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.