee and profit linked commission subject to the Central Government guidelines and rules but not any remuneration other than reimbursement of expenses. Participation in the Board meetings. The bill contains an elaborate process of appointment to ensure insulation. A promoter, a relation, a director / officer holder of a subsidiary associate organization are some of the exclusions which are essential as some listed companies were violating these norms.

A company is controlled by the dominant shareholder and his associates. The Companies Bill, 2012, therefore, settles for a modest minimum one-third strength for the Independent Directors on the Boards of listed companies, no matter what the Chairman is – executive or non-executive – while leaving the minutiae to the Central Govt. with regard to unlisted public companies.

In the new scheme of things, Independent Directors would be a class by themselves and have to be appointed as such. They would enjoy an uninterrupted tenure of fire years and need not to retire by rotation; rather can be re-appointed for another five years by passing a special resolution in AGM with the consent of 75% majority must give the moral boost up for the Independent Directors in the discharge of their ethical role.

The bill also provides under Section 49(12) that, Independent Directors should be liable, of an offence which occurred with his knowledge, attributable through Board process, consent, connivance or lack of due diligence is a welcome step as no part-time director on that excuse alone can allow grass to grow under his feet.

As far as the celling of an individual serve as an Independent Directors in the public listed companies are restricted to 7 as per the National Voluntary Guideline (NVG) or Social, Environmental and Economic responsibilities of business are concerned as suggested by MCA is the reflection of positive and long run vision of corporate governance in India. It should further be remembered that it will be difficult for companies to get such individuals on Boards, taking into account the responsibilities given to Independent Directors and the fact that they are liable for any fraud detected. Again, the remuneration for Independent Directors should be adequate enough, not excessive.

The recently published norm for Independent Directors on Central Public Sector Enterprise (CPSEs) Boards is the finest example of government’s commitment on corporate governance practices at par with the corporate world. The norms suggest that Independent Directors should satisfy themselves on the integrity of financial information and financial controls, besides ensuring that the risk management systems of the company are robust and defensible. The Independent Directors are expected to discharge the duty of an arbitrator in the interest of the company as a whole in situations of conflict between management and shareholder’s interest. They should report concerns about unethical practice, actual or suspected fraud or violation of company’s code of ethics policy. Further, it is expected that the Independent Directors should maintain professional integrity and business secrets.

Independent Directors should not hesitate to audit the strategy presented before the Board for approval and asks uncomfortable question. This helps the promoter to receive objective feedback on the strategy. An Independent Directors should focus on the adequacy and effectiveness of the internal control and risk management systems. It must critically review the strategy implementation and operating performance. They should not develop animosity towards the promoter or the CEO. They should act as friend, philosopher and guide.

On the contrary, unfortunately Independent Directors often become subservient to the CEO and his team. One of the reasons are the wide knowledge gap between the CEO and his team and the Independent Directors. Independent Directors should invest at least two days in a month to contribute effectively in Board meetings. They should be allowed to interact with senior executives on regular basis to understand the business and its environment. They should have the time and inclination to learn.

The professional directors should be appointed as Independent Directors having vast experience in the age group of 60-70 with good health and vision to serve the interest of all stakeholders especially the minority groups.

Role of Belief:

Belief is subjective truth, independent directors’ truth and all other stakeholders’ truth, the lens through which all of us makes sense of the world. Humans, are consumed with notions of what is true, (Satyam in Sanskrit), good (Shivam) and beautiful (Sundaram). Belief establishes these. Belief establishes us to qualify people as heroes, villains and victims. Everyone believes their subjective truth to be objective truth, and clings to it firmly, as it determines their self-image and their self-worth.

Belief plays a key role in business it determines choices and propels the decision of buyers and sellers, regulators and shareholders, investors and entrepreneurs, employers and employees, vendors and customers – i.e. all the stakeholders. It determines how we do business and what ultimately gets done. As is belief, so is behaviour, so is business. This is business sutra. Belief may express itself in behaviour; the reverse may not be true. The Independent Directors in today’s changing environment has to go beyond statutory position and compliance to address the manner in which they manage their economic, social and environmental impact and their stakeholders’ relationships in all their key spheres of influence – the workplace, the market place, the supply chain, the community and the public policy realm.

Conclusion:

Boards are essentially social systems and what distinguishes exemplary Boards is that they function as robust, effective social systems, in a virtuous cycle of respect, trust and candor. Good Board governance cannot be fully ensured by external legislation alone but has to build overtime and the best set for success lies in building a climate of trust and condor in the Board to share important information with directors in time; introducing measures for evaluating Board performance in terms of integrity of directors, quality of the directors, degree of knowledge and personal relationships. We have to accept the reality that Independent Directors cannot monitor the executive management. At best they provide checks and balances and enrich Boardroom deliberations. Therefore, each Independent Directors should understand the business well and should have adequate knowledge to appreciate management issues. Independent Directors should not be held responsible for the misdeeds of the company provided they have applied due diligence in carrying out their responsibilities. There is a gap between what is expected from Independent Directors and what they can do in practice. Independent Directors in enlightened companies, improve enterprise performance by providing innovative solutions to issues that pull down performance of company. They, through the audit committee, strengthen audit functions and risk management systems. They usually stop decisions that directly hurt the interest of non-controlling shareholders. And perhaps, that is what shareholders expect from Independent Directors.