Tuesday, May 31, 2011

Independent Directors: Governance Matters




With the new reforms in place and the numbers of independent directors increasing there is a need to consider all aspects of the board’s operations that might reduce the effectiveness of independent directors. In this context awareness of the human and behavioral aspects of boardroom dynamics is essential in the campaign for improved corporate governance.

While external directors have been present on corporate boards since the nineteenth century, focusing on them as monitors of board behavior is still relatively new as it all began in the wake of a series of high-profile corporate scandals that led to collapse of many big corporations in US and Europe, beginning with the spectacular collapse of Enron in 2000. Since then, various governments and regulators including SEBI in India (Clause 49) have responded to a perceived crisis by raising the standard of corporate governance.

A common theme in these reforms has been creating some requirement for the independence of directors - although the extent of these requirements has differed. Recent reforms like the Sarbanes Oxley Act (SOA) to the composition of corporate boards are seen as a way of improving the decision-making processes on corporate boards as well as increasing the rigor of the board’s monitoring of management. The key to many of these changes is the independent director.

Brought in from outside, the independent director is conceived of as having no direct or indirect connection with the corporation other than the position they hold on the board. Therefore they are seen as having the ability to bring an independent judgment to bear on the performance of management. However, how well this reform strategy works in practice is still unclear. And, recent past episodes like the Madoff scandal and Satyam-Maytas fiasco and more importantly the global financial crisis which has seen the collapse of a number of banking and financial institutions either collapse or reach the verge of bankruptcy only exposes the chinks in the firms’ corporate governance structure and that there is something seriously wrong with the independent directors’ framework/system. Against this backdrop, it is critical to evaluate the reality of the independent director’s role and how they can best fulfill these expectations. Central to this is raising awareness of the power of group dynamics to compromise the independent director’s ability to monitor and contribute to the performance of a corporation.

Some practical steps can assist in this regard:

• The corporation can develop protocols to ensure that important information is automatically passed to the independent directors.

• The board’s agenda can be set at the end of each board meeting thereby allowing members of the board to add any important issues.

• Independent directors can be encouraged to meet both formally and informally outside the board process to share ideas and concerns.

• Independent directors can have access to independent outside advice on matters relevant to their role in the corporation.

• The board can increase awareness of external issues and improve the decision-making process allowing indirect input by shareholders and stakeholders through access to independent directors.

Definitions of independent directors
According to Higgs’ definition: “that a non-executive director is considered independent when the board determines that the director is independent in character and judgment and there are no relationships or circumstances which could affect, or appear to affect, the director's judgment”. Such “relationships” are enumerated.

According to the SEBI’s Clause 49 of the Listing Agreements an ‘independent director’ shall mean non-executive director of the company who apart from receiving director’s remuneration, does not have any material pecuniary relationships or transactions with the company, its promoters, its senior management or its holding company, its subsidiaries and associated companies; is not related to promoters or management at the board level or at one level below the board.

Satyam-Maytas fiasco calls in question the role of the independent directors The Satyam-Maytas fiasco has drawn the attention of Government towards the role of independent directors, especially when the new Companies Bill provides for 33 per cent of such directors in boards of companies. In the longer run, it needs to be seen. The Satyam deal certainly raises the question whether the independent directors of the company failed to carry their duties. India's fourth largest software company Satyam Computer Services recently decided to buy two firms -- Maytas Properties and Maytas Infra -- promoted by Satyam chief R Raju's two sons for USD 1.6 billion (about Rs 8,000 crore), but called off the deal within few hours following investors' wrath. The IT major's decision to buy out the two firms also raised the larger issue of corporate governance. Satyam's Board, including independent directors, had unanimously given a go-ahead to the deal.

The listed companies are already bound by SEBI's Listing Agreement, which calls for certain proportion of independent directors in the board for keeping a check on the management of companies and work as an oversight mechanism. Apart from value addition they are also entrusted with the task of representing the financial interests of others investors. The fiasco has raised some important questions about the role of the independent directors of the firm and hence calls for some serious introspection.

Indian Scenario
For the sake of mere compliance a company may appoint independent directors but whether they are really independent in their thinking, approach and actions is a moot issue. For instance, director resignations are an important indicator of the sensitivity and urgency of issues involved at the board level. We have no studies in India illustrating how director resignations impact stock prices and what other signals they provide for interpreting the existing or evolving corporate governance practices in India. There is hardly any shareholder activism in India.

Shareholder associations exist but whether they able to exert any meaningful influence over the managements of the companies is a moot issue. The limitations of influence of independent directors arise because of internal sources such as the personality of an individual director or external sources such as ownership of a firm, board composition and structure, board process and strategies. The value that independent directors add to the board process only will ensure effective corporate governance.

Board independence is to be achieved and the board needs to emerge as a role model; rather than a predictable stereotype. We in India do not have any formal mechanism of evaluating a board performance and therefore, we have no precedent or comparable information. We also need to note that leadership is not synonymous with designations and age; for leaders need to be developed at a fairly early stage of managerial career life cycle.

There is therefore, scope for introducing leadership courses and a generic curriculum at the higher secondary levels of education so that in the more specialized modules of management education can be inculcated in the mindset of the potential managers. The regulatory and legislative framework can only streamline the existing practices of corporate governance but too much focus on compliance orientation so far has not resulted into awareness for self-regulation and accepting best practices of corporate governance as a way of life for the corporations.

A conscious effort by the top leadership in companies is required, regardless of ownership, to inculcate a culture of transparency and accountability and propagate a well articulated message that in the long run ethical behavior and corporate social actions are not incompatible with good corporate governance and sustainable profitability of the companies.


Recent changes in corporate governance require firms to maintain boards with a majority of outside independent directors. The belief seems to be that outside independent directors will strengthen corporate boards by monitoring the actions of management and ensuring that management decisions are made in the best interests of the stockholders. This belief, however, may be founded on an assumption that has its roots in public perception and not in fact.

The results of several studies suggest that outside independent directors do appear to strengthen corporate boards; however, more needs to be done to reestablish the market's confidence in corporate America's ability to effectively govern itself. The time to ensure independent directors work best in their role on corporate boards is now. With the new reforms in place and the numbers of independent directors increasing there is a need to consider all aspects of the board’s operations that might reduce the effectiveness of independent directors. In this context awareness of the human and behavioral aspects of boardroom dynamics is essential in the campaign for improved corporate governance.
N Janardhan Rao,  Senior Economist.

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