Where Angels Prey

Where Angels Prey is a novel by Ramesh S Arunachalam. Please refer to www.whereangelsprey.com for more information

Friday, April 29, 2011

Defining Independence of Directors in Boards: What Micro-Finance Can Learn From Four Global Corporate Governance Frameworks?

Ramesh S Arunachalam
Rural Finance Practitioner

The topic of independent directors in any organization (especially, companies) has been long debated globally for several reasons: (1) Conflicts of interest hinder judgment and affect decision-making; (2) Judgment and decision-making are what directors are asked to do; and (3) Directors must feel free to think, express, question and decide in the interest of those they represent. And all of these apply very much to micro-finance institutions as well, where the last year or so, especially seen a lot of (negative) publicity with regard to Corporate Governance and role of independent directors at MFIs.

In his now famous EPW article, Prof Sriram (2010) raises several critical issues with regard to conflicts of interest and enforcing independence. The debate has widened to encompass not only the role of independent directors but also that of nominee directors from institutions like SIDBI and several questions continue to be raised regarding real and potential conflicts of interest as well as enforcement of independence on the ground. Some of the key issues that the micro-finance industry continues to grapple with are: (a) Does a board need to have clear guidelines with regard to conflicts of interest that must be disclosed?; (b) Who discloses conflicts?; (c) To whom are conflicts disclosed?; (d) What happens if conflicts are not disclosed?; (e) What if conflicts are disclosed later?; and (f) What if, not all is disclosed to the Board and/or to shareholders?

While the above issues need to be addressed squarely and fairly and there can be no compromise with regard to that, some guidance for this can also be had from the definition of independence as per four major global corporate governance frameworks – in fact, they should serve to better guide the micro-finance industry where corporate governance is still rather nascent and independence of directors at MFIs has come under serious scrutiny. Read on…

The salient features from the four global Corporate Governance frameworks, witrh regard to the definition of independence, are summarized as under:

Sarbanes-Oxley, (USA):
An independent director is a member who, other than in his capacity as a board member may not (a) accept any consulting, advisory; or other' compensatory fee from the company; or (b) be an affiliated person of the company or any subsidiary thereof and other advisers, as it determines necessary to carry out its duties.

India-SEBI Amended-Clause 49:
An independent director is a non executive director of the company who:
a.      apart from receiving directors' remuneration does not have any material pecuniary relationships or transactions with the company... which may affect independence of the director;
b.      is not related to the promoters or persons occupying management positions at the board level or at one level below the board;
c.      has not been an executive of the company in the immediately preceding three financial years;
d.      is not a partner or an executive or was not partner or an executive during the preceding three years, of any of the following: (i) the statutory audit firm or the internal audit firm that is associated with the company, and (ii) the legal firm(s) and consulting firms(s) that have a material association with the company;
e.      is not a material supplier, service provider or customer or a lessor or lessee of the company, which may affect independence of the director; and
f.        is not a substantial shareholder of the company, i.e., owning two percent or more of the block of voting shares. (Note: Nominee directors appointed by an institution which has invested in or lent to the company shall be deemed to be independent directors[i])

OECD Principles:
The OECD principles have no prescribed definition of independence. Boards are required to ensure that non- executive board members are capable of exercising independent judgment to tasks where there is a potential conflict of interest and declare the criterion for judging a board member to be independent.

King II, South Africa:
An independent director is one who:
a.      is not a representative of a shareowner who has the ability to control or significantly influence management,
b.      has not been employed by the company or the group in any executive capacity for the preceding three financial years,
c.      is not a member of the immediate family of an individual who is or was in the past three years, employed by the company or the group in an executive capacity,
d.      is not a professional advisor to the company or group other than in a director capacity,
e.      is not a significant supplier to, or customer of the company or group,
f.        has no significant contractual relationship with the company or group,
g.      is free from any business or other relationship which could be seen to materially interfere with the individual's capacity to act in an independent manner.

As evident from above, most global frameworks define independence in terms of ownership of shares, contracts and services rendered, relationships, family ties and the like. While this is indeed important, we also need to pay attention to two other aspects of effective independence – in terms of directors being “independent minded” and also showing the necessary “commitment” in terms of time, knowledge and effort invested in carrying out their duties. And one final aspect that also needs attention is the issue of selection of independent directors in terms of: (a) Who selects directors?; (b) How are they selected (pool, resources, interviews)?; (c) Who determines their independence?; (d) Who elects directors?; (e) Who evaluates directors?; and (f) Who removes directors?. And unless MFIs consciously attempt to be transparent in these aspects, as Mr Damodaran, former SEBI chairman, has said, ‘promoters, founders and CEO’s are likely to fill their boardrooms with people who are more of nodders and often older than the furniture in the boardrooms’ and Corporate Governance will remain an elusive dream at best

I sincerely hope that the micro-finance industry in general and MFI associations (sa-Dhan and MFIN) in particular, are able to draw on the above comparative analysis and critical issues to establish appropriate governance standards for “independent directors” at MFIs and also facilitate their adoption in real time…That alone will prevent Satyam[ii] like situations in Indian micro-finance in the future…

Have A Nice Day!

[i] This is taken up in a separate post
[ii] The Satyam referred to here is the former IT Corporate Group under (the now disgraced) Mr Ramalinga Raju

1 comment:

  1. hi Ramesh, the question of 'independence' of the independent directors is an age old question which is difficult to answer in any straight and simple manner. the law does permit a company to pay an independent director sitting fees, commission on profits and also stock options. when a director is drawing commission (subject to the legal ceiling of 1% of profits as per Sec 349 of Cos Act), how does one regard him as independent? the higher the company declares its profits, the better it is for him ... so can he really be in form and substance be independent? same applies to stock options which are also legally permissible.

    while the basic things can be taken care of such as no relationship with other shareholders, no business or consulting relationship etc, the real challenge is when his remuneration or earning is linked to the company's performance, can he technically be still held as independent? and if not, then no company has any independent directors since all comkpanies do have commission, if not stock options.

    also as per the quote of Damodaran provided by you, a promoter can fill the board room with people who are on paper independent but really are 'yes' men to the promoter ...so what gets achieved then?

    hence while as suggested by you and the global best practices, while we need to look for independent status for directors, the real benefit a company can derive through active participation of the independent directors is dependent on the value system and culture of the promoter. the focus needs tobe very specifically on the promoter to achieve true benefits of independent director system