Sunday, January 11, 2009

Like IAS, IES, IFS etc., Needed : Indian Directorial Service (IDS)

Corporate frauds wherever and whenever they occur, from Enron in US to Satyam in India, bring focus on the role of independent directors in the boards of companies. In India, Clause 49 of the Listing Agreement with the Stock Exchanges specifies the role and requirements of independent directors on the boards of listed companies. Clause 49 is positive and comprehensive. Unfortunately however, neither the Clause in its scope nor the concept of independent directors in practice has the teeth or enablement to deal with the detection, prevention and correction of deliberate, systematic corporate frauds undertaken by the managements of the companies and the systemic deficiencies that are perpetuated in organizations to facilitate such frauds, as exemplified by the Satyam episode.

Several white papers on the collapse of Enron pointed out that lax regulatory environment in the US and poor oversight by the Enron board contributed to the collapse of the company. Regulations have since been tightened up significantly; reporting requirements enhanced substantially and oversight expectations on boards escalated notably in the major economies of the world. In all this effort, major emphasis has been placed on having a higher proportion of independent directors in the boards. This focus on independent directors has not helped matters as evidenced by the successive corporate failures in the US and the shocking Satyam imbroglio in India.

Satyam, for example, had some of the most talented and respected names as the independent directors on its board, prior to the recent events. The list includes Mr V P Rama Rao, former Chief Secretary to the Government of Andhra Pradesh, Dr (Mrs) Mangalam Srinivasan, Adviser to Kennedy School of Government, Harvard, Professor Krishna Palepu of Harvard Business School, Mr Vinod Dham, the famous Intel chip discoverer, Professor M Rammohan Rao of Indian School of Business, Mr T R Prasad, a former cabinet secretary, Government of India and Professor V S Raju of Indian Institute of Technology. The number of independent directors at 7 is larger than the number of whole-time directors at 3. The company was listed on NYSE and therefore was subject to the most rigorous reporting requirements of Sarbanes-Oxley Act of the USA.

From an analysis of Satyam’s corporate governance report, the independent directors participated in the board meetings as well as in the governance committees such as audit committee in full compliance of corporate governance norms. The directors represented proven, distilled administrative, technological, management, governance and academic experience. The company had a full-fledged Code of Conduct and Ethics for Directors. None of the above has, however, helped the board or the independent directors of Satyam, individually or as a group, to detect the corporate fraud that happened under the board’s very nose. It is indeed ironic that one of the independent directors of Satyam, Professor Krishna Palepu had the distinction of co-authoring with Professor Paul Healy of Harvard Business School a landmark book titled “The Fall of Enron” in 2003! Obviously, there is more than individual expertise and integrity that is on test under the independent directors system.

The fault does not lie in the independent directors, per se. The very act of having professionals at the peak of their respective careers or at the launch of new careers post-retirement as independent directors brings with it the twin disadvantages of a non-aligned career focus and an enormous time constraint. In the few hours they have at their disposal for each board meeting, such directors can bring no more than a whiff of world’s best practices or a gentle advice of caution to the deliberations of the boards. They would have neither the time nor the capability to analyze projects, operations, plans and finances to detect systematic fraudulent activities. The problem of inadequate attention gets compounded as such reputed professionals are much sought after as outside directors in several companies.

India has several thousand joint stock companies out of which over 5000 are listed in India’s oldest stock exchange, Bombay Stock Exchange. Assuming that these board managed companies require 5 to 7 independent directors each (based on an average board size of 10, with 2 to 3 members being whole-time directors and 2 members representing investors) there is a gigantic requirement for 25000 to 35000 independent directors to guide and manage these listed companies. It would be self-defeating to try to source them from a professional pool which is otherwise engaged in fulltime work of its own. If one superimposes the need for such independent directors to contribute effectively to the affairs of the company through industry knowledge, strategic guidance, operational oversight and risk management and in addition in the post-Satyam situation by way of regulatory compliance, internal audit and management audit the job of independent directors becomes a fulltime job with specific skill sets. The problem is not confined to private sector alone; several public sector companies too face the problem.

If the Government of India and India, Inc are serious about making the boards truly perceptive and powerful bodies with independent directors making a distinctive knowledge cum practice based contribution to the functioning of the boards, major structural and systemic changes in the institution of independent directors are called for. There are three aspects to this: (a) creation of a dedicated all-India talent pool for independent directors (b) making the independent directors truly independent and empowered and (c) integrating the independent directors in the strategic functioning of the company. These objectives can be fulfilled by the creation of an Indian Directorial Service (IDS) on the lines of the famed Indian Administrative Service (IAS) which creditably runs the Indian government.

IDS will be a special, high profile corporate cadre selected, trained, placed and compensated by the Government of India through its entities. The selection to IDS will be made through an all-India selection process by a newly created Union Corporate Directors Commission (UCDC) akin to the Union Public Services Commission (UPSC). The training for the directors selected for IDS will be carried out by a newly created National Corporate Directors Academy (NCDA) akin to the National Defence Academy (NDA) in collaboration with the various Indian Institutes of Management, which will be encouraged to set up academic verticals for corporate directors. The placement of independent directors from the IDS in various companies will be made by a Standing Committee for Independent Directors (SCID) under the governance of SEBI. The compensation for the independent directors will be carved out of a share of tax earnings reported by the corporate entities and administered by the Ministry of Corporate Affairs(MCA) if necessary through Company Law Board (CLB).

Unlike the IAS and other public services, the minimum entry age for IDS will be 40 years of age with a minimum of post-graduate qualification and15 years of senior level industrial, business, academic or armed forces experience. Maximum age of entry will be 60 years. Superannuation age will be 70 years. Senior executives from private and public sector companies as well as universities will be encouraged to apply. Aptitude, intelligence and psychological tests appropriate to directorial responsibilities will be administered as part of the selection process. The selection will be national and conducted annually. The tenure will typically be for renewable terms of 5 years and subject to the usual shareholder approvals. The IDS pool will be typically rotated across companies and industries to promote cross-fertilization of ideas and avoid the development of vested interests.

The independent directors are expected to influence the boards to make bjective and ethical quarterly and annual reports to the shareholders, stock exchanges, SEBI, SCID and MCA on the state of affairs of the companies they manage. The reports will be strategic in nature and cover critical aspects such as business environment facing the company, competitiveness of the company, performance parameters and ratio analysis, regulatory compliance, SHE (safety, health and environmental) profile, risk and prudential management and human resource accounting. Each of the independent directors on the board is expected to take a lead role in each of the 7 areas. One of the independent directors is expected to be appointed as the Chairman or Vice-Chairman of the company.

It is expected that each independent director from IDS will not be on the boards of two or three companies and not be on the board of more than one company from the same industry. Each independent director will have a working office as well as a basic secretariat in the company and possess the freedom to operate fulltime in the company. The independent directors will be provided access to the management information system (MIS) of the company and will be afforded the freedom to interact with the senior tier of executives directly reporting to the CEO.

When IDS takes off on the lines suggested above, it may evolve from being a governance cadre to a becoming a total talent source for directorships in the companies. It may lead to a healthy competition between the home-grown whole-time directors and the externally-inducted independent directors. Companies would have the benefit of a knowledge driven, fully functional board contributing to all aspects of corporate management.

Obviously for a major structural initiative such as IDS to succeed, this new public service has to be provided with the necessary legal enablement. Necessary supportive institutions such as UCDC, NCDA, SCID discussed here should be established. MCA and CLB as well as SEBI should be expanded to be able to handle additional administrative responsibilities efficiently. Apex industry associations such as Confederation of Indian Industry (CII) should lend their full support to the concept. Indian Directorial Service could be a major structural and systemic reform that could be a pioneering one even globally.

Posted by Dr CB Rao on January 11, 2009.

Friday, January 9, 2009

Corporate Growth and Collapse:A Competence-Conscientiousness Interplay?

Enron, Tyco, Worldcom and Xerox of the recent years, the Wall Street of the recent months and Satyam of the recent days raise the question as to how just one or two top ranking leaders of a company can perpetuate gross operational mistakes and / or financial falsification of the magnitude reported in each case. The occurrence of such events in a public listed company is even more surprising given the size and scale of operations a large company has, the public visibility it receives and the innumerable transactions it has with thousands of its stakeholders.

One conclusion that emerges is that such adverse outcomes cannot be attributed to just one leader, however powerful he or she is in an organization but probably are the result of a number of individuals working collectively together, knowingly or unknowingly, towards such outcomes. However, even this conclusion is paradoxical in the context of such organizations being expected to have people with established backgrounds and appropriate perspectives. Are these adverse outcomes caused by an organizational behaviour dynamic that is not adequately researched?

The answer probably lies in the interplay between two critical dimensions that drive human behaviour. Competence and conscientiousness are the two dimensions which drive the behaviour of any personality, in an organizational context. Competence is the important skill (or skill-set) that is needed to do a job effectively. Such competencies are acquired through education and experience. Conscientiousness is the part of an individual’s thought process that judges the morality of the individual’s own actions.
Competence stems from knowledge and awareness. The more competent a person the more likely the person is likely to be able to contribute in his or her role to the organization. A competent person is likely to be aware of the various decisions he takes and the implications for business growth and propriety. More importantly, competence provides a unique sense of self-worth and the requisite confidence to an individual to operate as per the fair dictates of his or her profession. A competent person is thus likely to stand his ground against any undue pressures and conduct his activities in a performance oriented and ethical manner. As a corollary, an incompetent person is likely to be a pliant individual susceptible to various types of pressures besides being a poor contributor to corporate performance.

Conscientiousness provides the sense of right or wrong to an individual. It helps a person with the requisite sensitivity to analyse whether the decisions and actions he takes by himself or is asked to take by his superiors are consistent with professional and business ethics and practices of good governance. A conscientious person is more likely to exercise his competence in a positive manner for the good of the business and society. As a corollary, a person who is not conscientious is likely to be more amenable to undue pressures and questionable ways, and worse still may even put his competence to misuse in pursuit of short run gains.

A person’s contribution to and influence over the ethical performance of a company is thus an interplay of these two essential dimensions of a personality. The issues one encounters in various organisations are linked to the variability that is found in each of these the two dimensions. Like every attribute or outcome in the universe, competence and conscientiousness also follow stochastic distributions. In a well-run organisation, the talent pool is likely to reflect a normal distribution in terms of levels of competence and conscientiousness each.

One can, therefore view the human resource base of an organization, irrespective of the domain specialization or hierarchy level to which the talent pool belongs, in terms of a 2 X 2 matrix which classifies people in terms of high or low levels of competency or conscientiousness. Organizations being the sum-total of individual profiles, the aggregation of competency-conscientiousness profiles of the individuals also contributes to the organizational DNA. An interplay of these two dimensions of a collective human resource base results in organizations which are clearly differentiated, as shown by the 2 X 2 organizational grid below.

High in Competence and High in Conscientiousness: Virtuous and vibrant organizations
High in Competence and Low in Conscientiousness: Aggressive and mercenary organizations
Low in Competence and High in Conscientiousness: Ethical and static organizations
Low in Competence and Low in Conscientiousness: Opaque and shallow organizations

Organizations which have people with high levels of individual competence and conscientiousness turn out to be virtuous and vibrant organizations which demonstrate industry leading performance in business, ethics, governance and safety. These firms figure consistently as the top rankers in the blue chip league and often set the tone in all aspects of corporate behaviour. Companies such as Toyota fall in this category.

Organizations which have large pools of highly competent people but with low levels of conscientiousness typically post high business growth rates. However, the methods they deploy to achieve the performance could be questionable. These organizations are typically driven overwhelmingly by a performance criterion and are likely to choose the quantitative goals of performance over qualitative ideals of ethics, governance or safety if it were to come to a crunch ever. Most performance-centric companies which are loved by investors for the momentum of their earnings tend to fall in this category.

Organizations which have a preponderance of people who subscribe to high levels of ethics but have not bothered to equip themselves with the competencies required to handle the challenges of modern-day business would be virtuous organizations but with pedestrian performance. Though such organizations have the ability and intent to do good to the economy and the society they would be unable to do so for want of requisite technical and managerial bandwidth. Most traditional family-held businesses and NGOs run by individual champions fall in this category.

Organizations which are low in competence and conscientiousness are a drag to the economy as well as society for they represent a waste of public resource. In addition, if these companies desire to emulate the high performance companies without the inherent competence and conscientiousness they could pose a grave risk to the economy and society. Such companies could resort to questionable means to grow in business. Short term tactics deployed by such companies under the cover of opaque management processes result in hollow and risky business models that are susceptible to collapse at the first downturn. From Enron to Satyam, gigantic corporate failures take place in companies with such low levels of competence-conscientiousness mix that fail to support aspirations of high achievement.

Given the interplay discussed above, the top leadership in an organization has to aim at enlarging the human resource pool that is truly both competent and conscientious while shrinking the human resource base that is patently low in competence and conscientiousness. This is easier said than done for a couple of reasons. Competence is often measurable and visible as quantitative outcomes of performance while conscientiousness is qualitative and perceptional. It is a matter of further complication that high level of quantitative performance could itself be due to low levels of conscientiousness.

Organizations have to deploy 360 degree analysis during recruitment, training and performance appraisal phases of its human resource management so that each individual is analyzed in terms of not only the individual’s competence and conscientiousness levels but also how he or she integrates these two essential factors in terms of a performance work ethic. The top leadership of a company has to necessarily set the pace for processes which recognize and reward individuals only when their competencies are combined with conscientiousness. Such an approach will doubtless help create an organizational DNA that is virtuous and vibrant, leading to high performance with high ethics.

Posted by Dr CB Rao on January 9, 2009

Wednesday, January 7, 2009

The Sordid Satyam Saga : DAACS in the Dock?

The continuing Satyam saga has touched a new, horrendous low today with the resignation of the Chairman, B Ramalinga Raju and the shocking explanation tendered by him on the inflated accounts of the company. If the earlier episode of the aborted Satyam-Maytas merger brought into question the role, in corporate governcnce, of board of directors in the overall and that of the independent directors in particular, today’s episode brings into focus an errant axis that could exist amongst the promoters and directors, accountants, auditors and company secretaries (DAACS) in deviant corporations.

Viewed in a relevant perspective, DAACS as a group of corporate officers are trustees of public money that is created, transacted or held through corporate mechanisms. Each of these corporate officers has a specific purpose in an organization that serves corporate as well as public interest.

A director, whole time or part time, has an inviolable duty to provide the right vision, strategy and execution in an ethical climate to the affairs of the company. When a promoter is also a director or the CEO the responsibility becomes even greater. Whatever may be the seed capital with which an entrepreneur sets up a venture, sooner than later the capital structure gets expanded to include external equity and debt that is several, several times over the seed capital that is brought in by the promoter. It is to be therefore expected that the promoter-director acts as a trustee of the public money for public good rather than as a total owner of a corporation which has grown as much through public money as much through the founder’s passion and capital .

An accountant, or the chief financial officer, has the responsibility to ensure that the operations are conducted in a financially prudent and stable manner while fulfilling the corporate aspirations for growth and insulating the company from economic and business risks. Whatever be the IT and accounting systems deployed, it is ultimately the translation and interpretation of physical performance into the financial numbers and the performance certification that is provided by the CFO that determines the solidity and integrity of the financial status of the company.

Equally, significant emphasis is placed on the audit function, both internal and external, to ensure that a company’s operations and financial numbers are in compliance with all the statutory requirements and are reflective of the true state of affairs. Typically however, auditors are a highly pressured lot having to attend to multiple account closures in short windows of time on a quarterly and yearly basis. In any case it may be impossible to check the veracity of each transaction and consequently, reliance is placed on the self-certification by the operations and management teams. This however, does not absolve the auditors of their responsibility to ensure that a company’s systems and procedures are laid out and observed in practice in such a manner that the accounts represent a true and fair reflection of the business.

Last but no less important is the company secretary who is privy to all the agenda, deliberations and minutes of all board meetings. The secretary who in several companies acts also as the responsible officer for corporate governance and risk management has a special responsibility to ensure that the capabilities and competencies of the board are harnessed for the benefit of company operations. It also dwells on the secretary to ensure that the statute and prudential norms are followed in both letter and spirit and compliance as well as violation is reported diligently to the board.

Given the critical roles played by each of the DAACS officer group, a manipulative crisis of the magnitude that has hit Satyam could have been possible only when each member of the DAACS group collaborated, actively or passively, to abdicate the respective responsibilities and in fact acted in complete counter-direction to such requirements.

Obviously, the corporate and regulatory systems would need fundamental changes to avert these types of collusive behavior. Several measures are needed to ensure the needed robustness to the system. For example, the boards should reflect ownership interests in a truly proportionate manner. The independent directors should be appointed by ombudsman and regulatory institutions such as stock exchanges and SEBI. The two core corporate officers (the CFO and the company secretary) should be made accountable only to the board. Larger companies should be required to have two audit firms on a mandatory basis. Corporate compliance reports should be made a part of overall quarterly reporting as well as annual corporate reporting. Banks and financial institutions should have key client managers. The nexus between analysts and corporate managements should be discouraged. Media and industry associations should control their irrational exuberance and cease painting corporate leaders as demi-Gods. There could be several other logical measures.

If the Satyam episode serves as a clarion call for a fundamentally ethical transformation in the way companies are established, grown and managed; in the way corporate performance is compiled, reported and reviewed; and in the way responsible officers think, act and comply with reference to prudential norms, it would have served a purpose, albeit at a high cost.

Posted by Dr CB Rao on January 7, 2009