Thursday, February 2, 2017

Shareholder Primacy in India: So Near and Yet So Far!

[The following guest post is contributed by Professor Bala N. Balasubramanian, who is an Adjunct Professor at the Indian Institute of Management, Ahmedabad.][1]

The scholarly debate on primacy among the shareholders, boards and the executive in corporate governance is intellectually as challenging as it is yet inconclusive, although more recent trends around the world would seem to suggest at least a glacial tilt towards shareholders’ supremacy. This post attempts to explore the issue with specific reference to India and its listed corporate universe.

A.        Some Measures Supporting Shareholder Primacy

Indian company law incorporates several measures that aim to establish shareholder primacy over the corporate board and the executive. Some of these (with illustrative comparisons with some developed market jurisdictions) are enumerated below.

Right to Elect and Remunerate Directors

As is quite well known, the fundamental format of the corporation makes it impossible and indeed even undesirable for all shareholders to actively participate in management; instead, shareholders elect a small group of people trusted for their “integrity” and “competence” as directors to protect and promote their interests, guiding and overseeing the executive management, and to periodically report back on the company’s state of affairs. The directors thus elected incur, consequently, a fiduciary or trusteeship obligation to act in the interests of the company and all its shareholders. The components of this right include choosing fit and proper candidates to act as directors, expecting their independence from operating management so as to promote fair and objective supervision, approving appropriate executive and directorial compensation, and so on. Some of the distinguishing features of Indian company legislation and regulation are undernoted:

- Directors are to be elected individually and not collectively as a “slate” proposed by incumbent board and management in the United States (US) until recently;

- Director candidates’ profiles are to be circulated to shareholders for assessing suitability;

- Objectivity and independence of at least a third of the board is required by statute (unlike say in the US where the requirement of majority of the board to be independent is prescribed by listing regulations, and “controlled companies” are exempt from the requirement of majority of the board to be independent; additionally, such “controlled companies” are also exempt from independence requirements with regard to their compensation, nomination, and governance committees);

- Executive compensation is to be approved by the shareholders individually for each whole time director including the managing director (unlike in the US where the Compensation Committee of the board is authorised to finalise and approve such compensation). This US position is undergoing a change in recent times, thanks to the ‘Say on Pay’ movement that sought greater empowerment of shareholders in this matter; as yet, the ‘say on pay’ vote by shareholders is only advisory and not binding on the company unless its management and board choose to act on the advisory votes;

- Statutory ceilings on non-executive directors’ compensation individually and in the aggregate (not to exceed 1% of net profits of the company if there is a managing director, whole time director or ‘manager” and 3% in any other case) help to contain such expense within reasonable limits (unlike in the US where no such limitations apply as long as the company’s remuneration policy for directors and certain other details are disclosed to shareholders in the annual report);

- Prohibition of stock option grants to independent directors is aimed at promoting independence levels (unlike in the US);

- Statutorily providing for board diversity by mandating at least one woman director on the board (although several countries in continental Europe and even the United Kingdom (UK) have, or are fast moving towards, such provisions (with the European Parliament having approved a draft directive to have 40% representation for the under-represented sex on listed company boards in member countries); the US (barring the State of California effective 2016) does not as yet  have any such mandate (companies however are required to report to shareholders whether they consider diversity in board composition and if yes, how they implement it);

- Statutorily enabling election of a ‘Small Shareholders’ Director’ to protect their interests (although the idea may be conceptually flawed, since once appointed a director from whichever constituency, the person’s fiduciary obligations extend to the whole company and body of shareholders, not limited to the constituency that elected him or her). There are no comparable provisions in the US or other developed markets.

Right to Protect Holdings Equitably

Shareholders’ rights to peaceably hold, dispose or otherwise deal with their holdings can be vitiated under certain circumstances such as when preferential issues of capital are made to some but not all the shareholders, or when mergers or acquisitions take place, or when there are changes in the ‘control’ of the company, and so on.  Some of the legislative or regulatory provisions in India seeking to protect shareholder interest are undernoted.

- Fair price discovery methodology mandated based on market prices over a period, in case of offers to buy out shares from holders so inclined to sell (the relatively small and shallow trading operations may render these mechanisms vulnerable to manipulation by vested interests, but if they succeed even to a limited extent they would be welcome);

- Mandatory offer to buy up to some prescribed percentage shares from willing shareholders in case of acquisitions and/or change of ‘control’ of the company;

- In the event of ninety percent of the capital having been acquired by the majority shareholders, the remaining ten percent shareholders can be squeezed out whether or not they wish to sell their holdings. The law provides for fair and reasonable price to be paid to the concerned shareholders.

Right to Credible and Comprehensive Feedback

- Entitlement to receive annually detailed financials and reports of directors. Disclosure requirements in India are probably the most comprehensive among comparable and developed markets;

- Right to appoint independent statutory auditors vested in shareholders at their annual general meetings, unlike many other jurisdictions where the audit committee of the board decides on the appointment and remuneration of such auditors. Auditor independence criteria and rotation are other topics statutorily covered in India;

- All subsidiary company accounts and financials need to be audited individually and summary results made available to the shareholders of the holding company, with full audited accounts being made available on holding company websites  (unlike in jurisdictions such as the US where unlisted subsidiaries’ accounts need not be audited separately or made available to holding company shareholders).

Right to Protect and Determine Business Purpose, Continuity, and Solvency

- Restriction on the powers of the board in respect of selling, leasing, or otherwise disposing of the whole or substantially the whole of the undertakings of the company;

- Restriction on borrowings aimed at preventing undue financing risk of the company without specific shareholder concurrence by a super majority for borrowings beyond the aggregate of the company’s paid up share capital and free reserves;

- Restrictions and disclosure of contributions to political parties;

- Contributions in excess of prescribed limits, to charitable and other funds to be approved by shareholders;

- Modifications in the objects clause in the charter documents may not be made except with the approval of shareholders by a special (super majority) resolution through postal ballot (to provide for widest possible access to all shareholders). Companies with unspent money from an IPO are also required to offer an exit option to dissenting shareholders.

Right to Agitate against Oppression and Mismanagement

- Eligible shareholders (at least 100 in number, or at least 10% of the total number of shareholders, or holders of at least 10% of the issued share capital including preference capital if any) may seek legal redress in case of alleged oppression of shareholders or mismanagement of the company, prejudicially impacting the interests of the company or its shareholders;

- Central government has been vested with powers to carry out inspections and investigations on the basis of a special resolution of the shareholders or a report from the Registrar of Companies, or in public interest. Similarly, government’s Serious Fraud Investigation Office is also empowered to undertake investigations in appropriate cases.

Right to Reasonable Protection from Tunnelling

- A common method of unfair expropriation of shareholder wealth by controlling shareholders is through related party transactions favouring the controlling shareholders at the expense of other absentee shareholders. By prohibiting such shareholders from exercising their votes supporting resolutions on such transactions at shareholders’ meetings, interests of shareholders not in operational control are safeguarded since only they can by a majority approve or reject such transactions;

- Audit committees are required to review and approve or reject all related party transactions; although this requirement imposes a very onerous responsibility on audit committee members, it provides a valuable oversight mechanism to filter out abusive related party transactions, protecting other absentee shareholders’ interests.

B.    Shareholder Primacy in India: Fact and Fiction

While these and other such measures clearly indicate the legislative intent of protecting and promoting shareholder primacy in key areas of company governance, whether these translate in to reality is a moot question. There are several reasons why these measures are rarely utilised optimally to their full potential, some of which are undernoted.

Attendance and Voting at Members’ Meetings

- In general, votes are exercised at members’ meetings in person, or by proxies present at the meeting. Attendance at such meetings thus assumes great significance. Traditionally, only a fraction of the shareholder population takes the trouble of attending meetings, either because their miniscule holdings do not merit or justify the time and effort involved or they simply do not have the expertise to meaningfully participate in such meetings;

- To incentivise attendance (as well as to minimise and manage any potential shareholder hostility), companies have often offered some freebies but even in such cases, it is not unusual for many shareholders to collect the freebies and depart without participating in the proceedings, or just be mute spectators.

- To obviate this deficiency at least in respect of key resolutions coming up for approval, a system of postal/electronic ballot has been introduced for some years but even this appears to have had limited success due to continuing retail shareholder indifference; but a regulatory mandate covering mutual funds (but not other institutional investors as yet) regarding disclosure of voting details with reference to their investee companies has led to a significant increase in their voting participation. 

Investors Apathy and Impact of Crony Capitalism

- Many institutional investors, especially in the foreign institutions category, believe their relatively small holdings (in their overall portfolio) in the companies do not justify the cost of monitoring and evaluation of governance practices, and participation in voting. To some extent, emergence of proxy advisory firms appears to have persuaded at least some of them to more actively participate in members’ meetings in recent years. Blatant breach of basic governance norms of course do attract their intervention (as in the case of Satyam Computers) but even then, the time consuming and costly processes of navigating such interventions through the Indian judicial system often act as major deterrents;

- Large domestic institutional investors largely are owned or controlled by the State and hence their voting decisions are as often as not likely to be influenced by political compulsions of the incumbent government. Traditionally, business and government nexus or crony capitalism has worked to their mutual advantage both in the field of policy making and in operational facilitation (here). As a general rule, governments of the day in India have tended not to upset incumbent managements of companies (as for example, in the case of (now Lord) Swraj Paul’s unsuccessful attempts to take over DCM and Escorts, two of India’s vintage companies in the nineteen eighties). Manifestation of this basic policy of calculated non-interference usually takes the form of such institutions abstaining from participating in meetings or voting on key resolutions, paving the way for incumbent management or the “establishment” to cope with any serious challenge

C.        Strengthening Shareholder Primacy

Maintaining a tenuous equilibrium of constructive tension among shareholders, boards of directors, the executive and the controllers is an important mechanism for establishing good governance in companies. Any effort to further strengthen the level of good governance will need to address both the inhibitors and the gaps in the governance structures. Following are some areas where further scope for improvement likely exists.

Enhancing Institutional Investor Participation in Company Governance

Institutional investors do have their accountability and trusteeship obligations to their own stakeholders and in that context likely owe it to them to actively participate in their investee companies’ governance processes to contain governance risk premiums such companies’ securities suffer. The Stewardship Code dealing with such institutional investors may be revisited to explore further strengthening of its provisions to promote greater investor participation in such matters.

 Enabling Independent Directors towards Enhanced Contribution

Having introduced the undoubtedly valuable institution of independent directors in board governance, it is probably opportune now to take some further legislative initiatives to strengthen the voice of independence at the board level (here) Following are some of the measures that may help in that direction:

- Certain key proposals and decisions to require affirmative approval of a majority of all independent directors (whether or not present or participating);

- Quorum requirements for board and committee meetings to require the presence of a majority of the independent membership of the board or the committees. The newly introduced requirement of presence of at least one independent director at board meetings is a good beginning but its utility is likely limited since it applies only to board meetings called at short notice.

Countervailing Controlling Shareholders’ Inappropriate Governance

Board and director “capture” is a well-established phenomenon that impairs good governance; to shield the institution of independent directors from the debilitating effects of such practices, some structural reforms may be necessary in countries like India where concentrated corporate ownership and dominant control are the rule rather than the exception. Following are some of the measures may help in this direction:

- Recommendations of the nomination committee for induction of new independent directors to be approved by a majority of only the independent directors on the board (whether or not present and participating) for tabling at shareholders’ meetings;

- Resolutions electing new independent directors at shareholders’ meetings to be approved by a majority only of shareholders not in operational control, with controlling shareholders not participating in the voting (such a restriction on voting rights has already been accepted in principle in case of related party transactions). This measure is justified on the basis that one of the major role of independent directors is to monitor executive performance to ensure wealth is created and created wealth is passed on to (or held for) all the shareholders of the company; in electing such directors with a surveillance role over the executive, it is not unreasonable to disempower shareholders in management whose activities are to be so supervised, from voting and influencing the  election of such independent directors;

- Independent directors “resigning” mid-term during their tenure to be required to explain the reasons for their decision to the shareholders at an immediately following members’ meeting for approval by a majority only of non-controlling shareholders. Barring extenuating personal circumstances, such “resigning” directors may also be required to be present at the members’ meeting and respond to any questions from the non-controlling shareholders.

Pretty much the same reasoning also applies to the appointment of independent statutory auditors whose role by definition is to objectively examine the affairs of the company and report to shareholders on the true and fair status of the financials. Accordingly, it would not be unfair to require that their appointment at the general meeting of members be approved by a majority of non-controlling shareholders, with the controlling shareholders’ votes not being reckoned. Auditors’ resignations or proposals for their replacement may also similarly be required to be subject to approval of the majority of non-controlling shareholders, with such auditors being required to explain their viewpoint to them.

D.        Towards Better Governance in a World of Concentrated Corporate Ownership

It is apparent from this discussion that Indian corporate law leans towards protecting and promoting shareholder primacy even while recognising other stakeholder interests and  offering substantial freedom to the boards and the executive to carry out their responsibilities. The sting in the tail however is that many of these wholesome provisions are frustrated partly out of non-controlling shareholders’ own indifference and partly by gaps in measures aimed at containing self-serving controlling shareholders in pursuit of their illicit objectives. Of course, there will be, and indeed are, examples of excellence even now of controlling shareholders with exemplary concern and behaviour towards absentee shareholders and their interests but regrettably they are relatively a small proportion of the total corporate population. This post has enumerated some of the measures that may help to bridge these gaps and take the country closer to better standards of governance in the corporate sector.   

As a general rule, excessive and invasive legislation is not a preferred option in a free market economy and it would be ever more desirable if corporations were to adopt such measures on their own and distinguish themselves from the rest. Sadly, experience in most countries has shown that corporations tend to respond to mandates than exhortations. Affirmative action in respect of having due share of women on corporate boards is a telling instance of legislation over persuasion being the more effective method of achieving objectives as observed in continental Europe and the UK in recent decades. Nevertheless, the recommended measures may perhaps first be introduced on a “comply or explain” basis and depending upon the level of observed compliance in practice over a two or three year period, and be made mandatory if found necessary.

- Bala N. Balasubramanian




[1] Assistance provided by Jitendra Nath Gupta and Stakeholder Empowerment Services is gratefully acknowledged

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