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