The removal this week by three Tata group companies of Mr. Nusli Wadia as an independent director from each of them has reinvigorated some of the debate surrounding board independence from a conceptual standpoint. This has provided critics of board independence with more fodder. In the past, there was anecdotal evidence that whenever there were disagreements between managements or promoters on the one hand and independent directors on the other, either the term of the independent director would not be renewed upon expiry or such director simply resigned from the board. To my knowledge, this the first time an independent director has been removed by shareholders on account of a disagreement, in this case with the promoters. Hence, the occasion is somewhat momentous and may require some regulatory soul-searching.
Retaliating to his removal, Mr. Wadia has argues that independent directors carry onerous duties and responsibilities without any protection whatsoever. Moreover, he alleges that the promoters of the respective Tata group companies ought to have abstained from the extraordinary general meetings called for his removal, and that the majority for his removal should have been a higher threshold of 75% rather than a simple majority. Here, the episode reveals some significant chinks the regulatory armour surrounding independent directors.
In an earlier paper in 2011 titled “Evolution and Effectiveness of Independent Directors in Indian Corporate Governance”, I had sought to identify some of the problems relating to board independence, which have now manifested in the Tata group. The first concern is that independent directors are appointed like any other directors. I had noted:
[The law] does not contain any specific procedure for nomination and appointment of independent directors. That process occurs in the same manner as it does for any other director. It therefore requires us to explore the provisions of the Indian Companies Act to examine how directors are appointed and the various factors that play out in that regard.
In India, the appointment of each director is to be voted on individually at a shareholders' meeting by way of a separate resolution. Each director's appointment is to be approved by a majority of shareholders present and voting on such resolution. Hence, controlling shareholders, by virtue of being able to muster a majority of shareholders present and voting on such resolution can control the appointment of every single director and thereby determine the constitution of the entire board. Similarly, controlling shareholders can influence the renewal (or otherwise) of the term of directorship. More importantly, shareholders possess significant powers to effect the removal of a director: all that is required is a simple majority of shareholders present and voting at a shareholders' meeting. The only protection available to directors subject to removal is that they are entitled to the benefit of the principles of natural justice, with the ability to make a representation and explain their own case to the shareholders before the meeting decides the fate of such directors. The removal can be for any reason, and there is no requirement to establish "cause," thereby making it a potential weapon in the hands of controlling shareholders to wield against directors (particularly those directors that the controlling shareholders see as errant to their own perceptions regarding the business and management of the company).
The absence of a specific procedure for nomination and appointment of independent directors makes it vulnerable to capture by the controlling shareholders. Assuming that one of the purposes of the independent directors is to protect the interest of the minority shareholders from the actions of the controlling shareholders, such a purpose can hardly be achieved given the current matrix of director appointment, renewal and removal. The absolute dominance of controlling shareholders in this process creates a level of allegiance that independent directors owe towards controlling shareholders. If controlling shareholders cease to be pleased with the efforts of an independent director, such a director can be certain that his or her term will not be renewed, even if such director is spared the more disastrous consequence of being removed from the board.
In the case of Mr. Wadia, he had to face the “most disastrous consequence” noted above, which makes this episode somewhat exceptional.
Of course, since the publication of the above paper in 2011, there have been significant corporate governance reforms in India culminating in the Companies Act, 2013 and the SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2013 (“LODR Regulations”). The roles and responsibilities of independent directors have been delineated more clearly. However, when it comes to their appointment and removal, there is only one significant change, which is that the requirement of a Nomination And Remuneration Committee has now become mandatory under section 178 of the Companies Act, 2013. This formalizes the process for appointment of directors, including independent directors, as it is required to determine qualifications, positive attributes and independence of a director. It allows for a great deal of transparency and minimizes the influence of management and promoters in the nomination of independent directors. However, as I have argued in the above paper, any system of nomination committee is acutely insufficient to address the problems facing board independence in countries like India:
… Even if an independent nomination committee were to nominate candidates without the influence of the controlling shareholders or management, those candidates would ultimately have to be voted at a shareholders' meeting, where the controlling shareholders would wield significant influence. … The nomination committee tackles the first process, but it does not touch upon the second. Controlling shareholders will continue to have the ability to sway the shareholder decision on whether the candidate nominated by the nomination committee should be appointed on not. Hence, nomination committees are compelled to function in the shadow of an ultimate shareholder decision (with controlling shareholder influence). For this reason, nomination committees are unlikely to pick a candidate who does not have the tacit acceptance of a controlling shareholder. It would be an embarrassment after all if the person nominated by the nomination committee fails to muster enough votes at a shareholders' meeting due to opposition from the controlling shareholders. …
Given that the present episode reveals inadequacies in the current board independence structure, it is imperative to consider potential reforms to the process. As I had noted:
Currently, independent directors in India are elected by shareholders through the "straight voting" system, whereby a majority of the shareholders present and voting for a resolution can determine whether or not a candidate for independent directorship is appointed. It is the straight voting system that confers dominance on controlling shareholders in the appointment of independent directors, as minority shareholders do not have any say at all. My proposal deals with the enhancement of minority shareholder involvement in independent director elections. This would make independent directors accountable to the shareholder body as a whole (including the minority shareholders) as opposed to the sole allegiance to controlling shareholders as currently practiced in India.
Minority shareholder participation can be introduced through two principal methods: (i) cumulative voting by shareholders; and (ii) election of independent directors by a "majority of the minority." …
a. Cumulative voting
Cumulative voting will ensure that minority shareholders will have the ability to elect such number of independent directors as is proportionate to their shareholding in the company, thereby reducing the dominance of controlling shareholders in the process. In this structure, each shareholder gets to exercise such number of votes determined as the product of the number of shares held by the shareholder and the number of independent directors to be elected. A shareholder can exercise all votes in favor of a single candidate or can split the votes among different candidates. In case all votes are cast in favor of a single candidate, then that candidate may have a chance of being elected depending on the total number of candidates that are in the fray. …
The advantage of cumulative voting is that it allows both controlling shareholders as well as minority shareholders to elect independent directors depending on the proportion of their respective shareholding.
b. Voting by 'majority of the minority'
In this schema, only the minority shareholders are entitled to vote for the election of independent directors. Each independent director will be elected so long as the candidate enjoys majority support within the constituency comprising the minority shareholders. In this approach, neither the controlling shareholder nor the management can influence the appointment as they have no role at all. The controlling shareholders will not be permitted to vote in independent director elections under this proposal. Furthermore, this is useful where the number of independent directors to be appointed is small whereby the system of cumulative voting would render itself ineffective. This will result in true representation of minority shareholders on corporate boards and instill accountability in the minds of the independent directors towards minority shareholders.
Of course, it is not sufficient if the regulatory process fixes issues relating to the appointment of independent directors: it must also address the question of removal which surfaced in the case of Mr. Wadia. As I had argued:
The procedure for renewal of the term of independent directors ought to be the same as that for a fresh appointment, i.e., through selection by an independent nomination committee and election through minority shareholder participation. As far as removal is concerned, there are some key issues to be borne in mind. There is no benefit in having a carefully considered election process for independent director if that can be undone in one stroke by a straightforward removal process. For example, if independent directors can be removed by a simple majority of shareholders, then the controlling shareholders can reverse the effect of appointing independent directors by removing them through exercise of their influence. In order to obviate such a reversal, along with minority shareholder participation in independent director elections, it is necessary to impose stringent removal requirements. Either independent directors can be removed by shareholders only for "cause" or they can be removed with a supermajority that requires a higher threshold (of say 3/4 or 2/3 majority of shareholders voting for the resolution). This would ensure that independent directors are capable of being removed only in extreme circumstances, and not simply because such directors no longer enjoy the trust of the controlling shareholders. Such a requirement is essential to ensure that independent directors remain outside the influence of controlling shareholders.
While some may argue against the theoretical nature of the debate or implying that such excessive reforms are unnecessary, the episode involving Mr. Wadia has demonstrated that these issues are real. It would to foolhardy to brush these issues aside. Other such as Professor Bala Balasubramanian too have long argued for “majority of the minority” voting in case of specific transactions, including in case of appointment of independent directors. Even an OECD document titled “Improving Corporate Governance in India” highlights the undue influence of controlling shareholders in the appointment and removal of independent directors, finding that “jurisdictions, like Italy and Israel, have provisions for the appointment of independent directors by minority shareholders, which ensures more independence”, thereby suggesting that “controlling shareholders not be allowed to vote in the election of independent directors so as to ensure the latters’ independence”.
Granted the recent round of reforms surrounding corporate law and governance have given more teeth to independent directors, but the current episode exposes the continued vulnerability of individuals who occupy that office. The legislators and regulators ought to take cognizance of these glaring loopholes, and address them in the appropriate manner.