Reorganising bank selection advisory panel is a good governance imperative for the RBI!

Ramesh S Arunachalam

There is a common misconception that conflict of interest only arises if a person has done something improper. The answer is a big NO! Perception is a very critical aspect to the notion of conflict of interest

In the last few Moneylife articles, we have been talking about the issue of conflict of interest with regard to the recently appointed RBI financial inclusion committee and in this article I focus on the RBI banking selection advisory panel. At the outset, I would like to state that serious conflicts of interests exist because one of the members of the banking selection advisory panel, Dr Nachiket Mor, is also chair of the RBI financial inclusion committee which has two members who have directly applied for the banking licenses. Further, several members of the above mentioned RBI financial inclusion committee have a relationship to these and other banking license applicants. The key relationships have already been highlighted in the previous money life articles and the interested reader may refer to these for understanding the exact nature of the various conflicting relations -  RBI’s New Financial Inclusion Committee: Rife with conflicts of interests,  Does the RBI know how much conflicts of interest it has created? and Why should RBI immediately disband newly appointed Committee on Financial Inclusion?

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Corporate governance: What boards of large NBFC MFIs can do on the ground? (Part II)

Ramesh S Arunachalam

Corporate governance is the collective responsibility of the directors. While we can have impressive norms for corporate governance, they cannot be effectively enforced through regulation alone

While the previous Moneylife article (How to make the boards of large NBFC MFIs implement corporate governance norms in practice? (Part I) discussed critical issues with regard to corporate governance in large NBFC MFIs, this article explores what MFI (microfinance institution) boards can (themselves) do to improve the practice of corporate governance in reality. Here are some initial practical suggestions based on experience: 

1.    Limit the number of MFI boards on which a director may sit to not more than three at any given point in time. This will hopefully afford directors the time and space to understand how the MFIs-on whose boards they serve as directors-are actually performing on the ground. During and before the crisis in India, I had personally witnessed directors-who were on multiple MFI boards (often exceeding three)-jumping planes in a literal sense and having very little time to attend to their fiduciary and other responsibilities. Many of them could not even visit the field areas, even before the customary quarterly board review. Some of them who served on sub-committees were even more harassed for time. Therefore, it appears necessary to ensure that there is a limit-in tune with physical reality-on the number of MFI boards in which a director may sit. And three appears to be a good permissible number.

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How to make the boards of large NBFC MFIs implement corporate governance norms in practice? (Part I)

Ramesh S Arunachalam

Apart from looking after shareholders’ interests, the five star boards of microfinance companies need to take better account of other stakeholders’ interests and a proactive approach to put into practice their stated governance principles

It was almost two years ago that we had the first signs of the 2010 Andhra Pradesh microfinance crisis. And indeed a lot of water has flown under the bridge. But one aspect that I have been unable to come to grips with is how the (five star) boards of the MFIs (microfinance institutions) concerned—often filled with illustrious people—failed so miserably in discharging their fiduciary and other duties.

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Life after Vikram Akula at SKS Microfinance: Some unanswered questions?

Ramesh S Arunachalam

It seems unlikely that Vikram Akula’s exit will transform SKS Microfinance into a better governed and managed microfinance company. Only time can tell if and whether the exit of Vikram Akula would bring better times to SKS micro-finance, its investors and clients

The board of SKS Microfinance is said to be meeting in Mumbai today and it has been widely speculated that Vikram Akula is all said to resign from SKS Microfinance as its executive chairman. While the reasons for this are not exactly known, it has been suggested that the poor performance of the company during the last quarter has brought increased pressure on Mr Akula to resign.

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Award winning Sahayata Microfinance is the latest to go astray

Ramesh S Arunachalam

Charges of serious misreporting and mismanagement again surfaced in the Indian micro-finance. The question is how could a company like Sahayata Microfinance, which was darling of so many investors, lenders and stakeholders go astray

I came across a very interesting news item in a newspaper today:

“Sahayata Microfinance Pvt Ltd has suspended the brass, including its chief executive, on charges of mismanagement. The Rajasthan-based microfinance company has also stopped fresh lending temporarily, to set its house in order. Following the suspension of management and poor performance, rating agency CARE downgraded its non-convertible debentures of Rs 19.5 crore from CARE BB+ to CARE B-. In September some board members pointed out prima facie evidence of the management’s misrepresentation of company performance. The board has ordered a detailed portfolio audit. The investors have placed an interim -management to control operations, to ensure the business continues uninterrupted. The company will resume loan disbursement from December. The board questioned chief executive, chief financial officer and other senior managers on charges of serious misreporting and mismanagement. ... While chief executive was suspended with immediate effect, the CFO and head of operations were stripped of their duties immediately. They were subsequently suspended.” (Business Standard, November 18, 2011,)

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MFI corporate governance norms: How can these be put in place?

Ramesh S Arunachalam

It is great for banks to appoint many nominee-directors to MFI boards, but they must act responsibly on the ground

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Who is an independent director? Who should be treated as an independent director in NBFC MFIs?

Ramesh S Arunachalam

MSME and Rural Finance Practitioner

It is critical to define the criteria for independent directors and implement this strictly in the interests of good governance; otherwise we could be in for a ‘blind date’ with yet another crisis

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Governance of MFIs: Time to implement ‘connected lending’ provisions of RBI circular of 2007

Ramesh S Arunachalam

MSME and Rural Finance Practitioner

Is it appropriate for a company, established to provide access to finance to low-income people, to lend to its promoter and managing director to buy shares in the same company at par value?

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Establish standards for MFI independent directors as first step to ensure good corporate governance

The RBI and the Union Finance Ministry must provide clear guidelines on the appointment, roles, compensation and evaluation of independent directors for microfinance companies, critical for effective and ethical operations

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Does a five-star board guarantee good corporate governance?

Ramesh S Arunachalam

Rules and regulations are not enough. They must be implemented. Sadly, recent episodes have shown that even independent directors stayed silent when rules were violated

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Who is An Independent Director and Who Should be Treated As An Independent Director: Some Suggested Standards For Adoption by MFIs…

Ramesh S Arunachalam

Rural Finance Practitioner

The issue of independence of “independent directors” is a very critical one with regard to Corporate Governance and the same applies to MFIs as well. How to make this determination of a director’s independence? What criteria are used globally and what can be effectively used in micro-finance and especially in India.

Some suggestions are provided in this post and I also provide a comparative analysis of what top global corporate governance frameworks suggest with regard to director independence in a separate accompanying post. Read on…

For an MFI Director to be considered independent, it must affirmatively be determined that the Director has no material[i] relationship (whether financial, business, personal or otherwise) with the MFI or any of its sister concerns or subsidiaries or affiliates, either directly or as a partner, shareholder or officer or employee of an organization which in turn has a relationship with them.  This is very critical.

In my opinion, in making the determination of independence, a Director’s relationships can be deemed immaterial as long as the following standards are met: 

1.      The Director is not, and has not been within the previous three years, an employee of the MFI or any of its subsidiaries or affiliates or sister concern.

2.      No member of the Director’s immediate family[ii] is, or has been within the previous three years, an executive officer of MFI or any of its subsidiaries or affiliates or sister concerns

3.      Neither the Director nor any member of his or her immediate family has received, during any twelve-month period within the previous three years, more than INR 1.2 Million[iii] in direct compensation from the MFI or any of its sister concerns or subsidiaries or affiliates (including, without limitation, any consulting, advisory or other compensatory fees) except (a) fees which the MFI pays to its Directors for their services as members of the Board and members or Chairs of Board Committees and (b) fixed amounts of deferred compensation for prior service, which is not contingent in any way on continued service; provided that compensation paid to an immediate family member for service as an employee other than an executive officer will not be considered in determining the Director’s independence so long as the compensation is comparable to the compensation paid to other similarly situated employees.

4.      The Director is not a partner or an employee with a firm that is the internal or external auditor for MFI or any of its sister concerns or subsidiaries or affiliates; nor is any member of the Director’s immediate family a partner with such a firm or an employee who participates in the firm’s audit and/or tax compliance practice (as well as similar tasks); nor has the Director or any member of the Director’s immediate family within the previous three years been a partner or employee with such a firm who within that time has personally worked on the audit of MFI or any of its sister concerns or subsidiaries or affiliates.

5.      Neither the Director nor any member of his or her immediate family is employed, or has been employed within the previous three years, as an executive officer of any company whose compensation committee at the same time included an individual who currently serves as an executive officer of MFI or any of its sister concerns or subsidiaries or affiliates.

6.      The Director is not an employee, nor is any member of his or her immediate family an executive officer, of another company as to which payments by MFI to that company, or from that company to MFI, including their respective subsidiaries and affiliates or sister concerns, for property or services have exceeded more than 2% of the other company’s consolidated gross revenues, in any of the other company's past three fiscal years.

However, notwithstanding anything to the contrary in the standards #1 through #5 above, any MFI shall not treat as categorically immaterial, but instead will discuss case by case and will disclose, (i) any relationship between a Director and MFI or any of its sister concerns or subsidiaries or affiliates that is required to be disclosed under the relevant section of the Indian Companies Act, 1956 (and other SEBI/RBI directives from time to time) and (ii) any contributions made by MFI or any of its sister concerns or subsidiaries or affiliates to any tax-exempt organization of which a Director serves as an executive officer if, within the preceding three years, such contributions in any single fiscal year exceeded 2% of the tax-exempt organization’s consolidated gross revenues.

Likewise, an MFI Director will be deemed to meet special independence standards required of Audit Committee members if the Board of Directors determines that the Director qualifies as independent under the above-described standards and that the Director meets the following additional criteria:

A.      The Director has received no direct compensation from MFI or any of its sister concerns or subsidiaries or affiliates (including, without limitation, any consulting, advisory or other compensatory fees) except (a) fees which MFI pays to its Directors for their services as members of the Board and members or Chairs of Board Committees and (b) fixed amounts of deferred compensation for prior service, which are not contingent in any way on continued service.

B.     The Director is not an affiliate of MFI (i.e., not controlling, controlled by, or under common control with, the MFI), such as a 2% plus shareholder.

C.     The Director is not providing simultaneous service as an Audit Committee member in audit committees of more than 3 companies (or MFIs) at any point in time

I hope that the industry associations in India (Sa-Dhan and MFIN), regulators, supervisors, lenders, investors and other stakeholders provide due thought to this very critical aspect of director independence. They would also need to establish guiding benchmarks for the various compensations issues given above and ensure the implementation of these standards on the ground as only “real” independent directors can enhance the quality of Corporate Governance (in Indian MFIs), which is certainly at a low ebb...

Have A Nice Day!

[i] "Materiality" is to be considered from the standpoint of the Director and that of each person or organization with which the Director is affiliated, including organizations of which the Director is a partner, shareholder or officer. The determination that, as to each Director individually, there is no material relationship (whether financial, business, personal or otherwise) will have to be made after due consideration of the information provided by the Director and any other information that may be known to the Board. The purpose is ultimately to determine whether a Director has any relationship with the MFI that may interfere with the exercise of the Director’s independence with regard to the MFI and its management.

[ii] "Immediate family" means a Director's spouse, parents, stepparents, children, stepchildren, siblings, mothers- and fathers-in-law, sons- and daughters-in-law, brothers- and sisters-in-law, and any person (other than a tenant or employee) who comprise the Director’s household but not the physical space necessarily

[iii] This is a suggested number and has to be debated further and decided accordingly, as per consensus.

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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!

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[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

Does A Five Star Board Guarantee Good Corporate Governance in MFIs?

Ramesh S Arunachalam

Rural Finance Practitioner

A common judgment made with regard to Corporate Governance has often and repeatedly proved costly. Very often, people look at members of the board as a surrogate for good corporate governance and Micro-finance is no exception…

If you look at the credit rating reports of MFIs in the last few years and especially, those pertaining to some of India’s largest MFIs, the above is apparent…Most of these reports[i] use the presence of a five star board to claim that governance in these MFIs is very good.

Yet, as the last few months have shown, there could be serious governance and related violations in some MFIs…as espoused by the granting of a huge loan to the founder to buy shares in the MFI…to sacking of the CEO of a large MFI who had just led the company through a spectacular IPO…to turbo charging growth and tweaking performance through multiple, over and ghost lending to attract equity investment at a premium and build wealth for themselves and their shareholders and so on and so forth.

What is interesting is that all of these happened despite the concerned MFI boards having so called ‘5 star’ board members… and despite institutional representation on the boards…of these MFIs…

Therefore, using board membership as a surrogate for good Corporate Governance is fraught with danger and I hope that credit rating companies do not use this in the future…the damage created by the use of this inappropriate surrogate is already huge…as the lessons from India’s largest corporate failure suggests…Read on…

“It was the autumn of 2008 and Satyam Company Secretary G Jayaraman was beaming. For the second time in six years, India's IT outsourcer had walked away with the coveted Golden Peacock Award for excellence in corporate governance, an award instituted by the World Council for Corporate Governance.

Later that week, Vadlamani Srinivas proudly told the press that the award was 'a testament to our [Satyam's] efforts to continually innovate corporate governance best practices in the industry.' The Golden Peacock was not the first award that year. In April, a global investor relations firm MZ Consult ranked Satyam among the top five companies in the Asia-Pacific region in the financial disclosure procedures category. 'We are pleased to be recognised...

Our practices are designed to provide complete, accurate, timely information in clear formats,' said Vadlamani Srinivas. To the corporate world, Satyam's hubris was well earned. After all it had all the bells and whistles required of a well-governed modern-day company.

Sat yam's five star board of directors, as on- lookers liked to call it, had just the right number of independent directors with just the right credentials-eminent scholars and administrators.  Also, Sat yam had Price Waterhouse-one of the big four audit firms-as the statutory auditor.

All was well with Satyam's world-or so everyone thought.

Two blows dealt to the company's image within a span of one month ended Sat yam's high-prized innocence-the fateful and insane board decision taken on 16 December and then Mr Ramalinga Raju's confession of false invoicing of 7 January.

Never in the history of corporate India has a company fallen so hard and fast. And everyone, from investors to experts, attributes this to the failure of the company's corporate governance controls. In fact, all events surrounding the scam-the aborted Maytas bid, World Bank barring the company from all Bank contracts-were being linked to the way Satyam was governed.”[ii]

Therefore, if Mr Ramalinga Raju created false invoices to show better operating performance to create greater wealth for shareholders/himself and bring in more investments and use this vicious cycle of maniupulation, there appears to be a parallel in micro-finance as well, especially regarding Corporate Governance and other practices. Some MFIs seem to have used similar practices to grow inorganically - as has happened during April 2007 to March 2009 (and there is hard data available) and thereafter – and attract huge equity investment at a premium and the investors perhaps forced these MFIs to grow faster so as to recover their premium investments quickly and the cycle continued…. We all saw what this could do in terms of the following – a) multiple lending; b) over lending not commensurate with the loan absorption and debt servicing capacity of the clients; c) ghost lending; d) large focus on consumption loans; e) use of agents to turbo charge growth and several other issues…leading to what is now famously described as the 2010 AP micro-finance crisis caused by huge levels of indebtedness amongst the poor and other factors…

Satyam, had won every conceivable Corporate Goverance award and yet, it (then) blatantly violated every single CORPORATE GOVERNANCE rule. Likewise, there are also some Indian MFIs who top the global charts for the Corporate Governance awards in micro-finance while in reality, perhaps, engaging in not-so-good (NSG) and non-transparent (NT) governance and other practices – in areas such as - board practices (including meetings, minutes, sub-committees), shareholding, compensation for senior management and board members, appointment (there is so much conflict of interest) and compensation of independent directors, presentation of results and operating performance, systems and the like.

And many of these MFIs have been cited as having good governance just because they had a famous board. Therefore, having a high profile board and/or winning Corporate Governance awards, does not automatically guarantee Good Corporate Governance in MFIs. And let us be clear on that…as for a variety of reasons, board members may be not so active and/or have a disconnect with the CEO and senior management…

Therefore, the key point is that Corporate Governance has to be ensured by appropriate regulation and supervision (both on and off site) and other means including enhancing accountability of auditors and third party supervisors (like externally appointed internal auditors and/or rating agencies, without conflict of interest), incentivizing MFIs/organizations for appointment of truly independent directors (IDs) and making IDs responsible/liable for Board decisions, presentation of Operating Performance and the like

And as Dr N R Narayana Murthy stated, 'Corporate governance…is about maximizing shareholder value legally, ethically and on a sustainable basis, while ensuring fairness to every stakeholder-the company's customers, employees, investors, vendor-partners, the government of the land and the community.'

And the regulators should not give up their roles in ensuring this as self regulation has not and will not work…and I sincerely hope that SEBI and RBI (including The Malegam Committee) work together to frame (and bring into force) appropriate Corporate Governance guidelines for all NBFC MFIs including those that are listed as well as those that aspire to be listed…

Forthcoming (This Week and Thereafter):

1)      The Self Regulation Experience in Indian Micro-Finance: Critical Issues to Ponder….

2)      Is the Current Indian MFI Business Model Flawed As Dr Rangarajan Argues?

3)      What is Responsible Finance and How to Ensure it Operationally?

4)      What does the IFMR Access to Finance Study Tell Us?

Plus More…

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[i] While I can quote several examples from these credit rating reports, the idea is not to embarrass anyone and so, I have refrained from quoting these reports…

[ii] Source: Corporate Governance: The Indian Way, Aanand Pandey…In The Satyam Saga

The Role of Independent Directors in Enhancing Corporate Governance in Indian MFIs: Specific Issues That Need To Be Examined By The RBI Board Sub-Committee

Ramesh S Arunachalam

Rural Finance Practitioner

A lot has been heard about the role of independent directors in MFIs during the last few months and I will not get into the specifics but there are numerous examples of situations (at MFIs) which could been salvaged, had only the independent directors acted 'independently'. The fact of the matter is that the image of micro-finance did take a beating and could have been avoided, had only the independent directors acted swiftly and appropriately...Never mind and let bygones be bygones…

Given below are several critical issues - with regard to the roles, appointment, compensation and other aspects - pertaining to independent directors. It would be useful if the RBI sub-committee looks closely at these issues and provides some clarity on how best independent directors can be used to enhance/improve governance of MFIs in India. The various specific issues are listed hereafter:

How To Hire The Independent Directors?: First, in many MFIs, the promoter, who is (often) also the CEO, hires the board rather than the desired practice of the board hiring the CEO. That practice needs to be looked at from a corporate governance standpoint. The key question is “how can boards hired by the Promoter/CEO be really independent?” While declarations provided periodically by independent directors could be used to monitor their independence, this is certainly an issue that the RBI sub-committee must ponder about and try to work out a solution.

Who Can Become Independent Directors?: Second, there is a lack of clear cut eligibility requirement for independent directors - in terms of objective criteria such as age, expertise and experience (especially related to micro-finance). The RBI sub-committee could attempt to spell out such criteria including age, experience, knowledge and expertise (in finance, micro-finance etc) and also specify operational standards for these criteria so that the task of identifying independent directors (for MFIs) perhaps becomes more transparent and relatively easier.

Who is An Independent Director?: Third, we need clarity regarding the definition of 'independent directors', especially in line with globally-accepted standards. The RBI sub-committee could try to define the same with regard to MFIs and may be SEBI could also be involved in the process so that the same can be broad based later. Without question, there is an immediate need is to adopt a clearer definition of 'independent director' in line with the criteria recommended by leading governance codes such as those of the New York Stock Exchange, UK's Combined Code and others etc.

Should There Be A Board Nomination Committee With Vesting Powers?: Fourth, whether it would be desirable to have the vesting powers of appointment of new independent and executive directors in specially constituted board nomination committees is something that needs to be examined, in the context of MFIs. These committees would have to follow a process and lay down clear criteria for selecting board members. The nomination committee chaired by an independent director should not only hire independent candidates to the board, but also be made responsible for ensuring the 'real independence' of the proposed appointment. This is another aspect that the RBI sub-committee could look into as part of its mandate and provide suitable recommendations

How Much Time Should Be Spent by Independent Directors on Their Work?: Fifth, should the independent directors be mandated to spend a certain minimum time on work at the MFI? As an industry observer argues, 'independent directors should be required to devote a certain minimum number of hours every quarter or so to understand the business of micro-finance and gain insights of the MFIs in which they are serving as directors. This will enable them to examine the risks being taken and the appetite of their MFI to take such risks as well as understand and provide guidance on other strategic aspects, as may be required.’ This again could be looked into by the RBI sub-committee

How Many MFIs To Serve as an Independent Director?: Sixth, a related aspect is the time spent by independent directors on board meetings of a single MFI, annually. When there are people who have at any one point in time, serve as independent directors on several MFI boards, naturally, the quality of directorship is likely to suffer. It may appropriate for the RBI sub-committee to recommend a threshold level for number of MFIs, in which people (professionals) could serve as independent directors.

Should Peer Appraisal of Independent Directors Be Made Mandatory?: Seventh, peer appraisal of independent directors is an option for enhancing their effectiveness and this needs to be examined from the perspective of MFIs. While such an appraisal process would need to be managed with associated sensitivities, board members should also view this as an opportunity for continuous improvement and enhancing the corporate governance framework. Traditional methods of evaluation (in terms of share prices and strategy initiatives) can be augmented with a formal and objective appraisal of the governance framework. The appraisal should enable identification of gaps, better decision making, improve effectiveness of meetings, etc. This is also an aspect that could be looked at by the RBI sub-committee, in the context of MFIs

Do First Time (Independent) Directors Need Capacity Building?: Eighth, another critical area often ignored is the need for continuous director education programs, especially for the entry or first time (independent) directors. This is very critical for micro-finance and especially, if we want to ensure that the same people do not serve on the boards of too many MFIs. This capacity support could be done through the College of Agricultural Banking or any other appropriate institute. This is a very critical issue and could be examined by the RBI sub-committee

How Should Independent Directors Be Compensated?: Ninth, the compensation of independent directors is a very critical and contentious issue and there have been a lot of controversies in the recent months. The RBI sub-committee must surely set standards for the same and ensure that the independence of the independent directors is not compromised, under any circumstances. One option would be to entrust this to the board nomination committee and ensure that the promoter/CEO do not interfere in setting and implementing norms of compensation for independent directors. While there could be other strategies, I think that this is one of the most important issues that needs to be looked at by the RBI sub-committee.

How to Protect Client Interests on The MFI Board?: The RBI sub-committee could also examine whether there could be specially designated independent directors, representing client interests. This is especially crucial in MFIs that have and use the Mutual Benefit Trust (MBT) structure, which is indeed a client owned body – please recall that there have been many issues with regard to governance of MBTs in the recent past and the extent to which their interests are being protected in the boards of MFIs. The same should be explored by the RBI sub-committee and suitable recommendations provided and like compensation, this is a very important issue in MFI governance.

Finally, while enhancing the quality of independent directors would surely enhance governance, there is also a right mindset aspect that we should not forget. As Mr Kris Gopalakrishnan, (Infosys CEO) says, 'We may not be able to eliminate corporate frauds altogether. No amount of regulation will help to stop frauds. At the end of the day, corporate governance is a mindset issue. We need stricter, stronger and quick enforcement of law by regulatory agencies so that it will act as a deterrent for others.[i]’  Other observers agree, “As a baseline, MFIs need to have good governance in case they need to sustain and be profitable in the long run. Governance needs to be lived and practiced by the promoters and senior management at all times – and most importantly, when faced with the most difficult of situations.”

Therefore, while practicing good governance at all times is certainly a mindset issue, the least we can do is to incentivize good governance and perhaps penalize bad governance and do this consistently and without fear or favour. For this, we need a practical guiding framework pertaining to appointment, roles, responsibilities and compensation of independent directors and this is something that the RBI sub-committee could gift to the Indian micro-finance sector…that is perhaps low on its governance quotient...at least at this moment...  

[i] Quoted with Adaptation from The Satyam Saga, Business Standard Publication

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The Governance of Remuneration in Indian MFIs: Lessons from The Indian Experience

Ramesh S Arunachalam

Rural Finance Practitioner

As we move through the current crisis in Indian micro-finance, there are several important lessons for me and the first of these relate to Governance in Indian MFIs and I articulate the same in a series of posts, for readability and also segregating the key issues. The first post is on the governance of remuneration and here is some food for thought and I am sure this applies to other countries and their micro-finance contexts as well…

Some of the compensation practices that I have come across in Indian micro-finance include the following: Irrational and unusually high compensation of senior management, founder/other directors and much of this seems to be similar to that observed in financial services companies during the sub-prime and global financial crisis. Further, adhoc bonuses, pay raises (followed by sudden termination), the grant of shares when options have been sanctioned, the non-transparent pricing of options, provision of (huge) loans to enable founders and board members to buy their own company shares are some of the key compensation/remuneration issues in Indian micro-finance. Much of this practice is observable during the last 4/5 years, although the seeds were sown much earlier.

While the above provides a brief summary of the various existing practices, here are the lessons that I learnt from the Indian micro-finance experience:

Lack of Arms Length Decisions and Negotiations: The governance of remuneration and incentive systems seems to have (apparently) failed in some Indian MFIs because decisions and negotiations (carried out) have not been at arm’s length. Conflicts of interest at various levels have aided such improper decision-making and negotiation and much of this is applicable to remuneration and incentive systems for a range of senior management personnel and not just the CEO or Managing Director or Chairman of the Board. There are several examples from the Indian micro-finance context but I have decided to refrain from naming organisations and people because of the sensitivities involved…

Inordinate Level of Influence of Senior Management in Establishing Remuneration Schemes: In the several cases that I have personally seen, senior management generally appears to have far too much influence over the level and conditions (including measures) set for performance based remuneration. On the other hand, boards are often unable to or sometimes, even incapable of exercising objective, independent judgement. Here again, there are serious conflicts of interest, which certainly exacerbate this whole issue – in fact, this has been one of the most important reasons for inaction by the board against inappropriate remuneration proposals of senior management in MFIs

Medium and Long Terms Risks are Not Taken Into Account: In some cases that I have closely observed, the relationship between performance and remuneration is rather tenuous and sometimes, even difficult to establish, especially, given the nature of micro-finance operations. A very critical aspect here is that medium as well as long term risks and possibility of adversarial political action are rarely factored into the whole process – something that should have been done, given the nature of micro-finance and given what has happened in Andhra Pradesh recently

Complicated and Opaque Remuneration Schemes: Some of the MFI remuneration schemes are fairly complicated and also opaque in terms of shrouding actual conditions in the operation of scheme and the consequences. What I am saying is that these (operational conditions and terms) are perhaps not clear and obvious to the naked eye of an unassuming observer. These conditions also tend to encourage excessive and mindless (growth and) risk taking…

Mere Disclosure is Not Transparency: While transparency (in some cases) may exist in terms of disclosure, several MFIs couch the main characteristics of their performance related remuneration programs in verbose technical language and thereby make it very difficult for comprehension to the normal reader. Very rarely do we get information on the following: a) The total cost of the remuneration program to the MFI; b) The specific performance criteria and measures along with their conceptual and operational definitions; and c) The manner in which remuneration has been adjusted for relevant risks – especially, medium and long term risks as well as risk of political action (which is so relevant today). Without question, MFIs will surely need to have remuneration and incentive systems that focus and encourage at least on the medium term, if not long-term performance. This, in turn, means that MFIs must choose to reward their senior management after some actual performance has been realised and that has not usually been the case – a good example is a recent high front loaded one-time bonus paid to a senior management executive of a large MFI

Overall, remuneration does not seem to have been established through an explicit governance process where the roles and responsibilities of all stakeholders involved, including committee members, consultants, risk managers and others, are clearly defined and separated (without conflict of interest). The roles given to non-executive independent board members in the process - although they may seem somewhat appropriate - again appears to be laden with serious conflicts of interest. And finally, while remuneration policies are sometimes submitted to the annual meeting and subject to shareholder approval, much of this seems to be a routine matter, with minimal (informed) discussion…because of aspects mentioned earlier…

Therefore, given the above, in my opinion, a key question that stakeholders always need to ask is whether the compensation approaches being pursued are indeed consistent with the institutions (MFIs) ethical values of creating value for clients and its objectives, strategy and control environment as well as that of the overall industry? This aspect on compensation is nicely summarized by Mr Jan Postmus in his paper {Cited from Arunachalam, Ramesh S (2010)} and reproduced in Box below:

Box: Creating Value for Clients is the Raison d’ être of an MFI[i]

“The second lesson from the financial crisis deals with the huge bonuses that fuelled the crisis. The Dutch book ‘de Prooi’ (‘the Pray’)[ii] concludes that the excessive remunerations in the banking and financial sector failed. Especially the investment bankers took too many risks in their hunt for excessive bonuses. One of the main and important conclusions of this book is that banks need to become reliable, sound and maybe a bit ‘dull’ again with the core focus on the client and share value becomes as stable as an ‘government bond with a little extra’. This lesson is utmost valid for the microfinance sector where the clients consist of mainly illiterate clients.[iii] The MFI needs to be responsible for its clients in the first place and not for its investors. Both the MFI and the investors in microfinance need to be fully aware of the fact that the client always stays central. High expectations from investors about returns on their equity investment by creating increased share value for personal gains (which is happening frequently nowadays) needs to banned from the microfinance sector. We need to make sure that greed and excessive self enrichment, which is the root cause of the financial crisis, does not get a hold on microfinance. We know by now that this will become the downfall of the microfinance sector. If banks now want to become reliable, stable and ‘dull’ again and return to conventional banking, why should microfinance want to continue to measure itself with the investment bankers in the capital markets? Microfinance is not about creating personal gains rooted in greed. An MFI needs to be focused on creating maximum value for its clients. That is the raison d’ être of an MFI.”

To summarise, “Compensation…is one factor among many that contributed to the financial crisis that began in 2007. Official action to address unsound compensation systems must therefore be embedded in the broader financial regulatory reform program, built around a substantially stronger and more resilient global capital and liquidity framework. Action …must be speedy, determined and coherent. Urgency is particularly important to prevent a return to the compensation practices that contributed to the crisis.”[iv] I hope that the RBI sub-committee focuses on this aspect as part of its Micro-finance regulatory exercise…

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[i] Jan, Postmus (2010), “Micro-finance at Cross Roads”, Unpublished Working Paper

[ii] De Prooi (‘the Prey’), about the rise and fall of ABN AMRO, a fascinating book written by J.Smit, 2008, recently translated in English

[iii] Jan Postmus, Lessons for Microfinance (based on ‘the Prey’), 2009 at http://www.microfinance.nl/en-GB/Content.aspx?type=news&id=196

[iv] Quoted from BIS paper on Compensation and Corporate Governance, 2010

Corporate Governance in Indian MFIs: Changes Required to Current Practice

India’s MF landscape is largely dominated by promoter-owned/controlled MFIs (there are some exceptions to this). Many such promoter-owned MFIs have distinct characteristics (not exhaustive):

1. Inadequate checks and balance over executive decision making and behaviour,

2. Lack of transparent reporting to the outside world,

3. Lack of truly independent board nomination sub-committees,

4. Insufficient transparency about ownership/control, related-party transactions and the (group’s) overall financial position,

5. Promoters’ friends/families often leverage themselves highly to acquire stake in order to maintain control over the MFIs, and

6. Conflicts of interest at various levels including board and senior management level

Without question, these Corporate Governance practices will have to change if MFIs are to be viewed positively

I would like to sign off by quoting Dr N R Narayana Murthy, who while addressing the students of the George Washington University in 2006, stated what corporate governance meant to him: ‘Corporate governance, to me, is about maximizing shareholder value legally, ethically and on a sustainable basis, while ensuring fairness to every stakeholder - the company’s customers, employees, investors, vendor-partners, the government of the land and the community.’

I sincerely hope that MFIs attempt and try to practice this in full earnest.

Corporate Governance in Indian MFIs: Critical Issues

Mr Ramalinga Raju, who created false invoices to show better operating performance to create greater wealth for himself/shareholders and bring in more investments, was a trend setter in Corporate (Mis) governance. There appears to be a parallel in micro-finance as well, especially regarding Corporate Governance practices.

Satyam, had won every conceivable Corporate Goverance award and yet, it (then) blatantly violated every single CORPORATE GOVERNANCE rule. Likewise, there are also several Indian MFIs who top the global charts for the Corporate Governance awards in micro-finance while in reality, perhaps, practicing not-so-good (NSG) and non-transparent (NT) governance – in areas such as - board practices (including meetings and minutes drafting), shareholding, compensation for senior management and board members, appointment (there is so much of conflict of interest) and compensation of independent directors, presentation of results and operating performance, systems and the like.

My Observations: Some of the largest and biggest Indian MFIs have a poor track record in Corporate Governance:

1.    Related Party Transactions: MFIs have provided huge loans to founder directors to enable them to buy shares in the same MFI (that the founders promoted in the first place)

2.    Whimsical Management Style: MFIs have suddenly terminated services of their senior management including CEOs, without any explanation and/or apparent reason. A live example is currently available…

3.    Black-Box Type Operations: MFI boards function like a black box and are very difficult to understand. MFI boards often use procedures and make decisions, in a non-transparent manner that may not necessarily be in the best interest of the MFI and/or its (minority) shareholders. The examples given in points 1 and 2 should suffice and there are numerous other examples

4.    Family/Friends as Board Members: Many MFI boards consist of members who are either friends and/or family of the founder and/or chief functionaries including CEOs. There are boards in MFIs where the father and/or the mother and/or the son and/or daughter and/or their spouses and/or their uncles are active members – prompting a friend to say that MFIs are Common Wealth of the families concerned. Sometimes, board members become more permanent than the furniture in the board room (as former SEBI chairman, Mr Damodaran said in a similar Indian context)

5.    Functioning of Independent Directors: Independent directors in Indian MFIs lack accountability and true independence in their functioning. Some of them are even compensated by way of stock options and the like – instruments that compromise their independent functioning. As noted in point 4 above, when independent directors owe their appointments to the promoter/CEO, then, it is very unlikely that they would be anything different than nodders (as Mr Damodaran has said in a similar context)

6.    Functioning of Nominee Directors: Strangely, even directors nominated by institutional investors are quite and sometimes, they do not even write a dissent note, when the board norms and procedures are violated. The current procedures adopted by institutional investors, to ensure the accountability (and effective functioning) of their nominee directors, also appears very weak. Examples 1 and 2 are a case in point and there are several such incidents available

7.    Compensation Practices: Irrational compensation of senior management, founder/other directors – much similar to that observed in financial services companies during the sub-prime and global financial crisis is observable today in Indian micro-finance. Adhoc bonuses, pay raises (followed by sudden termination), the grant of shares when options have been sanctioned, the non-transparent pricing of options, provision of loans to enable board members to buy own company shares are some of the key issues in Indian micro-finance

The key lesson for me is:

Having a high profile board and/or winning Corporate Governance awards, does not an automatically guarantee Good Corporate Governance in MFIs. 

It has to be ensured by:  

a) appropriate regulation and supervision (both on and off site)

b) using other means including enhancing accountability of auditors and third party supervisors (like externally appointed internal auditors and/or rating agencies), who are capable of challenging the MFI and its board, if and when required

c) incentivizing MFIs/organizations for appointment of truly independent directors (IDs) and making IDs responsible/liable for Board decisions, presentation of Operating Performance (results) and the like. In fact, board members must spend quality time at the MFI and should also become familiar with operations through discussions and field visists, and

d) penalising institutional investors who appoint and forget about the working of their nominee directors. The accountability of nominee directors to their (parent) investors must be enhanced