What is the number one corporate governance issue in your home country, and how would you address it?

Sharp market falls are not uncommon in emerging economies such as India. Markets crash for reasons other than a slowing economic outlook; one of the main reasons is lapses in corporate governance. Many firms relegate corporate governance to their annual reports and do not implement it. Good governance structures and rules are necessary to protect minority shareholders and keep company operations transparent. Bad governance can ultimately hurt profitability in the long run and expose investors to high economic risk. Opaque accounting practices, inefficient board structures and outright fraud, such as fudging data submitted to market regulators, are often the result of bad governance. IL&FS, Yes Bank and MCX are some of the high-profile Indian companies that caused over 90% loss of shareholder value, and the Hindenburg report on the Adani group of companies is still fresh in investors' minds. Some of these companies were, or are, part of market indices, and their governance lapses highlight significant downside risk both to investors in individual companies and to passive investors.

One of the main levers to strengthen corporate governance is the appointment of independent directors to company boards. The Companies Act of 2013 and the market regulator SEBI mandate these appointments to enforce checks and balances on management excesses. According to InGovern, a proxy advisory firm, many reports have highlighted challenges to the independence of independent directors. Many independent directors have affiliations with the promoters, which compromises their intended purpose and leaves them open to management pressure, undermining their ability to act in the interests of all shareholders. Independent directors also have a long average tenure of over 9 years, despite the Companies Act of 2013 limiting their tenure to five years and requiring a cooling-off period of 3 years before a subsequent re-appointment.

Companies are also failing Clause 49 of the listing agreement, which mandates that listed companies have at least 50% independent directors. This flouting of rules continues into the audit committee, which should be composed of independent directors only (2 independent directors and a chairman who should also be an independent director), yet many of the top 100 companies have executive directors on their audit committees.

An interesting fact highlighted by InGovern is the pecuniary relationship between independent directors and audit firms: many independent directors are also managing partners at the company's audit firm, which again is contrary to the Companies Act 2013.

Independent directors have been a subject of serious debate among academics and the investor community. The concept is not new: independent directors were voluntarily introduced in the United States in the 1950s before being mandated by law, then in the UK in the 1990s, and later imported to other countries, including India in the 2000s. This poses a fundamental implementation challenge, because shareholding in the US and UK is diffused, with large institutional holdings, unlike India, where ownership is concentrated with promoters. As a result, implementation is more effective in the West than in other countries. The diffused ownership in the US and UK helps companies in those jurisdictions curb the agency costs of managerial misconduct, which has been termed the outsider model. India follows an insider model, where shareholding is concentrated mostly with business family groups, and the rest is held by retail and institutional investors who have little say because they do not possess dominant voting power to change the affairs of the company. By virtue of majority shareholding, the "family" is able to exercise control over the company, making the principal–agent problem all the more apparent.

The Indian market regulator SEBI and the government are aware of the prevailing situation and have enacted rules to overcome the agency problem, for instance by limiting promoter stakes to under 26% for private banks. This should be extended to other industries to curtail undue promoter influence on governance. But in the larger scheme of things, companies and promoters should realize that an independent board will improve operational efficiency and will be rewarded by investors (HDFC Bank is a case in point) when they believe that the corporate information disclosed is accurate.

The following are some of the best practices cited by various advisory firms to strengthen the independence of company boards:

1. Independent directors should not be involved in any commercial dealings with the company.
2. Independent directors should be members of both the audit and risk management committees.
3. Independent directors should uphold their fiduciary duty to protect investors' interests.
4. The re-appointment cooling-off period should be followed in true spirit.
5. Independent directors should attend two-thirds of all meetings annually or lose their board seat in the following year.

For a country with the ambition to become the third-largest economy by achieving a high growth rate and reaping its demographic dividend, corporate governance should be made a priority, either voluntarily by companies or enforced by law.

"A commendable effort was made to structure the presentation and include academic references, statistical research, and reasonable remediation measures." Michael Perez, competition reviewer (New York-based lawyer)

References

• Hastings Business Law Journal, UC Law SF
• Private bank ownership: RBI accepts recommendations of internal working group (The Hindu BusinessLine)
• The long and short of corporate governance (Moneylife)
• The risks of poor governance to investors in India (The Economic Times)

Notes since writing