Bad Corporate Governance: Are Independent Directors Truly Independent?

by Sourav Datta - Aug 19, 2021 07:20 AM
Bad Corporate Governance: Are Independent Directors Truly Independent?A board meeting.
Snapshot
  • The current 'independent directors' model does not really judge ‘independence’ correctly.

    Therefore, investors are better off sticking to managements who have taken shareholder friendly decisions in the past, rather than relying on independent directors.

As per the Companies Act of 2013, all publicly-listed companies are required to have independent directors (IDs) who comprise one-third of the total number of directors.

Independent directors are expected to serve as an impartial and unbiased voice on the board. Because of this function, IDs are seen as guardians of minority shareholders. However, the trust in independent directors might be misplaced.

Perverse Incentives

The greatest barrier to ‘independence’ is the high remuneration paid to independent directors. While the Securities Exchange Board of India (SEBI) has put caps on directors’ sitting fees, companies often circumvent these caps through commission payments.

Often, the fees form a large part of the director’s income. No director would kill the goose that lays golden eggs by going against the management or the promoters.

For instance, an infrastructure company, whose head honcho has used shareholder money to fund personal projects in the past, has independent directors who are paid around Rs 60 lakh to Rs 70 lakh per year as remuneration.

Given the substantial income earned through relatively low effort (a few board meetings), most independent directors have not flagged corporate governance issues and bad investment/acquisition decisions at the company.

Though these directors hold directorships in other companies, the fees earned through this directorship forms a substantial part of their income, according to data available in the public domain.

Another tactic used by companies is hiring retired government bureaucrats as independent directors. The move achieves two goals. Firstly, it helps companies leverage the network and power these bureaucrats often wield. Secondly, current bureaucrats are unlikely to trouble the company in the hope that they would have a cushy corporate job after retirement.

Several ex-bureaucrats sit on the boards of India’s largest companies, earning multiple times of what they officially earned as government servants.

Recently, institutional investors moved to remove an ex-bureaucrat, who is an independent director with a conglomerate. Despite having worked to protect shareholder rights in the past, the director now supported decisions that put minority shareholders at a disadvantage. Self-interest, without any exposure to the negative consequences for the decisions taken, clearly blurs the ability to introspect.

A Flawed Selection Process

The procedure of selecting independent directors is usually a biased one. In promoter-run Indian companies, promoters take care to invite dependable directors who will never show dissent. Boards are usually filled with the promoters’ friends and families, which further makes it difficult to have a truly independent voice.

Promoters, who usually own the majority of voting rights, decide who gets a seat on the board. The average tenure of a director is 8.2 years, implying high job safety if one conforms to the promoters’ expectations.

If a director raises too many objections, they won’t be re-elected to the board and other companies won’t touch them. On the other hand, a director who happily passes all resolutions will be re-elected and probably be recommended to boards of other companies looking for directors.

No Skin in the Game

A quick study of India’s largest companies’ annual reports shows that independent directors seldom own any stock in the companies. The stock they own is usually obtained through stock option grants. The directors’ interests in the company seem to be limited solely to the huge salaries they receive.

Therefore, it is unlikely that independent directors would look at the business from a shareholder’s perspective, which is supposed to be a part of their job.

A Global Perspective

The issue is not limited to India. Even Warren Buffett has highlighted the issues several times in his annual reports. In his 2004 annual report he wrote, “In our view, based on our considerable boardroom experience, the least independent directors are likely to be those who receive an important fraction of their annual income from the fees they receive for board service (and who hope as well to be recommended for election to other boards and thereby to boost their income further). Yet these are the very board members most often classed as independent.”

In 2020, Buffett commented on the irony of being an independent director, “the director for whom fees are important – indeed, craved – is almost universally classified as ‘independent’ while many directors possessing fortunes very substantially linked to the welfare of the corporation are deemed lacking in independence”.

Buffett’s statements clearly show that self-interest often take precedence over moral obligations. The lack of skin in the game, combined with the need to earn more money has made ‘independent’ directors quite unhealthily dependent on their jobs.

A director receives greater commission if the profits rise but has a safety-net if business deteriorates. Such perverse incentives have created a ‘yes-man’ culture in most boardrooms.

The independent director model leaves a lot to be desired. Further, the current model does not really judge ‘independence’ correctly. In this scenario, investors are better off sticking to managements who have taken shareholder friendly decisions in the past, rather than relying on independent directors.

Independent directors begin quitting after someone else flags the problems – a pattern seen in most corporate scams. Minority investors are quite truly alone, and must act accordingly.

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