Monday, April 20, 2009

Independent Directors in the Post-Satyam Era

The Serious Fraud Investigation Office (SFIO) appears to have given a clean chit to Satyam’s independent directors, as it was found that the board was not involved in the fraudulent conduct and that they were kept in the dark. Much has already been written about the difficulties of placing too much reliance on the role of independent directors in corporate governance. Independent directors spend only a few days in a year on affairs of the company, and they are indeed busy individuals carrying out their regular business and professional activities unrelated to the companies on whose boards they serve. Even where independent directors are generous with their time and effort, their advise and decision-making is based on information provided by the management (or promoters) of the company, who can control the amount, quality and structure of information that reaches the board. It has been said that “power over information flow is virtually equivalent to power over decision”. It is unsurprising then that the independent directors of Satyam were neither aware of the goings on in the company nor were they in any position to prevent it.


An outcome of the Satyam episode is that it seems to have instilled fear in the minds of independent directors in India. The Economic Times reports today that “more than 500 directors have quit the BSE-listed company boards since January 1 this year … citing reasons ranging from ill-health to work pressures”. It is indeed difficult to fathom whether the resignations are due to fear of liability in the minds of the directors or their apparent lack of confidence in the company and its business, financial performance or reporting systems. It would augur well if independent directors are more transparent about the specific reasons for their departure than to offer the standard lines. It is debatable whether a statement from the resigning director should be mandated by regulation so there is transparency as far as investors and other stakeholders are concerned. In fact, a similar scenario was played out in Singapore a couple of years ago, and the response of the regulators was to prescribe a template for director resignation that sets out the reasons:


Singapore Exchange Ltd (SGX) will be launching a new announcement template on SGXNET for notice of resignation of directors and key officers with effect from 1 October 2007. This will be applicable to all listed companies in Singapore. The new template is the first practical measure to be implemented as a result of the recent study commissioned by the Monetary Authority of Singapore (MAS) and SGX to review the state of corporate governance practices of SGX-listed companies.


One of the findings of the study highlighted the importance of listed companies providing detailed information on the resignations of their directors and key officers to investors and the marketplace. The new easy-to-use announcement template will facilitate listed companies disclosing in detail the reasons for the resignations. The resignation of one director or a succession of them, particularly of independent directors, may indicate something untoward in terms of corporate governance or commercial developments. Investors should be made aware of these changes.


This is not to suggest that there is something untoward in every Indian company where independent directors have resigned in the past. That would be too rash a conclusion to draw. It could also be the fear of potential liability. Independent directors are often fearful about this issue (and understandably so) for two reasons: (i) they are not involved in the day-to-day activities of the company although they may bear some responsibility for the actions of management; and (ii) there are myriad directions from which liability could strike since directors are responsible (subject to exceptions) for violation of various statutes by companies, particularly for the so-called socio-economic offences. There is “fear of the unknown” on both these counts.


Having said that, the past track-record of directors being held liable for actions of the company favours independent directors. In an influential series of studies carried out across several countries (though not including India), it was found that the risk of liability on independent directors is far lower than what commentators and directors themselves believe. Even in a litigious society such as the U.S., it was shown that there were only a handful of cases where directors in fact had to make payments (and these include the high profile Enron and WorldCom settlements). The researchers show that these were cases where there was a “perfect storm” scenario (e.g. where the company was in bankruptcy, the D&O insurance was inadequate, and so on), unlikely to occur in most circumstances. However, independent directors are indeed concerned not about direct financial liability but the time, cost, lost opportunity and reputational risk that accompany the mere initiation of legal action against them, even if that action does not succeed in the end.


Although the studies above are generally optimistic, it can be even starker issue in the Indian context where the litigation process tends to be prolonged and cumbersome, and a closure on the issue being unlikely within a short time frame. Further, the number of socio-economic legislation in India that could potentially give rise to directors’ penalties is quite vast, as we can see in a recent example. Among them, some are fraught with more difficulties to independent directors than others. The liability under Section 138 of the Negotiable Instruments Act appears to be one of the frontrunners. However, unless the number of successful liability claims and prosecutions can be empirically verified, it would not be possible to determine the magnitude and extent of the risk in the Indian context. Some of this risk (particularly for financial liability) can be mitigated through D&O insurance policies, but the rest cannot be wished away, making the independent director’s position an unenviable one.

3 comments:

Kodur_Sathya said...

The way out?!!!!

Being one of the independent director for a company is a difficult task. Particularly for a country like india.

India has innumerable acts, rules and other guidelines to follow. The independent directors are not executive authorities. Certain legislation has defined "officer at default" to mean executive director while other acts is silent about it. In such cases the independent director also become responsible for it.

Time has come where in all acts / legislation in principle should bring in the term "Officer in default" and shall exclude the independent director from it.

Regards
sathya
9444415038

Umakanth Varottil said...

Sathya, thanks for your comments. I did not offer any way out because the solution is not likely to be simple at all. One option is to set a low bar for independent directors (as compared to executive directors) both for civil liability as well as criminal liability. That may appear to solve the problem. However, at the same time, there needs to be some incentives/disincentives to motivate independent directors to discharge their monitoring functions (to the extent possible). The key is to draw that fine line.

Kodur_Sathya said...

Sir,

I present the scenario. I am one of the independent director for a NBFC Pvt Ltd company. Under present laws its not obligatory for this type of company to have a independent director. It is basically to provide good corporate governance and like external people to contribute to the company.

Now my position is that of a "non executive director". Our focus is to provide overall direction and guidance to the business of this company. We could undertake board level checks & controls and for other aspects and compliance we depend on third party checks & controls such as Statutory auditors / Internal auditors / Company secretary.

Under no circumstances, we can be held responsible for the misconduct of the company / the stated external people.

Time has come for all legislation to have the definition for "officers at default" can only have person like executive director / CEO / manager etc and not "non executive directors".

I am also open for a discussion to the accountability of the non executive director / independent director.

Regards
sathya