Are Independent Directors Independent?

Thank you everyone for your support of last week’s blog “How Cyrus Mistry was Fired as Tata Chairman”. It received over a million views between my blog, social media, and websites of publications. Besides, it also appeared in the print editions of more than 30 national and regional newspapers.

The separation of control from ownership in publicly listed companies requires effective corporate governance. As investors have limited visibility, it gives rise to the “agency problem”, where managers, as agents, may not run the company in the best interests of the shareholders. In theory, the board of directors are supposed to protect the investors since the management has considerable discretion in running the firm. The board ensures that management does not steal the funds through private planes and plush carpets as well as direct the funds to suboptimal projects from the investors’ perspective.

In USA, with their dispersed shareholding pattern, there is usually no controlling shareholder (the new tech companies like Amazon or Facebook are exceptions). The shareholders are often represented by large mutual fund managers who are supposed to vote on their behalf. The role of the board, with considerable legal liabilities, is to ensure that the investors rights are protected and the managers are maximizing shareholder value.  The corporate governance challenge in the USA is that the large mutual funds are not activist enough, and CEOs, over their tenure, can be pretty savvy in obtaining considerable “control” over their boards.

The corporate governance challenge in India is different because ownership, as in other emerging markets, is concentrated. More than 75% of the large Indian listed companies are controlled by family businesses. The “promoter” owns a substantial proportion of the shares and is intimately involved in the management. Either, directly as CEO or as Chairman of the board of directors. Even, when there is a professional CEO, as Chairman, promoters have enough visibility of the operations to make the agency problem of management diverting funds from shareholders a minor concern.

Instead, the corporate governance problem in promoter led companies is protecting the rights of the minority shareholders. With their control over the companies, promoters can divert funds to themselves via various schemes such as tunnelling and/or pursue personal pet projects that cannot be justified from a maximizing shareholder value perspective.

Unlike in the USA, and even in the USA courts are hesitant to get involved except in the most egregious cases, the ability for a shareholder to get protection via courts is limited. Only recently, have class action suits been available to Indian shareholders.  Consequently, to date, there is no precedent on this.

Another check on poorly run companies in USA is the possibility of a hostile takeover. However, hostile takeovers are realistically not possible in India. This leaves the independent directors, theoretically not connected to promoters or executives, as the protectors of minority shareholders. Apart from their directors’ remuneration, independent directors in India must not have any pecuniary relationship with the company, its promoters, or associated companies.

Are independent directors independent?

People are not always clear as to the role of the board of directors. The most important role is monitoring for the agency problem, which in India, is protecting the minority shareholders from being ripped off by promoters. In practice, boards must also ensure compliance with laws, approve the strategic direction (rather than make strategy), as well as select and motivate the CEO.

One unarticulated role of board members in India is providing resources via their connections. Therefore, boards of companies, especially in industries where the hand of the government looms large (regulated like telecoms or infrastructure related), are heavily populated by ex-bureaucrats who have access to the halls of power. Typically, based on my personal observations, these directors make no substantive contributions during board meetings but are deployed when information or a favour is needed.

On paper, the laws in India are as stringent as anywhere in the world with respect to independent directors. The problem is how it plays out in practice. Increasingly, I have come to believe that an “independent director” is an oxymoron. Since promoters can vote on the appointment of independent directors, and minority shareholders rarely bother to exercise their voting rights, effectively promoters select the independent directors. Furthermore, the compensation for directors can be different among directors serving on the same board, usually determined at the whim of the promoter. In such a situation, who is going to vote against the promoter?

The Tata saga demonstrated that even someone as powerful as Nusli Wadia was outed for voting against the expressed wishes of the promoter. Most independent directors have much less stature in the absence of their directorships and are definitely not as wealthy. More generally, if an independent director dissents, they get a reputation of being difficult. This will make any further appointments to boards impossible in a country, where the social and economic ties between elites are highly intertwined.

Evidence from China

China provides interesting empirical evidence on directors. In 2001, China passed a unique law that required board members of public firms to reveal when they dissent from the majority opinion, along with an explanation for the vote. A fascinating paper demonstrated that dissent by board members is rare.[i] Based on my experience, I am sure if the data for India was available, it would show identical results. I cannot recall the last time a board member dissented on a board I served.

Juan Ma’s paper had three other findings which buttress my argument on independent directors being an oxymoron. First, dissent is correlated with breakdown of social ties between the independent director and the board chairperson. Most often, dissent happened after the board chair who appointed the independent director had left the board. Or, in the 60 days prior to departure of the board chair or departure of the independent director.

Second, dissenting directors were punished. Dissent substantially increased the likelihood of the dissenting director exiting the director labour market. It also resulted in more than 10% estimated loss of annual income. Third, while dissent could be interpreted as a sign of strong corporate governance, firms saw an average share price drop of 0.97% on the days in which the dissent was announced.

The unfortunate message is that if you wish to protect yourself and the stock price of the company, do not dissent! However, I doubt directors anywhere themselves need such advice as they are already aware of it.

[i] Juam Ma and Tarun Khanna (2016), “Independent Directors’ Dissent on Boards: Evidence from listed companies in China,” Strategic Management Journal, 1547-1557.



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