Competition Commission order puts independent directors' role in spotlight

Corporate governance structure through out the globe is converging towards the Anglo-Saxon model, in which independent directors occupy the pivotal position. The primary role of independent directors is to bring objectivity in the oversight function of the board of directors. They also bring varied and relevant, knowledge and experience in the board to enhance its effectiveness. The advisory role of independent directors is important but secondary to the supervisory role. Executive management, in most companies, is keen to use the board as the advisory board rather than the supervisory board.

The board of directors is collectively responsible for the long-term success of the company. Success is measured in terms of value created for shareholders. Different matrices such as return on invested capital (ROIC), economic value added (EVA) and total return to shareholders (TRS) are used to evaluate the performance of companies. Those are appropriate to evaluate yearly performance. They fail to measure long-term success. For example, the expected outcome of a strategy that is expected to create value over long-term is not captured by ROIC or EVA. TRS may reflect the same, provided the market understands and believes in the expected outcome of the strategy and ignores the short-term performance of the company. Usually market fails to give due consideration to expected long-term performance and recognise short-term performance. Therefore, managers live quarter to quarter. As a result, they often take decisions, which increase the value in the short-term, but are sub-optimal when viewed from the long-term perspective. This creates a tension between the executive management and independent directors. Independent directors cannot totally ignore the concerns of the executive management. They have to balance between the long-term and short-term performances to ensure long-term success of the company.

A company should be ethical and should obey relevant laws in achieving the objective of creating value for shareholders. Simply speaking, when formulating and implementing strategies, managers must ensure that they are doing what is right, just and fair to all stakeholders and that they are complying with all the relevant laws and regulations. The board is responsible for setting the tone at the top. Independent directors must ensure that the board is carrying out this function effectively. This is a great challenge before independent directors. We may take the recent example of DLF, the leader in real estate development. The Competition Commission of India (CCI), the anti-monopoly watchdog, in its 237-page order against DLF, was critical of 15 terms and conditions in the contract the company had signed with the buyers of The Belaire, a residential project in Gurgaon. It said these were stacked in favour of the developer and fined DLF Rs 630 crores. DLF, in its defence, said these were industry practices and it was merely adopting the same. This episode leads to a few important issues in corporate governance.

Is DLF case a result of corporate governance failure? Usually, independent directors do not get into details of contracts with stakeholders. They rely on the report of the internal/secretarial audit to ensure that the company is not adopting unethical practices and that it complies with all relevant laws. The board seeks legal opinion on some vexed issues. It does not go beyond that. Therefore, perhaps, we cannot label the DLF case as a case of corporate governance failure. But, this poses the question whether the board should examine in details model contracts with stakeholders to ensure that the terms are equal, just and fair to the counterparty. A more important question that arises from this case is whether the board should evaluate company practices against industry norms or they should evaluate them against normative standards.

Unless the company is a leader in the industry, it will lose competitive advantage if it incurs additional cost to adopt ideal practices. But a leader, like DLF, can establish best practices without losing the competitive advantage, although it might initially result in lower ROIC. However, if the company has grown by adopting the extant industry practices, those are likely to be ingrained in its culture and it would be difficult to change. These situations pose huge challenge to independent directors.

The task of independent directors is onerous. An individual should take up the position of independent director in a company only if he/she can commit sufficient time to perform the task effectively.

asish.bhattacharyya@gmail.com