Leveraging the power of an independent board

This article was first published in the Financial Express on March 14, 2023, Co-authors: Navneet Bhatnagar, Sougata Ray; https://www.financialexpress.com/industry/leveraging-the-power-of-an-independent-board/3008998/

Governance failures often jeopardise businesses, including family-owned firms. Family businesses are often blamed for poor corporate governance and oversight. In India, well known and established family firms have come under the regulatory scanner for opacity in financial dealings, related party transactions, and appropriation of minority shareholders’ wealth.

For corporate governance and monitoring issues, the buck stops at the apex governing body of the company, that is, its board of directors. The board of directors of a company determines its purpose, broad policies, and oversight mechanisms. An effective board ensures that executive decisions are made in the company's best interest. It is critical for the board oversight mechanism to assess the impact of executive decisions on shareholders and other stakeholders.

Aimed at improving corporate governance, the Companies Act 2013 stipulates the appointment of Independent Directors as non-executive members who can objectively scrutinise executive decisions and management performance. While monitoring the firm's reporting mechanism, independent directors are expected to evaluate and check the robustness of financial controls and risk management systems. They must uphold high ethical standards, integrity, and probity. Independent directors are not supposed to receive any monetary benefits except their fees. They are appointed for a five-year term and can not hold more than two consecutive terms.

Corporate governance standards were expected to be elevated through these legal provisions. However, various corporate governance debacles continue to hit the headlines in India. In 2015, Diageo alleged misappropriation of funds at United Spirits, which they had acquired from Vijay Mallya. Malvinder and Shivender Singh's fraudulent loan transactions at Religare and loan fraud at Gitanjali Gems were the other cases that poorly reflected the governance in Indian family businesses. So was the case of the Dhoot family-owned Videocon's loans obtained from ICICI Bank by questionable means and alleged kickbacks. In all these cases, the role that independent directors played as the custodians of stakeholder interest was wanting.

Our research on these cases of corporate governance failures of independent directors reveals some key insights.

Proximity to Promoters: One of the reasons why independent directors fail to discharge their fiduciary duties is their proximity to the promoters. Due to this, they often do not hold management to account and avoid asking tough questions. Independent directors who continue to serve the companies for a long time develop an affinity with key management personnel, making oversight difficult as the emotional costs of a negative exchange escalate. Hence, independent directors impose self-restraint.

Power equation: In several cases, we observed that the aura and assertiveness of the promoter family's leader kept the independent directors constrained to voice concerns. Board selections were made so that the independent directors could not seriously challenge executive decisions.

Incentives: Another reason for this oversight was the lure of the incentives attached to the board position. Independent directors follow what pleases the management or postpone raising their concerns due to the significant monetary/non-monetary incentives they gain from the company.

Overworked: In some other cases, we observed that the independent directors were so occupied with multiple responsibilities across different companies that they failed to devote sufficient time and attention to their oversight responsibilities.

As a result of the above factors, independent directors are rendered “rubber stamps”, corporate governance falters, and the respective businesses suffer a significant loss of monetary and brand value.

The need of our times is to make independent directors “truly independent.” Several measures can be adopted to empower independent directors with the authority to intervene through more effective checks and control mechanisms.

Selection: First and foremost, it is vital to improve the independent directors' selection process. They must be chosen on merit and have an impeccable value system.

Induction: They must be appropriately inducted and familiarized with the business and its key challenges. They must be eager to learn and update their knowledge and skills. They must be able to assess the internal and external environments in which the business operates and be vigilant of the motives that drive executive decisions.

Promoters' Buy-In: The most crucial factor that may make the role of independent directors more effective is the promoters' realization of the genuine need to raise the corporate governance standards of their company. If promoter families embrace good corporate governance in its true spirit, they will see the value in fostering vocal, expert, empowered, and truly independent directors.

Family firms and promoters must realise that when boards fail to exercise effective oversight, deviations from governance norms go unchecked. Ineffective governance eventually results in bigger violations and the destruction of value. Therefore, the boards must be diligent in objectively assessing executive decisions and providing timely advice when remedial measures are required, and they must be 'allowed' to do it. 

Why the Rs 4.6 lakh crore pledged promoter shares matter for India Inc.,?

This article was first published in the Financial Express, on November 14, 2022, Co-author: Sougata Ray; https://www.financialexpress.com/industry/pledged-shares-valued-at-rs-4-6-trillion-the-good-and-the-bad/2812080/

Gautam Adani, hailed as the richest Asian and the third richest person in the world in October 2022, acquired 63.15% stake in Ambuja Cements and 56.69% in ACC in September 2022. Part of the acquisition was funded through pledging the entire acquired stake in both the companies, worth $13 billion. It once again highlights the popularity and importance of pledging as a financing tool for the Indian family business owners who usually have the dominant or controlling stakes in the companies.

Pledging at a varied degree is quite widely prevalent around the world. However, in countries where diversified ownership is more common, such as the United States, pledging is generally done by owners, directors, and executives to hedge and diversify their personal wealth or to meet personal needs. However, in India, pledging by family promoters often serves as a mechanism to generate financial capital for the firm or other affiliate firms belonging to the same business group. 

Promoters of almost a quarter of all companies listed on the National Stock Exchange (NSE) of India have pledged their shares to some degree. The average being a staggering 44 percent of the holdings of promoters in these companies. In the last quarter of financial year 2022 (January-March 2022), the value of shares pledged by promoters of NSE listed companies stood at Rs 4.6 Trillion. In a country like India, where more than 90% of the listed firms are family firms and concentrated shareholding is the norm, the exposure of investors and financial institutions to pledging can result in a systemic risk. It may not be so in many other countries where diversified firm is more of a norm when compared to concentrated ownership.

During the last couple of years, there have been many instances where promoters have lost ownership control in well-known large family firms. Of course, this outcome happened due to a combination of over-ambitious or bad decisions. But in many of them, the promoters had pledged their shares to financial institutions and when the share prices started to fall, the institutions sold the pledged shares in the open market. This resulted in the promoters losing ownership in their family firms. The situation was exacerbated due to the pandemic when the share prices of most companies took a hit. 

Just like the mark-to-market concept in the case of financial derivatives, when the share prices fall and the asset cover falls below a predetermined value, the financial institution raises a margin call to the pledging shareholder. Consequently, the shareholder is required to either top-up the loan with more shares or pay off a portion of the loan’s principal to increase the existing asset cover back to the pre-determined value. If the shareholder answers the margin call in the stipulated time, they will continue to own the shares. If the shareholder is unable to answer the margin call, the financial institution has the right to sell the shares in the market. The news of a margin call is generally perceived negatively by investors and the sale of a block of shares of a company in the open market accentuates the negative sentiment associated with the stock. Investors may indulge in panic selling of the stock. The increased supply of shares puts downward pressure on the stock price, thereby warranting further sale of shares by the lending financial institutions. 

In research conducted by the Thomas Schmidheiny Centre for Family Enterprise, Indian School of Business, the authors found increased crash risk, lower return on assets, increase risk aversion, and negative investor reaction to the news of pledging. We observe that the potential loss of ownership control faced by many firms that have pledged their shares is overwhelming and would have significant impact on the promoting families and the other stakeholders of those companies if the promoters were to lose the pledged shares due to an unforeseen circumstance.

However, we also find many instances of family business promoters that have effectively used pledging as a tool to finance strategic initiatives for expansion, new venture creation, acquisition, etc., and to buy back shares in their own firms. Such promoters have not only used pledging for growth, liquidity, market performance, and ownership consolidation, but also reduced pledging thereafter in a systematic way. Examples include firms such as Asian Paints, Apollo Hospitals, and Granules India. Therefore, pledging per se is not bad – it is a legitimate, legal, and effective tool to raise funds by the promoters. When access to capital is limited either due to tight liquidity in the overall economy or stretched bank limits and high debt-equity ratio of the firm, the environment may not be conducive to raise equity or the promoters may not want to dilute their stake, in all these situations, pledging comes in handy.

Pledging has been around for decades in India. However, its impact has become more accentuated now due to the VUCA world that we live in. Awareness about its possible negative consequences has also gone up. It is amply clear that the promoters need to be prudent and strategic in using pledging as a financing tool. A decision to pledge must be associated with a clear plan for usage of funds, returns from them, and a path to de-pledge the shares. The promoters should avoid getting into a trap of excessive pledging, being overconfident about the prospects of the firm and under preparing and underestimating the external risks. The family business leaders taking the decision to pledge the shares must consult the family members and keep them updated. The funds from pledging should be used responsibly, with immense accountability and transparency. The Board and particularly the independent directors have an important role to play in this regard. Timely disclosures and effective communication will help calm the nerves of the other investors. Financial institutions should closely monitor the pledging situation in a firm, as well as that of the companies affiliated with the same business group, when deciding to buy, hold or sell their investments in a firm.

Directors’ competencies: A tall order for India Inc

This article was first published in the Economic Times on August 08, 2021. Co-author: Kavil Ramachandran; https://economictimes.indiatimes.com/news/company/corporate-trends/directors-competencies-a-tall-order-for-india-inc/articleshow/85202226.cms

Recent discussions on the failure of corporate governance and how independent directors (IDs) can be effective have raised concerns about the qualifications and competencies of independent directors (IDs). The implicit message is that IDs with “lower” competencies may be failing in their responsibilities as the custodians of the overall interests of stakeholders. Do the directors of India Inc possess such competencies? Are these competencies enough? Further to the recent order of SEBI related to IDs, in this article, we examine the competencies of the Board of Directors (BoDs) of firms listed on the NSE, as measured by educational qualifications of the directors. We recommend the need to have other criteria for determining competencies of IDs.

Qualifications

As per data from Primeinfobase, 93.75 per cent of directors of firms listed on NSE are at least graduates. Majority of the directors (69.08 per cent) have post graduate technical qualifications. MBA is the single most popular degree at 26.56 per cent directors being management graduates- 16.27 per cent of them from the IIMs. CA, CS, ICWA or LLB come a close second at 24.38 per cent while 21.21 per cent of the directors are engineers. A few of them even have an MBBS degree (1.17 per cent). However, instances of corporate governance failures even at large corporations in India have highlighted that despite the highly qualified pool, corporate governance is wanting. Therefore, qualification does not necessarily mean a good fit. 

Diversity

More effort needs to go into identifying the right people who are a) at least in sync with the latest developments in their own areas of expertise, if not ahead of them, b) are not rubber stamps and not afraid of voicing their opinion, and c) bring diversity to the board discussions. Composition of the board is very important. A board that comprises all engineers or all MBAs or all CAs, while highly qualified, will have no diversity. Similarly, it should also evaluate the requirements of the firm depending on the life cycle that it is at. 

Values

Infosys co-founder Narayana Murthy once openly spoke about his spat with the first non-promoter CEO of Infosys, Vishal Sikka. “If the core values of Infosys such as “leadership by example, fairness, transparency, accountability” were “thrown to the dust, then you have to stand up and voice your anguish and disappointment”, he said. The BoDs need to possess similar attitude or value systems and the skills to be independent, so that they can voice their opinion when needed. Values of a person is not easy to assess and for the regulator to implement. But, SEBI can put some guidelines or conditions for the large corporations to start with, say companies with Rs 10,000 crore plus in revenue, where at least the IDs must have a dossier compiled to confirm that they have demonstrated their independence in thinking and acting, before being inducted into the board. 

Commitment

Often, IDs hold multiple board positions, advise various organizations, and are even associated full time with their own businesses or are employed somewhere. With so many other activities claiming their time and mind space, they may not devote enough time to fulfil their board duties in spirit. It is in the interest of the firm to demand time and guidance from the directors. Hilti Corporation, known for its values, culture, innovation and governance, demands that the board members devote a minimum of 20 days every year to Hilti affairs. In Hilti, a board member’s time commitment could extend up to 40 days if he or she is involved with the executive board, employee activities or any special projects. The remuneration flexibility that SEBI has mentioned in their regulation should make it easier for the firms to pay adequately to the BoDs. 

Conclusion

In essence, there has to be a change in mindset while companies are determining who their IDs should be. SEBI’s order included a more elaborate and transparent process to be followed by nomination and remuneration committee while selecting candidates for appointment as IDs. The amendments also enhanced disclosures regarding the skills required for appointment as an ID and how the proposed candidate fits into that skillset. Determining the “skills required” is tough yet doable. Detailed background check including demonstrated commitment to the practice of values will help create a pool of IDs with the right compentencies. Corporate governance and society’s wealth will be the losers if this challenge is not addressed soon. Industry champions must work with SEBI to set a new threshold for anybody to qualify to be an ID. As Ludmya "Mia" Love, American political commentator and the first black person elected to Congress from Utah and the first black woman elected as a Republican, says, “Difficult things aren’t easy, but they’re worth it."