Corporate governance codes of good practice around the world have a striking similarity. All the codes emphasise corporate transparency, accountability, reporting, and the independence of the board of directors (Board) from management. Independent directors play the pivotal role in ensuring independence of the Board from management. They bring outside perspective and express their independent views in boardroom deliberations and monitor the executive management.
Codes have drawn heavily from American-European corporate governance models, which address typical principal-agent conflict in companies in which there is no concentration of ownership. Indian code (clause 49 of the listing agreement and relevant provisions in the Companies Act 2013) is no different.
The general perception is that the independent directors in India have failed in monitoring the executive management. One reason might be weak regulatory institutions. But the more important reason is that in Indian business environment, where the issue is principal-principal conflict and not a typical principal-agent conflict, it is too much to expect effective monitoring by independent directors.
In India, concentration of ownership is a norm rather than an exception. Public sector enterprises, family businesses and group companies dominate the corporate sector. The dominant shareholder, who enjoys significant power, manages the company through its nominee managers. The Board has very little say in the appointment of CEO, directors and senior management. In PSEs, the government appoints independent directors and indirectly formulates corporate strategies, although autonomy is given to decide on investment up to specified limits.
Recently, the government has decided to remove independent directors on the Boards of PSEs, who were appointed in the earlier regime (see Business Standard, September 13, 2014). The decision provides evidence to support the argument that independent directors are nominees of the government and it can remove them at will. Therefore, independent directors in PSEs are not independent of the government, which is the dominant shareholder. The recent Coal India Limited (CIL) episode, as reported in the press, indicates that the government expects the Board to toe its line. In the context of the proposal to reduce the quantity of coal being sold through e-auction, the Board focused on maximising the firm value, while the government focused on national interest. The government was not happy with the Board.
The situation is no different in family managed companies and companies that belong to business groups. Although the law gives the shareholders the right to appoint directors, in practice, the dominant shareholder appoints directors, including independent directors. The situation is unlikely to change, although under the Companies Act 2013, listed companies and some specified classes of companies are required to constitute a remuneration and nomination committee. In a family-managed company, family governance takes precedence over the governance of the company. In case of a company that belongs to a business group, group policy assumes importance in decision-making. The dominant shareholder expects the Board to take into consideration issues in family governance and the policy of the business group. Therefore, companies adopt strategies, which not necessarily aim to maximise firm value.
The capital market (minority shareholders who trade in the capital market) develops a perspective on the impact of dominant shareholder's interference in the governance on future cash flows and risk, and values the equity of the company accordingly. Thus, a capital market, which is efficient, protects minority interest. Capital market's efficiency depends on transparency and effectiveness of the surveillance of the Securities and Exchange Board of India (Sebi) and its ability to enforce rules and regulations.
Transparency is achieved through disclosure of the right quality and quantity of information at the right time. High quality corporate financial reporting ensures market efficiency. In this context, the government's decision of implementing INDAS, which is the Indian clone of International Financial Reporting Standards, and providing Sebi with more teeth are welcome steps.
Efficient capital market protects minority interest but fails to eliminate social waste. The higher the perceived risk in investing in equity of companies, the higher is the cost of capital. The higher cost of capital results in rejection of some socially desirable projects and sub-optimal allocation of investible funds available in the economy. This social waste can be eliminated only if the corporate governance mechanism ensures that the companies adopt strategies that expect to maximise firm value. However, that is unlikely to happen in the current dispensation because independent directors are nominees of the dominant shareholder. The new provisions in the Companies Act would, at best, prevent management fraud or decisions that are blatantly against minority interest.
Too much focus on strengthening the institution of independent directors would not radically change the quality of corporate governance. We have to search for innovative solutions. Issues are challenging.