Independent directors or toothless tigers?

With the increased focus on shareholders’ wealth maximisation as the key corporate objective, regulators worldwide have understood the role independent directors can play to safeguard the interests of minority shareholders.

Clause 49 of the Listing Agreement in India, for example, expects the boards of listed companies with non-executive chairman to have at least one-third independent directors. The board must have at least 50 per cent independent directors if the company has an executive chairman.

While, in principle, it is a good idea to have many independent directors on the board, this in itself does not guarantee that minority shareholders’ interests are protected. At the end of the day, independent directors are appointed by executives of the company. Academic research finds companies largely appoint independent directors who remain loyal to the management.

So even if these directors are competent, they do not question the management. This, therefore, raises questions regarding the wisdom in according increasing focus on the number of independent directors. There can be possible reasons why academic research does not find any link between independent directors and financial performance.

It is possible, for example, that the company appoints more independent directors after a disappointing performance. One cannot expect the performance of such firms to improve overnight.

Second, independent directors suffer from having inadequate knowledge about the company. Satyam is a case in point. So, one cannot expect much from these directors. Third, independent directors may indeed be inefficient. Even when they are efficient, as they are appointed by the management, they may prefer to support the management.

We, therefore, looked at the financial performance of 5,317 companies and 20,999 directors to know the value created by independent directors in India. We looked at the return on equity generated by these firms in three fiscals (2013, 2014 and 2015) to see if there is any link between having more independent directors and the company’s financial performance.

We first compared the RoE figures for the companies that have more independent directors than required by the law, and compared that with the RoE for companies that just followed the Clause 49 requirements. As the chart shows, the former companies have actually reported marginally lower return on equity in all the three years that we studied.

Recruiting the right types of independent directors requires expertise and not every company can afford to do it. Section 165 of the Companies Act 2013 specifies that no person can be an independent director in more than 20 companies (including 10 public companies). There is definitely some merit in this rule. However, it creates an artificial shortage in the market for good independent directors. The number of qualified and effective independent directors is limited and those who are known to be efficient will be hired by big companies.

In fact, group companies can share their knowledge with each other and can ensure that the same independent director is hired by most of the group companies. Academic research shows that companies get the maximum benefit from independent directors when they are members on the board of another four companies. We performed a similar analysis to see if a pattern exists here.

In India, companies that hire independent directors who are members of another 10 companies get the maximum benefit from it. This pattern is found for companies with all the four ownership groups — MNCs, Indian businesses, public sector enterprises, and others. Our results show companies that hire more independent directors than is legally necessary are not necessarily more profitable. In fact, companies that do not hire more independent directors than is legally necessary are more profitable.

These results indicate shareholders do not necessarily benefit if the board consists of more independent directors. Of course, there may be a selection bias in the sample as the companies that are not doing well probably have hired more independent directors to eliminate possible corporate mis-governance problems.

We also find that independent directors who also serve on the board of 10 other companies prove to be quite valuable to companies. The demand for good independent directors is much higher than the total supply. We find the total number of independent directors to be only 10,978 in our sample.

Given that India has over 5,500 listed firms, the demand for independent directors is high. Only the profitable companies are able to hire the good independent directors. These directors serve on an average on 11 boards (including at least one private company).

Independent directors can play a more important and useful role in the functioning of the board if they ensure protection of the interests of minority shareholders. Indian companies started recognising the importance of independent directors only in this century and it is probably too early to expect them to really play the role they are expected to play.

The following moves can make a difference:

a) Section 165 of the Companies Act can be relaxed to ensure that other companies can benefit from the experience of independent directors. Probably, the law can be stated in terms of a maximum number in each ownership category of company that an independent director can serve to ensure that majority of the minority shareholders get benefited.

Indian media and analysts largely cover big companies and corporate mis-governance problems in smaller companies barely get noticed. Such a rule will help the minority shareholders of smaller and less profitable firms.

b) Clause 49 of the listing agreement makes the entire exercise of independent directors limited to legally-defined numbers. All companies follow the norm.

But unless independent directors give their independent views at board meetings, it will not serve any purpose in having them. That is probably why we find companies that hire more independent directors report lower RoE than companies that don’t.

Though on paper, shareholders decide whether a particular person should be appointed as a director or not, usually, all resolutions get passed in the AGM. Since not much information is available about most independent directors, minority shareholders also cannot take an independent view. In such a case, the view of proxy firms or some independent rating agency would prove to be useful to all the minority shareholders in the country.

Mohanty is with XLRI Jamshedpur and Mishra is with IMI Bhubaneswar

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